PAPER: BUSINESS ADMINISTRATION (100 MARKS)

Management
 Defining Organization, Management, and Management in Organizations

Organization
An organization or organisation is an entity comprising multiple people, such as an institution or
an association, that has a particular purpose.
The word is derived from the Greek word organon, which means tool or instrument, musical instrument,
and organ.
Types[edit]
There are a variety of legal types of organisations, including corporations, governments, non-governmental
organisations, political organisations, international organisations, armed forces, charities, not-for-profit
corporations, partnerships, cooperatives, and educational institutions.
A hybrid organisation is a body that operates in both the public sector and the private sector simultaneously,
fulfilling public duties and developing commercial market activities.
A voluntary association is an organisation consisting of volunteers. Such organisations may be able to operate
without legal formalities, depending on jurisdiction, including informal clubs or coordinating bodies with a goal
in mind which they may express in the form of an Manifesto, Mission statement,or in an informal manner
reflected in what they do because remember every action done by an organization both legal and illegal reflects
a goal in mind.[1][2]
Organisations may also operate secretly or illegally in the case of secret societies, criminal
organisations and resistance movements. And in some cases may have obstacles from other organizations
(ex: MLK's organization)[3] but what makes an organization an organization is not the paperwork that makes it
official but to be an organization there must be four things:
1. A goal in mind
2. A leader or committee making the decision
3. action involved
4. communication and members.
But what makes an organization recognized by the government is either filling out Incorporation (business) or
recognition in the form of either societal pressure (ex: Advocacy group), causing concerns (ex: Resistance
movement) or being considered the spokesperson of a group of people subject to negotiation (ex: the Polisario
Front being recognized as the sole representative of the Sahawri people and forming a partially recognized
state.)
Compare the concept of social groups, which may include non-organizations.[4]
Structures[edit]
Diagram of the Federal Government and American Union, 1864.
Main article: Organizational structure
The study of organisations includes a focus on optimising organisational structure. According to management
science, most human organisations fall roughly into four types:[citation needed]
 Committees or juries
 Ecologies
 Matrix organisations
 Pyramids or hierarchies
Committees or juries[edit]
These consist of a group of peers who decide as a group, perhaps by voting. The difference between a jury and
a committee is that the members of the committee are usually assigned to perform or lead further actions after
the group comes to a decision, whereas members of a jury come to a decision. In common law countries, legal
juries render decisions of guilt, liability and quantify damages; juries are also used in athletic contests, book
awards and similar activities. Sometimes a selection committee functions like a jury. In the Middle Ages, juries
in continental Europe were used to determine the law according to consensus among local notables.
Committees are often the most reliable way to make decisions. Condorcet's jury theorem proved that if the
average member votes better than a roll of dice, then adding more members increases the number of majorities
that can come to a correct vote (however correctness is defined). The problem is that if the average member is
subsequently worse than a roll of dice, the committee's decisions grow worse, not better; therefore, staffing is
crucial.
Parliamentary procedure, such as Robert's Rules of Order, helps prevent committees from engaging in lengthy
discussions without reaching decisions.
Ecologies[edit]
This organisational structure promotes internal competition. Inefficient components of the organisation starve,
while effective ones get more work. Everybody is paid for what they actually do, and so runs a tiny business
that has to show a profit, or they are fired.
Companies who utilise this organisation type reflect a rather one-sided view of what goes on in ecology. It is
also the case that a natural ecosystem has a natural border - ecoregions do not, in general, compete with one
another in any way, but are very autonomous.
The pharmaceutical company GlaxoSmithKline talks about functioning as this type of organisation in this
external article from The Guardian. By:Bastian Batac De Leon.
Matrix organisation[edit]
See also: Matrix management
This organisational type assigns each worker two bosses in two different hierarchies. One hierarchy is
"functional" and assures that each type of expert in the organisation is well-trained, and measured by a boss who
is super-expert in the same field. The other direction is "executive" and tries to get projects completed using the
experts. Projects might be organised by products, regions, customer types, or some other schemes.
As an example, a company might have an individual with overall responsibility for products X and Y, and
another individual with overall responsibility for engineering, quality control, etc. Therefore, subordinates
responsible for quality control of project X will have two reporting lines.
Pyramids or hierarchical[edit]
A hierarchy exemplifies an arrangement with a leader who leads other individual members of the organisation.
This arrangement is often associated with basis that there are enough imagine a real pyramid, if there are not
enough stone blocks to hold up the higher ones, gravity would irrevocably bring down the monumental
structure. So one can imagine that if the leader does not have the support of his subordinates, the entire structure
will collapse. Hierarchies were satirised in The Peter Principle (1969), a book that
introduced hierarchiology and the saying that "in a hierarchy every employee tends to rise to his level of
incompetence."
Theories[edit]
See also: Organizational theory
In the social sciences, organisations are the object of analysis for a number of disciplines, such
as sociology, economics,[5] political science, psychology, management, and organisational communication. The
broader analysis of organisations is commonly referred to as organisational structure, organisational
studies, organisational behaviour, or organisation analysis. A number of different perspectives exist, some of
which are compatible:
 From a functional perspective, the focus is on how entities like businesses or state authorities are used.
 From an institutional perspective, an organisation is viewed as a purposeful structure within a social
context.
 From a process-related perspective, an organisation is viewed as an entity is being (re-)organised, and
the focus is on the organisation as a set of tasks or actions.
Sociology can be defined as the science of the institutions of modernity; specific institutions serve a function,
akin to the individual organs of a coherent body. In the social and political sciences in general, an
"organisation" may be more loosely understood as the planned, coordinated and purposeful action of human
beings working through collective action to reach a common goal or construct a tangible product. This action is
usually framed by formal membership and form (institutional rules). Sociology distinguishes the term
organisation into planned formal and unplanned informal (i.e. spontaneously formed) organisations. Sociology
analyses organisations in the first line from an institutional perspective. In this sense, organisation is an
enduring arrangement of elements. These elements and their actions are determined by rules so that a certain
task can be fulfilled through a system of coordinated division of labour.
Economic approaches to organisations also take the division of labour as a starting point. The division of labour
allows for (economies of) specialisation. Increasing specialisation necessitates coordination. From an economic
point of view, markets and organisations are alternative coordination mechanisms for the execution
of transactions.[5]
An organisation is defined by the elements that are part of it (who belongs to the organisation and who does
not?), its communication (which elements communicate and how do they communicate?), its autonomy (which
changes are executed autonomously by the organisation or its elements?), and its rules of action compared to
outside events (what causes an organisation to act as a collective actor?).
By coordinated and planned cooperation of the elements, the organisation is able to solve tasks that lie beyond
the abilities of the single elements. The price paid by the elements is the limitation of the degrees of freedom of
the elements. Advantages of organisations are enhancement (more of the same), addition (combination of
different features) and extension. Disadvantages can be inertness (through co-ordination) and loss of interaction.
Among the theories that are or have been influential are:
 Activity theory is the major theoretical influence, acknowledged by de Clodomir Santos de Morais in the
development of Organisation Workshop method.
 Actor–network theory, an approach to social theory and research, originating in the field of science
studies, which treats objects as part of social networks.
 Complexity theory and organisations, the use of complexity theory in the field of strategic
management and organisational studies.
 Contingency theory, a class of behavioural theory that claims that there is no best way to organize a
corporation, to lead a company, or to make decisions.
 Critical management studies, a loose but extensive grouping of theoretically informed critiques of
management, business, and organisation, grounded originally in a critical theory perspective
 Economic sociology, studies both the social effects and the social causes of various economic
phenomena.
 Enterprise architecture, the conceptual model that defines the coalescence of organisational structure and
organisational behaviour.
 Garbage Can Model, describes a model which disconnects problems, solutions and decision makers
from each other.
 Principal–agent problem, concerns the difficulties in motivating one party (the "agent"), to act in the best
interests of another (the "principal") rather than in his or her own interests
 Scientific management (mainly following Frederick W. Taylor), a theory of management that analyses
and synthesises workflows.
 Social entrepreneurship, the process of pursuing innovative solutions to social problems.
 Transaction cost theory, the idea that people begin to organise their production in firms when the
transaction cost of coordinating production through the market exchange, given imperfect information,
is greater than within the firm.
 Weber's Ideal of Bureaucracy (refer to Max Weber's chapter on "Bureaucracy" in his book Economy and
Society)
Leadership[edit]
Main article: Leadership
A leader in a formal, hierarchical organisation, is appointed to a managerial position and has the right to
command and enforce obedience by virtue of the authority of his position. However, he must possess adequate
personal attributes to match his authority, because authority is only potentially available to him. In the absence
of sufficient personal competence, a manager may be confronted by an emergent leader who can challenge his
role in the organisation and reduce it to that of a figurehead. However, only authority of position has the
backing of formal sanctions. It follows that whoever wields personal influence and power can legitimise this
only by gaining a formal position in the hierarchy, with commensurate authority.[6]
Formal organisations[edit]
An organisation that is established as a means for achieving defined objectives has been referred to as a formal
organisation. Its design specifies how goals are subdivided and reflected in subdivisions of the organisation.
Divisions, departments, sections, positions, jobs, and tasks make up this work structure. Thus, the formal
organisation is expected to behave impersonally in regard to relationships with clients or with its members.
According to Weber's definition, entry and subsequent advancement is by merit or seniority. Each employee
receives a salary and enjoys a degree of tenure that safeguards him from the arbitrary influence of superiors or
of powerful clients. The higher his position in the hierarchy, the greater his presumed expertise in adjudicating
problems that may arise in the course of the work carried out at lower levels of the organisation. It is this
bureaucratic structure that forms the basis for the appointment of heads or chiefs of administrative subdivisions
in the organisation and endows them with the authority attached to their position.[7]
Informal organisations[edit]
In contrast to the appointed head or chief of an administrative unit, a leader emerges within the context of
the informal organisation that underlies the formal structure. The informal organisation expresses the
personal objectives and goals of the individual membership. Their objectives and goals may or may not
coincide with those of the formal organisation. The informal organisation represents an extension of the social
structures that generally characterise human life – the spontaneous emergence of groups and organisations as
ends in themselves.[7]
In prehistoric times, man was preoccupied with his personal security, maintenance, protection, and survival.
Now man spends a major portion of his waking hours working for organisations. His need to identify with a
community that provides security, protection, maintenance, and a feeling of belonging continues unchanged
from prehistoric times. This need is met by the informal organisation and its emergent, or unofficial, leaders.[6]
Leaders emerge from within the structure of the informal organisation. Their personal qualities, the demands of
the situation, or a combination of these and other factors attract followers who accept their leadership within
one or several overlay structures. Instead of the authority of position held by an appointed head or chief, the
emergent leader wields influence or power. Influence is the ability of a person to gain cooperation from others
by means of persuasion or control over rewards. Power is a stronger form of influence because it reflects a
person's ability to enforce action through the control of a means of punishment.
Management and Organizational Design
Management can be described as the people who design an organization’s structure and determine how different
aspects of the organization will interact. When designing an organization, managers must consider
characteristics such as simplicity, flexibility, reliability, economy, and acceptability. Different levels of
management will participate in different components of this design process, with upper management creating
the initial organizational architecture and structure.
Organizational design is largely a function based on systems thinking. Systems thinking involves identifying the
moving parts within an organization that add value and ensuring that these parts function together as an
effective and efficient whole. Perspective is essential in systems thinking: a manager’s role in organizational
design is to refrain from thinking of departments, individuals, processes, and problems as separate from the
system and instead think of them as indivisible components of the broader organizational process.
Modern organizations exist within a framework of globalization and constant technological disruptions; as a
result their organizational design is less static than in the past. Management must actively adapt organizations to
meet various challenges, opportunities, and technological improvements to maintain competitive output.
Because the organization is always changing, the problems of process and design are essentially limitless. Using
a systems approach, managers view their objectives as moving targets and actively engage in expanding the
organization day by day.
Management Processes
Organizations can be viewed as systems in which management creates the architecture for the system of
production. Managers’ role in organizational design is central but must be understood in the context of their
overall responsibilities within the organization.
Management operates through functions such as planning, organizing, staffing, leading/directing,
controlling/monitoring, and motivation. These functions enable management to create strategies and compile
resources to lead operations and monitor outputs.

The functions of management: Management operates through four main functions: planning, organizing,
directing (i.e., leading), and controlling (i.e., monitoring and assessing).
Management Hierarchy
All levels of management perform these functions. However, the amount of time a manager spends on each
function depends on the level of management and the needs of the organization—factors which play a role in
organizational design.
 Top-level managers include the board of directors, president, vice-president, CEO, and other similar
positions. They are responsible for planning and directing the entire organization.
  Middle-level managers include general managers, branch managers, and department managers, all of
whom are accountable to the top-level management for the functions of their departments. They devote
more time to organizing and directing.
 First-level managers include supervisors, section leads, foremen, and similar positions. They focus on
controlling and directing.
As a result of this hierarchy, upper management will view the organizational design from a macro-level and
consider all moving parts of the organization. Middle-management will generally focus on operations within
functional or geographic areas. Lower-level managers will look at specific processes within functions or
regions. From an organizational-design perspective, the higher managers are in the organization, the broader the
view they will take and the greater number of moving parts they will consider.
Basic Types of Organizations
Most organizations fall into one of four types: pyramids/hierarchies, committees/juries, matrix organizations,
and ecologies.
Basic Definition
Most of us have worked in an organization of people -- even a family is a type of organization. The word is so
widely used that its meaning can sometimes be lost. The word means a collection of resources that are working
together somehow to achieve a common purpose. When we talk about an organization, we are usually referring
to a group of people.
Organizations of people come in many forms. They might be a random group of people who spontaneously
came together to address a short-term need, such as collecting litter along a certain stretch of road. Or, it might
be a carefully collected, aligned and integrated group of people who came together for the long-term to address
a long-term need, such as stopping poverty in a certain country.
An overall organization can have a variety of small organizations within it, for example, various departments
and teams of people. The way that people work together in an organization depends on a variety of factors,
including the values in their culture, the nature of their leadership and types of current needs they are working to
address. See What Makes Each Organization Unique.
Let us look at some other definitions of the word "organization" and some more about how an organization
works toward a common purpose.
Organization (Wikipedia)
Organization: Meaning, Definition, Concepts and Characteristics
Organization's Purpose and Priorities
Mission
All of the people in an organization should be working toward a common purpose. That purpose is often
referred to as the mission. The mission might be implied to its members or explicitly expressed to them. When
explicitly expressed, it is often in the form of a mission statement. The statement is often reviewed during a
process called strategic planning.
Vision
The organization's vision is an image of what success would look like at some point in the future, both for the
people that the organizations serves and for the organization itself. It can be very inspirational and motivational
to explicitly articulate that vision in a statement like the mission statement during strategic planning.
Values
The organization's values are the overall priorities in the nature of how the organization wants to work toward
its mission. Values can be reflected in how the people in the organization are actually working together. These
might be referred to as real or enacted values. Values can also be about how the organization wants it members
to work together. These might be referred to as desired values.
Strategic Priorities
These are the overall, most important matters and activities for members to attend to, when working toward the
mission. Similar to the mission, vision and values, they might be implied or explicit among members. The
priorities might be associated with assignments for who is address which ones and by when. The priorities are
often referred as "strategic goals" during a strategic planning process.
Thus, it could seem to be a major challenge when working to lead, manage or improve an organization.
Fortunately, there are some things in common to all types of organizations -- because they all are systems. (We
will review more about systems later in this series of articles.

Learn More in the Library's Blogs Related to Organizations

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For the Category of Organizational Development:

To round out your knowledge of this Library topic, you may want to review some related topics, available from
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Also, scan the Recommended Books listed below. They have been selected for their relevance and highly
practical nature.
Related Library Topics
Recommended Books
A social unit of people that is structured and managed to meet a need or to pursue collective goals. All
organizations have a management structure that determines relationships between the different activities and the
members, and subdivides and assigns roles, responsibilities, and authority to carry out different tasks.
Organizations are open systems--they affect and are affected by their environment.

Defining “Organization”
Many people have attempted to define what is meant by the word “organization.” Instead of following suit and
throwing yet another definition into the mix, we’ve selected a number of definitions from common dictionary
definitions to ones used by business, psychology, economics, and communication scholars. Table 1.1 "Defining
“Organization”" contains a partial list of the different types of definitions seen across various academic
disciplines.
Table 1.1 Defining “Organization”

Dictionary Definition

(1) the act of organizing or the state of being organized; (2) an organized structure or whole; (3) a business or
administrative concern united and constructed for a particular end (4) a body of administrative officials, as of
a political party, a government department, etc (5) order or system; method.organization. (2009). Collins
English Dictionary—Complete & Unabridged 10th Edition. Retrieved March 18, 2012, from Dictionary.com
website: http://dictionary.reference.com/browse/organization

General Business Definitions

“a system of consciously coordinated activities of two or more persons.”Barnard, C. I. (1938). The functions
of the executive. Cambridge, MA: Harvard University Press, pg. 73.

“The accomplishment of an objective requires collective effort, men set up an organization designed to
coordinate the activities of many persons and to furnish incentives for others to join them for this
purpose.”Blau, P. M., & Scott, W. R. (1962). Formal organizations: A comparative approach. San Francisco:
Chandler, pg. 5.

“A social unit of people, systematically structured and managed to meet a need or to pursue collective goals
on a continuing basis. All organizations have a management structure that determines relationships between
functions and positions, and subdivides and delegates roles, responsibilities, and authority to carry out defined
tasks. Organizations are open systems in that they affect and are affected by the environment beyond their
boundaries.”organization. (n.d.). Retrieved March 18, 2012, from BusinessDictionary.com
website: http://www.businessdictionary.com/definition/organization.html

“a Body of individuals working under a defined system of rules, assignments procedures, and relationships
designed to achieve identifiable objectives and goals.”Greenwald, H. P. (2008). Organizations: Management
without control. Los Angeles, CA: Sage, pg. 6.

Organizational Behavior Definitions

“a social unit within which people have achieved somewhat stable relations (not necessarily face-to-face)
among themselves in order to facilitate obtaining a set of objectives or goals.”Litterer, J. A.
(1963). Organizations: Structured behavior. New York: John Wiley and Sons, pg. 5.

“an organization is a complex system, which includes as subsystems: (1) management, to interrelate and
integrate through appropriate linking processes all the elements of the system in a manner designed to achieve
the organizational objectives, and (2) a sufficient number of people so that constant face-to-face interaction is
impossible.”Lundgren, E. F. (1974). Organizational management: Systems and process. San Francisco:
Canfield Press, pg. 7.

Economics Definition
A short hand expression for the integrated aggregation of those persons who are primarily involved in: “(1)
the undertaking or managing of risk and the handling of economic uncertainty; (2) planning and innovation;
(3) coordination, administration and control; (4) and routine supervision” of an enterprise.Harbison, F. (1959).
Entrepreneurial organization as a factor in economic development. The Quarterly Journal of Economics, 70,
364–379, pg. 365.

Industrial/Organizational Psychology Definition

“work consists of patterned human behavior and the ‘equipment’ consists of the human beings.”Katz, D., &
Kahn, R. L. (1978). The social psychology of organizations. New York, NY: John Wile & Sons, pg. 55.

“lively sets of interrelated systems [task, structure, technology, people, and the environment] designed to
perform complicated tasks.”Levitt, H. J. (1972). Managerial psychology: An introduction to individuals,
pairs, and groups in organizations. Chicago: The University of Chicago Press, pg. 265.

Organizational Communication Definitions

“social collectives in which people develop ritualized patterns of interaction in an attempt to coordinate their
activities and efforts in the ongoing accomplishment of personal and group goals.”Kreps, G. L. (1986).
Organizational communication. New York: Longman, pg. 5.

“including five critical features—namely, the existence of a social collectivity, organizational and individual
goals, coordinated activity, organizational structure, and the embedding of the organization with an
environment of other organizations.”Miller, K. (2012). Organizational communication: Approaches and
processes (6th ed.). Boston, MA: Wasdworth-Cengage, pg. 11.

“Communicative structures of control.”Mumby, D. (in press). Organizational communication. Los Angeles,

CA: SAGE.

“an organized collection of individuals working interdependently within a relatively structured, organized,
open system to achieve common goals.”Richmond, V. P., & McCroskey, J. C. (2009). Organizational
communication for survival: Making work, work (4th ed.). Boston: Allyn & Bacon, pg. 1.

“an aggregate of persons, arranged in predetermined patterns of relationships, in order to accomplish stated
objectives.”Redding, W. C. (1964). The organizational communicator. In W. C. Redding & G. A Sanborn
(Eds.), Business and industrial communication: A source book (pp. 29–58). New York: Harper & Row, pg.
33.

After reading this laundry list of different definitions for the word “organization,” you may wonder how you to
determine which one is the best? Well, to be honest—we think they all have something to offer. When you look
at the various definitions for the word “organization,” you will start to see a certain pattern emerge of consistent
themes within the definition. Jason WrenchWrench, J. S. (in press). Communicating within the modern
workplace: Challenges and prospects. In J. S. Wrench (Ed.), Workplace communication for the 21st century:
Tools and strategies that impact the bottom line: Vol. 1. Internal workplace communication. Santa Barbara, CA:
Praeger. examined a similar list of definitions and concluded that there are three primary features that run
through all definitions of the term “organization”: the structure, the goal, and the people.
Organizational Structures
The first major theme commonly seen in the various definitions of the word “organization” has to do
with structure. When we talk about how organizations are structured, we are talking primarily about how they
function in terms of what happens both within an organization and how an organizations functions within its
external environment. For our purposes, we will look at structure in terms of four basic processes: external
environment, input, throughput, and output (Figure 1.1 "Organizational Structures")
Figure 1.1 Organizational Structures

External Environment
The first factor to consider when thinking about an organization is the external environment that an organization
exists in. The external environment consists of all vendors, competitors, customers, and other stakeholders who
can have an impact on the organization itself but exist outside the boundaries of the organization. Changes in
the external environment where an organization exists will have an effect on the organization itself. For
example, image that the government is going to pose new regulations on your industry, these new regulations
will have an effect on how the organization must function. When it comes to how organizations interact with its
external environment, we often refer to two different types of boundaries. An organization that has open
boundaries allows for the free flow of information to the organization and is more likely able to adapt to
changes that occurs within the environment. Closed boundaries, on the other hand, occur when an organization
tries to insulate itself from what is occurring within its environment. When an organization has closed
boundaries, that organization ends up being less aware of what is going on within the external environment and
sets itself up for major problems or obsolescence.
Input
The next major aspect of an organization’s environment involves inputs. Inputs are those resources that an
organization brings in from the external environment in order for the organization to accomplish its goals.
Typically, resources can be discussed in three general categories: physical materials, people, and information.
First, organizations bring in physical materials that it needs to accomplish its goals. Whether its computers,
desks, light fixtures, or supplies necessary to build silicon microchips, organizations rely on a variety of vendors
in the external environment to provide physical materials.
The second type of input necessary from the external environment involves people. People can either come in
the forms of workers, which are necessary resources for any organization. An organization is reliant on bringing
in skilled workers to help the organization accomplish its goals. One of the biggest complaints many
organizations have is a lack of skilled or qualified workers. Depending on the organization, skills or
qualifications can run from specific college or graduate degrees to specific industry experience to specific
technical know-how. According to Julian L. Alssid, executive director of the Workforce Strategy Center in New
York, "Employers seem to be less willing to invest in training in this economy. Again, it is the combination of
the right credential and practical experience they look for."Balderrama, A. (2010, February 22). Available jobs,
not enough skilled workers [online article]. Retrieved from http://msn.careerbuilder.com/Article/MSN-2192-
Job-Search-Available-Jobs-Not-Enough-Skilled-Workers/, Paragraph 7.
The final type of input an organization needs is information. Information refers to any data that is necessary for
an organization to possess in an effort to create knowledge.Atwood, C. G. (2009). Knowledge management
basics: A complete how-to guide. Alexandria, VA: ASTD Press. According to the American Society for
Training and Development (ASTD), data is “is raw and without context and can exist in any form, usable or
not.”ASTD. (2006). Managing organizational knowledge. In E. Biech (series Ed.), ASTD Learning System, Vol.
8. Alexandria, VA: ASTD Press, pg. 2. Often organizations end up with piles of data including customer service
reports, market trends, and other material typically in the raw, numerical form. Organizations then turn this data
into information by giving the data meaning through some kind of interpretation. While most people think of
data as purely numerical, there are other non-numerical types of data that can be important to turn into
information. For example, if the US congress passes a new law that impacts how your organization must handle
customer records, the law may not specifically say how your organization must comply with the law. In this
case, the new law is data and your organization must turn that law into usable information in the form of its own
policies and procedures. When you combine information with understanding that leads to action, information is
transformed from information to knowledge.
So, how do organizations go about acquiring data that can lead to action? ASTD discusses two types of external
environment scanning processes that organizations can employ: proactive and reactive.ASTD. (2006).
Managing organizational knowledge. In E. Biech (series Ed.), ASTD Learning System, Vol. 8. Alexandria, VA:
ASTD Press. First, proactive scanning occurs when an organization actively looks for data or existing
information that could be transformed into useable knowledge. For example, doing research on what your
competitors in an effort to stay on top of your market is an example of proactive scanning. The second type of
scanning, reactive scanning occurs when an organization faces a specific problem or crisis and then either
makes sense of data/information it poses or searches the external environment for data or information that could
be useful. Ideally, if an organization does a good job with proactive scanning, reactive scanning will not be
necessary very often. When an organization is forced to use reactive scanning, time gets wasted as they attempt
to find the data/information and turn it into actionable knowledge.
Throughput
Throughput is ultimately what an organization does with inputs within the confines of the organization itself.
Throughput can range from the use physical materials, people, and information to how organizations structure
themselves internally to create goal oriented throughput. While we cannot discuss every possible way an
organization can utilize inputs, we should note that the issue of internal organizational structure is very
important at this level of an organizations. For this reason, we really must discuss two ways that organizations
commonly structure hierarchies.
A hierarchy is a categorization system where individuals/departments are ranked over other
individuals/departments based on skills, centrality, and status. First, organizations can place people/departments
over others because of specific skill sets. For example, managers are placed over workers because of their skills
in managing people. While we know this isn’t always why people get promoted, the general idea of a
management class of people is because managers can help organize employees towards the organization’s
goal(s). Second, people can be ranked over others because of their centrality to the organization’s goals. For
example, if your organization is a tech company, the product developers may be ranged structurally over people
in customer support or marketing because without the product developers there is no need for customer support
or marketing. Lastly, organizations can be organized based on status, an individual’s relative position to others
as a result of esteem, privilege, or responsibility. When someone gets promoted to a higher position, her or his
status increases in terms of a formal hierarchy. Whether that promotion is a result of esteem, privilege, or
responsibility doesn’t matter at this point, only the elevation within the hierarchy.
Now that we’ve discussed what a hierarchy is, let’s talk about the two common ways that organizations are
typically patterned: flat vs. tall hierarchies (Figure 1.2 "Hierarchies").
Figure 1.2 Hierarchies
The first image in Figure 1.2 "Hierarchies" represents tall hierarchies, they are called such because they
represent many, many hierarchical layers between those at the bottom of the hierarchy and those at the top of
the hierarchy. Two commonly discussed tall hierarchies are the Catholic Church and the US military. With the
Catholic Church, you have the average parishioner at the bottom of the hierarchy the Pope at the top of the
hierarchy. In the US military, you have your average enlisted soldier at the bottom of the hierarchy and the
President of the United States (in her/his commander in chief title) at the top of the hierarchy. In both cases, the
people at the bottom have little or no communication with those at the top of the hierarchy.
The second image in Figure 1.2 "Hierarchies" represents flat hierarchies where there are only a couple of
hierarchical layers between those at the bottom and those at the top of the hierarchy. Think of these
organizations like mom and pop restaurants. In a typical small restaurant, the owner may also serve as the chef
and may only have a handful of waitstaff, table bussers, and dish cleaners as employees. In these hierarchies, it
is very easy for those at the bottom of the hierarchy to communicate with those at the top of the hierarchy.
Output
The final aspect related to organizational structure is output, which is the ultimate product or service that an
organization disseminates back to the external environment. Whether one is create the components of a cell
phone or sending computer technicians to people’s homes, every organization is designed to produce some kind
of service or product for the external environment. Even nonprofit organizations like the American Red Cross
are producing a range of both products and services for the external environment.
Organizational Goals
Organizations have many goals, but it helps to clarify those goals into a simple typology (classification into
ordered categories). Edward Gross examined the various types of organizational goals and created a simple
typology consisting of five distinct goals that organizations have: output, adaptation, management, motivation,
and positional.Gross, E. (1969). The definition of organizational goals. The British Journal of Sociology, 20,
277–294.
Output
The first type of goal that organizations commonly have are referred to as output goals, or organizational goals
that are “reflected, immediately or in the future, in some product, service, skill or orientation which will affect
(and is intended to affect) that society.”Gross, E. (1969). The definition of organizational goals. The British
Journal of Sociology, 20, 277–294, pg. 287. While Gross was initially discussing goals in terms of educational
organizations, the goals also apply to other organizational types as well. In essence, every organization has
some type of output goal that will be released back into the external environment. For a pizza chain, the output
goal could be the pizza it delivers to your house (product); the customer service it gives customers (service); or
the expertise in pizza making it brings to the enterprise (skill).
Adaptation
The second type of organizational goal argued by Edward Gross are adaptation goals, or goals that an
organization has in terms of adapting to the external environment.Gross, E. (1969). The definition of
organizational goals. The British Journal of Sociology, 20, 277–294. All organizations exist in environments
that change, and successful organizations are going to change and adapt to that external environment. One of
the biggest risks many organizations face if they do not adapt to the external environment is obsolescence,
which “occurs when there is a significant decline in customer desire for an organization’s products or
services.”Wrench, J. S. (2012). Casing organizational communication. Dubuque, IA: Kendall-Hunt, pg.
11. Many organizations becomes so focused on making a specific product that the product eventually is no
longer wanted or needed by customers, which will lead to the eventual death of an organization.
Management
The next type of organizational goal discussed by Edward Gross are management goals, which involves three
types of decisions: (1) who will manage or run an organization, (2) how to handle conflict management, and (3)
output goal prioritization.Gross, E. (1969). The definition of organizational goals. The British Journal of
Sociology, 20, 277–294. First, organizations need to decide on the formal structure of an organization and who
will exist at various rungs of the hierarchy. In addition to determining the formal structure, these goals also
determine what type of and who holds power within the organizational hierarchy. Second, managerial goals
focus on how conflicts within the organization will be handled. Organizations have a vested interest in keeping
the organization running smoothly, so too much conflict can lead to interpersonal or inter-departmental
bickering that has negative consequences for the organization. Lastly, management goals determine the
overarching direction of the organization itself. As the saying goes, someone has to steer the ship. We’ll discuss
different types of leaders in Chapter 7 "Leader and Follower Behaviors & Perspectives", but for now we’ll just
note that having a clear direction and clear prioritization of the products and services an organization has is very
important for the health of an organization. If an organization tries to do too much, the organization may end up
scatter-brained and not function as a cohesive whole. If the organization tries to do one and only one thing, the
organization may become obsolescent. Overall, people in management must place output goal prioritization
very high on the to-do-list.
Motivation
The fourth common goal organizations have, as discussed by Edward Gross, are motivational goals or goals set
out to ensure that all employees are satisfied and remain loyal to the organization.Gross, E. (1969). The
definition of organizational goals. The British Journal of Sociology, 20, 277–294. There is a wealth of research
that has examined the importance of employee motivation on job satisfaction and worker productivity.Latham,
G. P. (2007). Work motivation: History, theory, research, and practice. Thousand Oaks, CA: SAGE. In a study
conducted by Whitman, Van Rooy, and ViswesvaranWhitman, D. S., Van Rooy, D. L., & Viswesvaran, C.
(2010). Satisfaction, citizenship behaviors, and performance in work units: A meta-analysis of collective
construct relations. Personnel Psychology, 63, 41–81. doi:10.1111/j.1744-6570.2009.01162.x, the researchers
examined the relationship between job satisfaction and employee productivity across 73 different research
studies that have examined the subject. Overall, the researchers concluded that satisfied employees were more
productive. Secondly, ensuring that employees are motivated also helps to ensure that employees remain loyal
to an organization. According to Hart and Thompson, employee loyalty is “an individual’s perception that both
parties to a relationship [employee and organization] have fulfilled reciprocal expectations that 1) demote
enduring attachment between two parties, and that 2) involve self-sacrifice in the face of alternatives, and that
3) are laden with obligations of duty.”Hart, D. W., & Thompson, J. A. (2007). Untangling employee loyalty: A
psychological contract perspective. Business Ethics Quarterly, 17, 297–323, pg. 300. By this definition
employees are loyal because they knowingly enter into a relationship with an organization, sacrifice part of
themselves to the organization (and vice versa), and thus feel a sense of obligation or duty to the organization.
Of course, loyalty only works when an employee feels that the organization is standing up to its end of the
reciprocal expectations. If an employee feels that an organization is not meeting its basic obligations, then the
employee will view that organization unkindly and the employees loyalty will diminish over time.Hajdin, M.
(2005). Employee Loyalty: An Examination. Journal Of Business Ethics, 59, 259–280. doi:10.1007/s10551-
005-3438-4 As such, organizations must strive to make one of its goals ensuring that it is meeting its basic
obligations towards employees in an effort to foster employee loyalty.
Positional
The final type of organizational goal described by Edward Gross are positional goals, which are goals that
attempt to position an organization within the environment in comparison to other organizations within the
same market.Gross, E. (1969). The definition of organizational goals. The British Journal of Sociology, 20,
277–294. For example, imagine that your organization is an automotive tool manufacturer. Your organization
will attempt to position itself against other automotive tool manufacturers that exist in the market. There are two
common ways to position one’s self within a specific market: 1) higher volume at a lower price or 2) higher
quality at a higher price. The first way to position one’s self within a market is to create more products or faster
service at a cheaper cost. The second way to position one’s self in the market is to create a luxury
product/service that costs more. While the product or service costs more, you provide the appearance of being
the luxury brand. In a 2011 article in PCWorld, the authors mention that 56% of new cellphone users were
purchasing an Android device as compared to only 28% that purchased an iOS (iPhone) device.Kellog, D.
(2011, September 26). In U.S. market, new smartphone buyers increasingly embracing Android [Press release].
Retrieved from http://blog.nielsen.com/nielsenwire/online_mobile/in-u-s-market-new-smartphone-buyers-
increasingly-embracing-android/ Simply put, the Android is cheaper and there are more versions of the Android
available for cellphone subscribers. Only Apple makes iOS compatible cellphones and they are typically more
expensive than Android devices. Apple has historically set itself up as a luxury line in the computing industry
while PCs and now Android cellphones are cheaper and made for the mass market. Interestingly, iPhones
actually only account for 4% of the overall cell phone market in November 2011, but accounted for 52% of
industry profits.Hamburger, E. (2011, December 7). These charts tell the real story of Android vs. Business
Insider. iPhone. Retrieved from http://www.businessinsider.com/android-vs-iphone-charts-2011-12 Clearly, the
iPhone may not be getting a strong percentage of the market share, but it is still beating out its competition.
Organizational People
The final characteristic common the various definitions of the word “organization” involves people. In Jason
Wrench’s original discussion of the three common themes related to people, he discussed interdependency,
interaction, and leadership.Wrench, J. S. (in press). Communicating within the modern workplace: Challenges
and prospects. In J. S. Wrench (Ed.), Workplace communication for the 21st century: Tools and strategies that
impact the bottom line: Vol. 1. Internal workplace communication. Santa Barbara, CA: Praeger. For our
purposes, we also pose the notion of control as an important factor related to people as well.
Interdependency
The first term associated with people in organizations is the concept of interdependency. Interdependency is
mutual dependence or depending on one another. Interdependency is the notion that people within an
organization are dependent upon one another to achieve the organization’s goals. If one part of the organization
stops functioning properly, it will impact the other parts of the organization. For example, imagine you are a
copyeditor for a publisher in New York City. If you get behind on your job, the graphic designers, marketing
professionals, printers, and other groups of people will also get behind. At the same time, interdependency can
also help an organization. If you working with a solid group of colleagues, if something happens to get you
behind others can help pull the slack and keep things moving forward on schedule. Overall, people impact each
other in organizations.
Interaction
Our interactions with others help define and create what is an organization. Without the interactions we have
with our coworkers, customers, and other stakeholders, an organization really doesn’t exist. For this reason, you
can almost say that the “thing” we call an organization doesn’t really exist because it’s not a physical structure,
but rather an organization is the outcome of our interactions with others. An organization may have physical
things within it (desks, computers, pencils, etc.), but the actual organization is ultimately the people that make
exist.
At the same time, people within an organization also interact with each other in various roles in an effort to
accomplish the organization’s goal(s). People within organizations and people who come in contact with
organizations are constantly in a state of interaction. As we will learn later in this book, organizations have
many different stakeholders (an individual or group that has an interest in the organization), and each different
set of stakeholders requires different communication strategies. Ultimately, communicative interaction is one of
the most basic functions of any organization.
Control
As the definition of organization from Dennis Mumby, organizations are inherently entities that must control
the behavior of its members while members generally strive for their own sets of needs.Mumby, D. (in
press). Organizational communication. Los Angeles, CA: SAGE. When one group has one set of needs and
desires and another has a different set of needs and desires, we refer to these groups as being in dialectical
tensions. Table 1.2 "Dialectical Tensions" contains many of the dialectical tensions that exist between
organizations and its various members.
Table 1.2 Dialectical Tensions

What the Organization Needs/Wants What Workers Need/Want

Minimize Costs Maximize Salary/Benefit Package

Systemization of Job Duties Autonomy to do one’s job

Ability to Streamline the Organization Job Stability

Agreement Dissent

Transparency Privacy

Conventionality Innovation

Organization-Focused Self-Focused

Permanence Change

Rights of the Organization Rights of the Individual

Work life Social life

As a result of these inherent dialectical tensions, organizations try to stack the deck in its favor to maximize its
needs and desires, and subsequently minimizes the needs and desires of workers in the process. Let’s briefly
examine each of these dialectical tensions in turn.
Minimize Costs vs. Maximize Salary/Benefits. The first dialectical tensions occurs when organizations try to
keep their overhead costs low while workers try to maximize what they earn in terms of both salary and benefits
(insurance, stock options, retirement, etc.).
Systemization vs. Autonomy. Organizations like stability, so they prefer workers who learn how to do a specific
task and then systematize that task in the most efficient manner. As such, organizations (especially in
manufacturing contexts) will train in explicit detail exactly how an employee should accomplish a task.
Workers, on the other hand, prefer to have autonomy when making decisions for how best to accomplish their
daily work and do not enjoy being micromanaged.
Streamline vs. Stability. Organizations are fundamentally focused on the bottom line, and therefore often want
to have the ability to streamline the organization in an attempt to maximize profits. If an organization can lay
off workers and maintain maximum productivity, then it’s often in the organization’s best interest to do so.
While streamlining is good for an organization, it can create a chaotic environment for employees who crave
job stability. Workers want to know that their work is appreciated and it will keep them employed.
Agreement vs. Dissent. The next dialectical tension listed here is agreement vs. dissent. In this tension,
organizations prefer for workers to blindly follow and do what organizational leaders dictate. Workers, on the
other hand, want to have a voice to articulate when they disagree with the dictates of leaders or the general
direction of the organization. We’ll explore the area of organizational dissent more in Chapter 5
"Communicating Between and Among Internal Stakeholders".
Conventionality vs. Innovation. Organizations are innately slow moving organisms that do not like change, so
it’s very common to hear “But we’ve always done it that way.” Workers on the other hand want to bring their
own creative problem solving skills to the table and think of new and innovative processes and procedures that
could benefit both the organizations and the workers. While not all worker ideas spot-on, organizations that
stick to conventional ways of thinking may end up losing a lot of employees who prefer more freedom to be
innovative.
Transparency vs. Privacy. In our world today organizations are increasingly want to know what workers are
doing in the workplace. As such, organizations expect that employee’s work lives are completely transparent
and will do everything from monitoring e-mail and telephone calls to installing software on workers’ computers
that logs and monitors key strokes made on a keyboard. Workers, on the other hand, are increasingly demanding
that there be some privacy especially in their digital lives.
Organization vs. Self-Focused. Organizations innately want workers to be focused on their jobs and improving
their productivity. Workers, on the other hand, want to focus on themselves and improving themselves. Many
organizations will support self-improvement as long as it has a clear benefit for the organization, but workers
often want to focus on their own improvement even if that improvement has no benefits for the organization or
may lead the worker to find a new organization.
Permanence vs. Change. When looking at the permanence/change dialectic, organizations strive to maintain
knowledge and thus keep people who are hard workers for the long haul. Often, organizations call this
employee loyalty. Workers on the other hand, desire change and can get very bored doing the same work day-in
and day-out. Often workers become pigeonholed in specific jobs with specific duties, that there is no way to get
out besides leaving the organization itself. Overall, organizations in our society have many more tools at its
disposal to get its way than do workers.
Organizational vs. Individual Rights. Ultimately, when it comes to organizations the focus is on the
organization and its rights and less on the individual’s rights. Workers believe that their human rights shouldn’t
stop at the front door of the organization. For example, many workers are shocked when organizations fire them
for posts that are made on social networking websites. Workers believe these posts should be private and
organizations looking at these posts is a violation of one’s privacy rights. Organizations, on the other hand,
believe looking at social networking site posts is a completely appropriate behavior and well within its rights as
an organization. While this specific example also overlaps with the transparency/privacy dialectic, the focus
here is on whose rights are more important.
Work vs. Social Life. The last dialectical tension associated with organizational control is the focus on work vs.
social life. Organizations believe that workers should be focused purely on their work life. As a result of digital
technology, it has become increasingly easier for people to be on call 24-7 by their organizations. Workers, on
the other hand, believe they are entitled to a social life that does not involve one’s organization. Furthermore,
workers often believe that as long as their private, social life behavior does not impact their work life, their
organization’s should stay out of their personal lives. Many organizations go so far as to include “morality
clauses” into contracts that enable them to fire employees whose person-life behavior is deemed inappropriate
for organizational members.
Leadership
The last term associated with people in organizations is leadership. Any organization must have an individual or
clearly discernible group that guides the organization towards accomplishing its goal(s). Without strong
leadership, individual members of an organization are left to their own ideas of how to accomplish the
organization’s goals. Basically, if you have too many people trying to lead, you’ll end up with an organization
that is stretched entirely too thin to accomplish anything.
The opposite of leadership is followership. If an organization is going to thrive, it must have strong leadership
and followers who are willing to follow that leader. In Chapter 7 "Leader and Follower Behaviors &
Perspectives" we’ll examine leadership and followership.
Types of Organizations
The last factor in understanding organizations is to realize that there are numerous types of organizations. For a
good overview of the different taxonomies that have been created trying to categorize these different types of
organizations, we recommend reading Carper and Snizek’s article on the subject.Carper, W. B., & Snizek, W.
E. (1980). The nature and types of organizational taxonomies: An overview. Academy of Management Review,
5, 65–75. For our purposes in this book, we are going to use the classification scheme originally posed by Peter
M. Blau and W. Richard Scott.Blau, P. M., & Scott, W. R. (1962). Formal organizations: A comparative
approach (2004 printing). Stanford, CA: Stanford University Press. Blau and Scott created a taxonomy of
organizations that included four distinct categories: mutual benefit, business concerns, service, and
commonweal.
Mutual Benefit Associations
The first type of organization that exists is the mutual benefit organization, which is focused on providing for its
membership. Some examples are “political parties, unions, fraternal associations, clubs, veterans’ organizations,
professional associations, and religious sects.”Blau, P. M., & Scott, W. R. (1962). Formal organizations: A
comparative approach. San Francisco: Chandler, pg. 45. People generally join these types of organizations
because of the benefits of membership. When these organizations are first being created, organizational
members are generally very involved in the creation of the organization. However, once one of these
organizations has been around for a while, the majority of the members become passive and let the minority run
the organization.
Business Concerns
The second type of organization is the business concerns organization, which is focused on doing well for the
organization itself. According to Blau and Scott, the “dominant problem of business concerns is that of
operating efficiency—the achievement of maximum gain at minimum cost in order to further survival and
growth in competition with other organizations.” Blau, P. M., & Scott, W. R. (1962). Formal organizations: A
comparative approach. San Francisco: Chandler, pg. 49. Most for-profit organizations will fall into the business
concerns organization. Business concerns organizations are faced with problems associated with “maximizing
operating efficiency in a competitive situation.”Blau, P. M., & Scott, W. R. (1962). Formal organizations: A
comparative approach. San Francisco: Chandler, pg. 43. Because of the need to cut costs and maintain a
competitive advantage, these organizations are often cold and calloused in how they treat its members and
customers.
Service Organizations
According to Blau and Scott, service organizations are “one whose prime beneficiary is the part of the public in
direct contact with the organization, with whom and on whom its members work—in short, an organization
whose basic function is to serve clients.” Blau, P. M., & Scott, W. R. (1962). Formal organizations: A
comparative approach. San Francisco: Chandler, pg. 51. Service organizations can include “social-work
agencies, hospitals, schools, legal aid societies, and mental health clinics.” Blau, P. M., & Scott, W. R.
(1962). Formal organizations: A comparative approach. San Francisco: Chandler, pg. 51. The basic problem
service organizations face is “the problems associated with the conflict between professional service to clients
and administrative procedures are characteristic of service organizations.” Blau, P. M., & Scott, W. R.
(1962). Formal organizations: A comparative approach. San Francisco: Chandler, pg. 43. Often service
organizations are steeped in organizational hierarchies and procedures that prohibit providing the easiest and
fastest service to potential clients.
Commonweal Organizations
The last type of organization discussed by Blau and Scott are commonweal organizations “where the prime
beneficiary is the public-at-large.”Blau, P. M., & Scott, W. R. (1962). Formal organizations: A comparative
approach (2004 printing). Stanford, CA: Stanford University Press, pg. 44. Some examples of commonweal
organizations include “the State Department, the Bureau of Internal Revenue, military services, police and fire
departments, and also the research function as distinguished from the teaching function in universities.”Blau, P.
M., & Scott, W. R. (1962). Formal organizations: A comparative approach. San Francisco: Chandler, pg.
54. All of these organizations were created because they represented areas where the general public needed
some level of protection or knowledge or the organization serves administrative purposes of the government.
Overall, the crucial problem posed “by commonweal organizations is the development of democratic
mechanisms whereby they can be externally controlled by the public.” Blau, P. M., & Scott, W. R.
(1962). Formal organizations: A comparative approach (2004 printing). Stanford, CA: Stanford University
Press, pg. 43.
Definition of organization
(Entry 1 of 2)
1a: the act or process of organizing or of being organizedthe organization of his material into a speech
b: the condition or manner of being organizeda group with a high degree of organization
2a: ASSOCIATION, SOCIETYcharitable organizations
b: an administrative and functional structure (such as a business or a political party)The new president plans to
make changes to the company's organization.also : the personnel of such a structureThe organization will vote
on the proposed changes.
organization
adjective
Definition of organization (Entry 2 of 2)
: characterized by complete conformity to the standards and requirements of an
organizationan organization man
Management
1. The organization and coordination of the activities of a business in order to achieve defined objectives.
Management is often included as a factor of production along with? machines, materials, and money.
According to the management guru Peter Drucker (1909-2005), the basic task of management includes
both marketing and innovation. Practice of modern management originates from the 16th century study
of low-efficiency and failures of certain enterprises, conducted by the English statesman Sir Thomas
More (1478-1535). Management consists of the interlocking functions of creating corporate policy and
organizing, planning, controlling, and directing an organization's resources in order to achieve the
objectives of that policy.

2. The directors and managers who have the power and responsibility to make decisions and oversee an
enterprise.
The size of management can range from one person in a small organization to hundreds or thousands of
managers in multinational companies.

In large organizations, the board of directors defines the policy which is then carried out by the chief
executive officer, or CEO. Some people agree that in order to evaluate a company's current and future
worth, the most important factors are the quality and experience of the managers.

Read more: http://www.businessdictionary.com/definition/management.html

Management (or managing) is the administration of an organization, whether it is a business, a not-for-
profit organization, or government body. Management includes the activities of setting the strategy of
an organization and coordinating the efforts of its employees (or of volunteers) to accomplish
its objectives through the application of available resources, such as financial, natural, technological,
and human resources. The term "management" may also refer to those people who manage an organization.
Social scientists study management as an academic discipline, investigating areas such as social
organization and organizational leadership.[1] Some people study management at colleges or universities;
major degrees in management include the Bachelor of Commerce (B.Com.) Bachelor of Business
Administration (BBA.) Master of Business Administration (MBA.) Master in Management (MScM or
MIM) and, for the public sector, the Master of Public Administration (MPA) degree. Individuals who aim to
become management specialists or experts, management researchers, or professors may complete the Doctor
of Management (DM), the Doctor of Business Administration (DBA), or the PhD in Business
Administration or Management. There has recently been a movement for evidence-based management.
Larger organizations generally have three levels of managers, which are typically organized[by whom?] in
a hierarchical, pyramid structure:
 Senior managers, such as members of a Board of Directors and a Chief Executive Officer (CEO) or
a President of an organization. They set the strategic goals of the organization and make decisions on
how the overall organization will operate. Senior managers are generally executive-level professionals,
and provide direction to middle management who directly or indirectly report to them.
 Middle managers, examples of these would include branch managers, regional managers, department
managers and section managers, who provide direction to front-line managers. Middle managers
communicate the strategic goals of senior management to the front-line managers.
 Lower managers, such as supervisors and front-line team leaders, oversee the work of regular employees
(or volunteers, in some voluntary organizations) and provide direction on their work.
In smaller organizations, an individual manager may have a much wider scope. A single manager may
perform several roles or even all of the roles commonly observed in a large organization.

Contents
 1Definitions
o 1.1Theoretical scope
 2Nature of work
 3History
o 3.1Etymology
o 3.2Early writing
o 3.319th century
o 3.420th century
o 3.521st century
 4Topics
o 4.1Basics
o 4.2Basic roles
o 4.3Skills
o 4.4Implementation of policies and strategies
 5Policies and strategies in the planning process
 6Levels
o 6.1Top
o 6.2Middle
o 6.3Lower
 7Training
o 7.1United States of America
 7.1.1Undergraduate
 7.1.2Graduate
o 7.2Good practices
 7.2.1Evidence-based management
 8See also
 9References
 10External links
Definitions[edit]
Views on the definition and scope of management include:
 According to Henri Fayol, "to manage is to forecast and to plan, to organise, to command, to co-ordinate
and to control."[2]
 Fredmund Malik defines it as "the transformation of resources into utility."
 Management included as one of the factors of production – along with machines, materials and money.
 Ghislain Deslandes defines it as “a vulnerable force, under pressure to achieve results and endowed with
the triple power of constraint, imitation and imagination, operating on subjective, interpersonal,
institutional and environmental levels”.[3]
 Peter Drucker (1909–2005) saw the basic task of management as twofold: marketing and innovation.
Nevertheless, innovation is also linked to marketing (product innovation is a central strategic marketing
issue). Peter Drucker identifies marketing as a key essence for business success, but management and
marketing are generally understood[by whom?] as two different branches of business administration
knowledge.
Theoretical scope[edit]
Management involves identifying the mission, objective, procedures, rules and manipulation[4] of the human
capital of an enterprise to contribute to the success of the enterprise.[citation needed] This implies effective
communication: an enterprise environment (as opposed to a physical or mechanical mechanism) implies
human motivation and implies some sort of successful progress or system outcome.[citation needed] As such,
management is not the manipulation of a mechanism (machine or automated program), not the herding of
animals, and can occur either in a legal or in an illegal enterprise or environment. From an individual's
perspective, management does not need to be seen solely from an enterprise point of view, because
management is an essential function to improve one's life and relationships.[citation needed] Management is
therefore everywhere[citation needed] and it has a wider range of application.[clarification needed] Based on this,
management must have humans. Communication and a positive endeavor are two main aspects of it either
through enterprise or independent pursuit.[citation needed] Plans, measurements, motivational psychological
tools, goals, and economic measures (profit, etc.) may or may not be necessary components for there to be
management. At first, one views management functionally, such as measuring quantity, adjusting plans,
meeting goals.[citation needed] This applies even in situations where planning does not take place. From this
perspective, Henri Fayol (1841–1925)[5][page needed] considers management to consist of five functions:
1. planning (forecasting)
2. organizing
3. commanding
4. coordinating
5. controlling
In another way of thinking, Mary Parker Follett (1868–1933), allegedly defined management as "the art of
getting things done through people".[6] She described management as philosophy.[7][need quotation to verify]
Critics[which?], however, find this definition useful but far too narrow. The phrase "management is what
managers do" occurs widely,[8] suggesting the difficulty of defining management without circularity, the
shifting nature of definitions[citation needed] and the connection of managerial practices with the existence of
a managerial cadre or of a class.
One habit of thought regards management as equivalent to "business administration" and thus excludes
management in places outside commerce, as for example in charities and in the public sector. More broadly,
every organization must "manage" its work, people, processes, technology, etc. to maximize
effectiveness.[citation needed] Nonetheless, many people refer to university departments that teach management
as "business schools". Some such institutions (such as the Harvard Business School) use that name, while
others (such as the Yale School of Management) employ the broader term "management".
English-speakers may also use the term "management" or "the management" as a collective word describing
the managers of an organization, for example of a corporation.[9] Historically this use of the term often
contrasted with the term "labor" – referring to those being managed.[10]
But in the present era[when?] the concept of management is identified[by whom?] in the wide areas[which?] and its
frontiers have been pushed to a broader range.[citation needed] Apart from profitable organizations even non-
profitable organizations (NGOs) apply management concepts. The concept and its uses are not
constrained[by whom?]. Management on the whole is the process of planning, organizing,
coordinating, leading and controlling.
Nature of work[edit]
In profitable organizations, management's primary function is the satisfaction of a range of stakeholders.
This typically involves making a profit (for the shareholders), creating valued products at a reasonable cost
(for customers), and providing great employment opportunities for employees. In nonprofit management,
add the importance of keeping the faith of donors. In most models of management and governance,
shareholders vote for the board of directors, and the board then hires senior management. Some
organizations have experimented with other methods (such as employee-voting models) of selecting or
reviewing managers, but this is rare.
History[edit]
Some see management as a late-modern (in the sense of late modernity) conceptualization.[11] On those
terms it cannot have a pre-modern history – only harbingers (such as stewards). Others, however, detect
management-like thought among ancient Sumerian traders and the builders of the pyramids of ancient
Egypt. Slave-owners through the centuries faced the problems of exploiting/motivating a dependent but
sometimes unenthusiastic or recalcitrant workforce, but many pre-industrial enterprises, given their small
scale, did not feel compelled to face the issues of management systematically. However, innovations such as
the spread of Hindu numerals (5th to 15th centuries) and the codification of double-entry book-
keeping (1494) provided tools for management assessment, planning and control.
 An organisation is more stable if members have the right to express their differences and solve their
conflicts within it.
 While one person can begin an organisation, "it is lasting when it is left in the care of many and when
many desire to maintain it".
 A weak manager can follow a strong one, but not another weak one, and maintain authority.
 A manager seeking to change an established organization "should retain at least a shadow of the ancient
customs".
With the changing workplaces of industrial revolutions in the 18th and 19th centuries, military theory and
practice contributed approaches to managing the newly-popular factories.[12]
Given the scale of most commercial operations and the lack of mechanized record-keeping and recording
before the industrial revolution, it made sense for most owners of enterprises in those times to carry out
management functions by and for themselves. But with growing size and complexity of organizations, a
distinction between owners (individuals, industrial dynasties or groups of shareholders) and day-to-day
managers (independent specialists in planning and control) gradually became more common.
Etymology[edit]
The English verb "manage" comes from the Italian maneggiare (to handle, especially tools or a horse),
which derives from the two Latin words manus (hand) and agere (to act). The French word for
housekeeping, ménagerie, derived from ménager ("to keep house"; compare ménage for "household"), also
encompasses taking care of domestic animals. Ménagerie is the French translation of Xenophon's famous
book Oeconomicus[13] (Greek: Οἰκονομικός) on household matters and husbandry. The French
word mesnagement (or ménagement) influenced the semantic development of the English
word management in the 17th and 18th centuries.[14]
Early writing[edit]
Management (according to some definitions) has existed for millennia, and several writers have produced
background works that have contributed to modern management theories.[15][need quotation to verify] Some
theorists have cited ancient military texts as providing lessons for civilian managers. For example, Chinese
general Sun Tzu in his 6th-century BC work The Art of War recommends[citation needed] (when re-phrased in
modern terminology) being aware of and acting on strengths and weaknesses of both a manager's
organization and a foe's.[15][need quotation to verify] The writings of influential Chinese Legalist philosopher Shen
Buhai may be considered[by whom?] to embody a rare premodern example of abstract theory of
administration.[16]
Various ancient and medieval civilizations produced "mirrors for princes" books, which aimed to advise
new monarchs on how to govern. Plato described job specialization in 350 BC, and Alfarabi listed several
leadership traits in AD 900.[17] Other examples include the Indian Arthashastra by Chanakya (written
around 300 BC), and The Prince by Italian author Niccolò Machiavelli (c. 1515).[18]
Further information: Mirrors for princes
Written in 1776 by Adam Smith, a Scottish moral philosopher, The Wealth of Nations discussed efficient
organization of work through division of labour.[18] Smith described how changes in processes could boost
productivity in the manufacture of pins. While individuals could produce 200 pins per day, Smith analyzed
the steps involved in manufacture and, with 10 specialists, enabled production of 48,000 pins per day.[18][need
quotation to verify]

19th century[edit]
Classical economists such as Adam Smith (1723–1790) and John Stuart Mill (1806–1873) provided a
theoretical background to resource allocation, production (economics), and pricing issues. About the same
time, innovators like Eli Whitney (1765–1825), James Watt (1736–1819), and Matthew Boulton (1728–
1809) developed elements of technical production such as standardization, quality-control procedures, cost-
accounting, interchangeability of parts, and work-planning. Many of these aspects of management existed in
the pre-1861 slave-based sector of the US economy. That environment saw 4 million people, as the
contemporary usages had it, "managed" in profitable quasi-mass production.
Salaried managers as an identifiable group first became prominent in the late 19th century.[19]
20th century[edit]
By about 1900 one finds managers trying to place their theories on what they regarded as a thoroughly
scientific basis (see scientism for perceived limitations of this belief). Examples include Henry R.
Towne's Science of management in the 1890s, Frederick Winslow Taylor's The Principles of Scientific
Management (1911), Lillian Gilbreth's Psychology of Management (1914),[20] Frank and Lillian
Gilbreth's Applied motion study (1917), and Henry L. Gantt's charts (1910s). J. Duncan wrote the
first college management-textbook in 1911. In 1912 Yoichi Ueno introduced Taylorism to Japan and
became the first management consultant of the "Japanese-management style". His son Ichiro Ueno
pioneered Japanese quality assurance.
The first comprehensive theories of management appeared around 1920.[citation needed] The Harvard Business
School offered the first Master of Business Administration degree (MBA) in 1921. People like Henri
Fayol (1841–1925) and Alexander Church (1866-1936) described the various branches of management and
their inter-relationships. In the early-20th century, people like Ordway Tead (1891–1973), Walter
Scott (1869-1955) and J. Mooney applied the principles of psychology to management. Other writers, such
as Elton Mayo (1880–1949), Mary Parker Follett (1868–1933), Chester Barnard (1886–1961), Max
Weber (1864–1920), who saw what he called the "administrator" as bureaucrat,[21] Rensis Likert (1903–
1981), and Chris Argyris (born 1923) approached the phenomenon of management from
a sociological perspective.
Peter Drucker (1909–2005) wrote one of the earliest books on applied management: Concept of the
Corporation (published in 1946). It resulted from Alfred Sloan (chairman of General Motors until 1956)
commissioning a study of the organisation. Drucker went on to write 39 books, many in the same vein.
H. Dodge, Ronald Fisher (1890–1962), and Thornton C. Fry introduced statistical techniques into
management-studies. In the 1940s, Patrick Blackett worked in the development of the applied-
mathematics science of operations research, initially for military operations. Operations research, sometimes
known as "management science" (but distinct from Taylor's scientific management), attempts to take
a scientific approach to solving decision-problems, and can apply directly to multiple management
problems, particularly in the areas of logistics and operations.
Some of the more recent developments include the Theory of Constraints, management by
objectives, reengineering, Six Sigma, the Viable system model, and various information-technology-driven
theories such as agile software development, as well as group-management theories such as Cog's Ladder.
As the general recognition of managers as a class solidified during the 20th century and gave perceived
practitioners of the art/science of management a certain amount of prestige, so the way opened
for popularised systems of management ideas to peddle their wares. In this context many management
fads may have had more to do with pop psychology than with scientific theories of management.
Business management includes the following branches:
1. financial management
2. human resource management
3. information technology management (responsible for management information systems)
4. marketing management
5. operations management and production management
6. strategic management
21st century[edit]
In the 21st century observers find it increasingly difficult to subdivide management into functional
categories in this way. More and more processes simultaneously involve several categories. Instead, one
tends to think in terms of the various processes, tasks, and objects subject to management.[citation needed]
Branches of management theory also exist relating to nonprofits and to government: such as public
administration, public management, and educational management. Further, management programs related
to civil-society organizations have also spawned programs in nonprofit management and social
entrepreneurship.
Note that many of the assumptions made by management have come under attack from business-
ethics viewpoints, critical management studies, and anti-corporate activism.
As one consequence, workplace democracy (sometimes referred to as Workers' self-management) has
become both more common and more advocated, in some places distributing all management functions
among workers, each of whom takes on a portion of the work. However, these models predate any current
political issue, and may occur more naturally than does a command hierarchy. All management embraces to
some degree a democratic principle—in that in the long term, the majority of workers must support
management. Otherwise, they leave to find other work or go on strike. Despite the move toward workplace
democracy, command-and-control organization structures remain commonplace as de facto organization
structures. Indeed, the entrenched nature of command-and-control is evident in the way that
recent[when?] layoffs have been conducted with management ranks affected far less than employees at the
lower levels.[citation needed] In some cases, management has even rewarded itself with bonuses after laying off
lower-level workers.[22]
According to leadership-academic Manfred F.R. Kets de Vries, a contemporary senior-management team
will almost inevitably have some personality disorders.[23]
Topics[edit]
Basics[edit]
According to Fayol, management operates through five basic functions: planning, organizing, coordinating,
commanding, and controlling.
 Planning: Deciding what needs to happen in the future and generating plans for action (deciding in
advance).
 Organizing (or staffing): Making sure the human and nonhuman resources are put into place.[24]
 Coordinating: Creating a structure through which an organization's goals can be accomplished.
 Commanding (or leading): Determining what must be done in a situation and getting people to do it.
 Controlling: Checking progress against plans.
Basic roles[edit]
 Interpersonal: roles that involve coordination and interaction with employees
Figurehead, leader
 Informational: roles that involve handling, sharing, and analyzing information
Nerve centre, disseminator
 Decision: roles that require decision-making
Entrepreneur, negotiator, allocator
Skills[edit]
Management skills include:
 political: used to build a power base and to establish connections
 conceptual: used to analyze complex situations
 interpersonal: used to communicate, motivate, mentor and delegate
 diagnostic: ability to visualize appropriate responses to a situation
 leadership: ability to lead and to provide guidance to a specific group
 technical: expertise in one's particular functional area.
 behavioral: perception towards others.
Implementation of policies and strategies[edit]
 All policies and strategies must be discussed with all managerial personnel and staff.
 Managers must understand where and how they can implement their policies and strategies.
 A plan of action must be devised for each department.
 Policies and strategies must be reviewed regularly.
 Contingency plans must be devised in case the environment changes.
 Top-level managers should carry out regular progress assessments.
 The business requires team spirit and a good environment.
 The missions, objectives, strengths and weaknesses of each department must be analyzed to determine
their roles in achieving the business's mission.
 The forecasting method develops a reliable picture of the business' future environment.
 A planning unit must be created to ensure that all plans are consistent and that policies and strategies are
aimed at achieving the same mission and objectives.
Policies and strategies in the planning process[edit]
 They give mid and lower-level managers a good idea of the future plans for each department in an
organization.
 A framework is created whereby plans and decisions are made.
 Mid and lower-level management may add their own plans to the business's strategies.
Levels[edit]
Most organizations have three management levels: first-level, middle-level, and top-level managers. First-
line managers are the lowest level of management and manage the work of nonmanagerial individuals who
are directly involved with the production or creation of the organization's products. First-line managers are
often called supervisors, but may also be called line managers, office managers, or even foremen. Middle
managers include all levels of management between the first-line level and the top level of the organization.
These managers manage the work of first-line managers and may have titles such as department head,
project leader, plant manager, or division manager. Top managers are responsible for making organization-
wide decisions and establishing the plans and goals that affect the entire organization. These individuals
typically have titles such as executive vice president, president, managing director, chief operating officer,
chief executive officer, or chairman of the board.
These managers are classified in a hierarchy of authority, and perform different tasks. In many
organizations, the number of managers in every level resembles a pyramid. Each level is explained below in
specifications of their different responsibilities and likely job titles.[citation needed]
Top[edit]
The top or senior layer of management consists of the board of directors (including non-executive
directors and executive directors), president, vice-president, CEOs and other members of the C-
level executives. Different organizations have various members in their C-suite, which may include a Chief
Financial Officer, Chief Technology Officer, and so on. They are responsible for controlling and overseeing
the operations of the entire organization. They set a "tone at the top" and develop strategic plans, company
policies, and make decisions on the overall direction of the organization. In addition, top-level managers
play a significant role in the mobilization of outside resources. Senior managers are accountable to the
shareholders, the general public and to public bodies that oversee corporations and similar organizations.
Some members of the senior management may serve as the public face of the organization, and they may
make speeches to introduce new strategies or appear in marketing.
The board of directors is typically primarily composed of non-executives who owe a fiduciary duty to
shareholders and are not closely involved in the day-to-day activities of the organization, although this
varies depending on the type (e.g., public versus private), size and culture of the organization. These
directors are theoretically liable for breaches of that duty and typically insured under directors and officers
liability insurance. Fortune 500 directors are estimated to spend 4.4 hours per week on board duties, and
median compensation was $212,512 in 2010. The board sets corporate strategy, makes major decisions such
as major acquisitions,[25] and hires, evaluates, and fires the top-level manager (Chief Executive Officer or
CEO). The CEO typically hires other positions. However, board involvement in the hiring of other positions
such as the Chief Financial Officer (CFO) has increased.[26] In 2013, a survey of over 160 CEOs and
directors of public and private companies found that the top weaknesses of CEOs were "mentoring skills"
and "board engagement", and 10% of companies never evaluated the CEO.[27] The board may also have
certain employees (e.g., internal auditors) report to them or directly hire independent contractors; for
example, the board (through the audit committee) typically selects the auditor.
Helpful skills of top management vary by the type of organization but typically include[28] a broad
understanding of competition, world economies, and politics. In addition, the CEO is responsible for
implementing and determining (within the board's framework) the broad policies of the organization.
Executive management accomplishes the day-to-day details, including: instructions for preparation of
department budgets, procedures, schedules; appointment of middle level executives such as department
managers; coordination of departments; media and governmental relations; and shareholder communication.
Middle[edit]
Consist of general managers, branch managers and department managers. They are accountable to the top
management for their department's function. They devote more time to organizational and directional
functions. Their roles can be emphasized as executing organizational plans in conformance with the
company's policies and the objectives of the top management, they define and discuss information and
policies from top management to lower management, and most importantly they inspire and provide
guidance to lower level managers towards better performance.
Middle management is the midway management of a categorized organization, being secondary to the
senior management but above the deepest levels of operational members. An operational manager may be
well-thought-out by middle management, or may be categorized as non-management operate, liable to the
policy of the specific organization. Efficiency of the middle level is vital in any organization, since they
bridge the gap between top level and bottom level staffs.
Their functions include:
 Design and implement effective group and inter-group work and information systems.
 Define and monitor group-level performance indicators.
 Diagnose and resolve problems within and among work groups.
 Design and implement reward systems that support cooperative behavior. They also make decision and
share ideas with top managers.
Lower[edit]
Lower managers include supervisors, section leaders, forepersons and team leaders. They focus on
controlling and directing regular employees. They are usually responsible for assigning employees' tasks,
guiding and supervising employees on day-to-day activities, ensuring the quality and quantity of production
and/or service, making recommendations and suggestions to employees on their work, and channeling
employee concerns that they cannot resolve to mid-level managers or other administrators. First-level or
"front line" managers also act as role models for their employees. In some types of work, front line
managers may also do some of the same tasks that employees do, at least some of the time. For example, in
some restaurants, the front line managers will also serve customers during a very busy period of the day.
Front-line managers typically provide:
 Training for new employees
 Basic supervision
 Motivation
 Performance feedback and guidance
Some front-line managers may also provide career planning for employees who aim to rise within the
organization.
Training[edit]
Colleges and universities around the world offer bachelor's degrees, graduate degrees, diplomas and
certificates in management, generally within their colleges of business, business schools or faculty of
management but also in other related departments. In the 2010s, there has been an increase in online
management education and training in the form of electronic educational technology ( also called e-
learning). Online education has increased the accessibility of management training to people who do not live
near a college or university, or who cannot afford to travel to a city where such training is available.
While some professions require academic credentials in order to work in the profession (e.g., law, medicine,
engineering, which require, respectively the Bachelor of Law, Doctor of Medicine and Bachelor of
Engineering degrees), management and administration positions do not necessarily require the completion
of academic degrees. Some well-known senior executives in the US who did not complete a degree
include Steve Jobs, Bill Gates and Mark Zuckerberg. However, many managers and executives have
completed some type of business or management training, such as a Bachelor of Commerce or a Master of
Business Administration degree. Some major organizations, including companies, not-for-profit
organizations and governments, require applicants to managerial or executive positions to hold at
minimum Bachelor's degree in a field related to administration or management, or in the case of business
jobs, a Bachelor of Commerce or a similar degree.
United States of America[edit]
Undergraduate[edit]
At the undergraduate level, the most common business program is the Bachelor of Commerce (B.Com.).
However to manage technological areas, you need an undergraduate degree in a STEM area as preferred to
Defense Acquisition University guidelines. This is typically a four-year program that includes courses that
give students an overview of the role of managers in planning and directing within an organization. Course
topics include accounting, financial management, statistics, marketing, strategy, and other related areas.
There are many other undergraduate degrees that include the study of management, such as Bachelor of
Arts degrees with a major in business administration or management and Bachelor of Public Administration
(B.P.A), a degree designed for individuals aiming to work as bureaucrats in the government jobs. Many
colleges and universities also offer certificates and diplomas in business administration or management,
which typically require one to two years of full-time study.
Graduate[edit]
At the graduate level students aiming at careers as managers or executives may choose to specialize in
major subareas of management or business administration such as entrepreneurship, human
resources, international business, organizational behavior, organizational theory, strategic
management,[29] accounting, corporate finance, entertainment, global management, healthcare
management, investment management, sustainability and real estate. A Master of Business
Administration (MBA) is the most popular professional degree at the master's level and can be obtained
from many universities in the United States. MBA programs provide further education in management and
leadership for graduate students. Other master's degrees in business and management include Master of
Management (MM) and the Master of Science (M.Sc.) in business administration or management, which is
typically taken by students aiming to become researchers or professors. There are also specialized master's
degrees in administration for individuals aiming at careers outside of business, such as the Master of Public
Administration (MPA) degree (also offered as a Master of Arts in Public Administration in some
universities), for students aiming to become managers or executives in the public service and the Master of
Health Administration, for students aiming to become managers or executives in the health care and hospital
sector.
Management doctorates are the most advanced terminal degrees in the field of business and management.
Most individuals obtaining management doctorates take the programs to obtain the training in research
methods, statistical analysis and writing academic papers that they will need to seek careers as researchers,
senior consultants and/or professors in business administration or management. There are three main types
of management doctorates: the Doctor of Management (D.M.), the Doctor of Business
Administration (D.B.A.), and the Ph.D. in Business Administration or Management. In the 2010s,
doctorates in business administration and management are available with many specializations.
Good practices[edit]
While management trends can change so fast, the long term trend in management has been defined by a
market embracing diversity and a rising service industry. Managers are currently being trained to encourage
greater equality for minorities and women in the workplace, by offering increased flexibility in working
hours, better retraining, and innovative (and usually industry-specific) performance markers. Managers
destined for the service sector are being trained to use unique measurement techniques, better worker
support and more charismatic leadership styles.[30] Human resources finds itself increasingly working with
management in a training capacity to help collect management data on the success (or failure) of
management actions with employees.[31]
Evidence-based management[edit]
Main article: Evidence-based management
Evidence-based management is an emerging movement to use the current, best evidence in management
and decision-making. It is part of the larger movement towards evidence-based practices. Evidence-based
management entails managerial decisions and organizational practices informed by the best available
evidence.[32] As with other evidence-based practice, this is based on the three principles of: 1) published
peer-reviewed (often in management or social science journals) research evidence that bears on whether and
why a particular management practice works; 2) judgement and experience from contextual management
practice, to understand the organization and interpersonal dynamics in a situation and determine the risks
and benefits of available actions; and 3) the preferences and values of those affected
Management is the act of engaging with an organization's human talent and its resources to accomplish
desired goals and objectives.
Management in Organizations
ent - Meaning, Need and its Features
A set-up where individuals from diverse backgrounds, different educational qualifications and varied
interests come together to work towards a common goal is called an organization.
The employees must work in close coordination with each other and try their level best to achieve the
organization’s goals.
It is essential to manage the employees well for them to feel indispensable for the organization.
Organization management helps to extract the best out of each employee so that they accomplish the
tasks within the given time frame.
Organization management binds the employees together and gives them a sense of loyalty towards the
organization.
What is Organization Management ?
 Organization management refers to the art of getting people together on a common platform to make
them work towards a common predefined goal.
 Organization management enables the optimum use of resources through meticulous planning and
control at the workplace.
 Organization management gives a sense of direction to the employees. The individuals are well
aware of their roles and responsibilities and know what they are supposed to do in the organization.
An effective management ensures profitability for the organization. In a layman’s language
organization management refers to efficient handling of the organization as well as its employees.
Need for Organization Management
 Organization management gives a sense of security and oneness to the employees.
 An effective management is required for better coordination among various departments.
 Employees accomplish tasks within the stipulated time frame as a result of effective organization
management.
 Employees stay loyal towards their job and do not treat work as a burden.
 Effective organization management leads to a peaceful and positive ambience at the workplace.
Essential Features of Organization Management
1. Planning
 Prepare an effective business plan. It is essential to decide on the future course of action to avoid
confusions later on.
 Plan out how you intend to do things.
2. Organizing
 Organizing refers to the judicious use of resources to achieve the best out of the employees.
 Prepare a monthly budget for smooth cash flow.
3. Staffing
 Poor organization management leads to unhappy employees who eventually create problems for
themselves as well as the organization.
 Recruit the right talent for the organization.
4. Leading
 The managers or superiors must set clear targets for the team members.
 A leader must make sure his team members work in unison towards a common objective. He is
the one who decides what would be right in a particular situation.
5. Control
 The superiors must be aware of what is happening around them.
 Hierarchies should be well defined for an effective management.
 The reporting bosses must review the performance and progress of their subordinates and guide
them whenever required.
6. Time Management
 An effective time management helps the employees to do the right thing at the right time.
 Managing time effectively always pays in the long run.
7. Motivation
 Motivation goes a long way in binding the employees together.
 Appreciating the employees for their good work or lucrative incentive schemes go a long way in
motivating the employees and make them work for a longer span of time.
The process of organizing, planning, leading and controlling resources within an entity with the overall aim
of achieving its objectives. The organizational management of a business needs to be able to make decisions
and resolve issues in order to be both effective and beneficial.

Read more: http://www.businessdictionary.com/definition/organizational-management.html

Organization Management – Meaning, Need and its Features

An organization is usually made up of different individuals with different beliefs, cultural background,
educational qualification, and experience. But the best part is despite the disparities in their capabilities;
each has to work together to achieve the targeted goal of the organization.
Employees are obliged to work in unity and proper coordination with one another to ensure that objects at
the departmental level, including that of the organization as a whole, are met. And that’s where
effective organization management becomes critical. This post will throw more light on the meaning, need
and features of organization management.
What is the meaning of Organization Management?
Every organization or workplace has principles or rules governing their employees, which the employees in
question need to be aware of and follow strictly. For instance, employees in any specific department know
the right person to channel their complaints.
Organization management consists of everything the managers or superiors do to ensure the smooth running
of the firm, which also entails creating an enabling environment for the employees to be more efficient in
the discharge of their duties. It also involves the proper use of the available resources through adequate
planning and control of the working environment.
The primary focus of any organization is to achieve its objectives. It could be to increase client base,
improve business reputation, or have substantial financial returns. But profit is still the primary reason
organizations are set up. So, when the business is not making enough profit, it would be difficult to keep the
company running.
With adequate organizational management which entails proper planning, organizing, leading and control of
available resources, firms may end up achieving their objectives at the end of the day. But the executives
should have the capabilities to make decisions and resolve issues for it to be more effective and beneficial.
Need for Organization Management
Organization management is beneficial if properly planned out and executed. And firms might benefit from
a proper structure or management plan in several ways. Here is why organizational management is so
relevant for the survival of any establishment.
1. Helps to Create a Clearer Picture of the Goals within Each Department.
Organization management helps managers to split roles within each department. And in doing so, each
department will have a better understanding of their function and resources needed. Pictures of the size of
the targeted goal for each department will also be more apparent.
2. Effective Implementation of Business Plan to Achieve Targeted Goals
Organization management doesn’t stop at creating a roadmap regarding the goals of each department. It also
helps managers to determine what should be done to achieve the targeted goals of each department and the
company as a whole. Managers will also have the capacity to swiftly respond to issues that may undermine
the external and internal expectations of the establishment.
3. Better Coordination in the Various Departments
A proper organization structure allows the managers or executives to manage the affairs of each department
within the company. Employees would have a better understanding of their duties and responsibilities. They
will also carry them out without waiting for the manager’s instructions in most cases.
Effective management makes information sharing and communication easier. And there will also be no need
for conflict within each department and the organization at large.
4. Enables Employees to Deliver Assigned Projects Within Deadline
Effective organization management creates the right environment for employees to accomplish assigned
tasks within the agreed time-frame. They will have access to the right materials or resources to work with or
know who to approach to acquire them. Employees will also have no other choice but to follow due process
in the discharge of their duties.
5. Creates a Positive and Peaceful Work Environment
No employee can thrive in a workplace where there is always conflict. Business may also experience
negative growth in such circumstances. Effective organization management would help to set the guidelines
and define the mutual relationship that binds individual elements within the organization which includes
people, technology, processes and strategy to create an enabling environment for every department to work
together to accomplish the targeted goal.
Features of Organization Management
1. Planning
Create a working plan to avoid confusion in the future. As the business continues to grow, you can add to
your plan, instead of removing from it. You need to create a business plan that will help to give direction to
your business. How things will be done should also come up in your business plan.
2. Organizing
Organizing is also critical in organizational management and success of any business. It entails how you
intend to utilize the available resources to help employees to achieve the best results. Organizing allows
firms to make good use of their finances. But to ensure smooth cash flow, the management of the company
needs to create monthly budget.
3. Staffing
Fitting employees in the right position will not only cause them to deliver excellent performance. It will also
affect the organization positively. On the other hand, hiring or assigning tasks to employees that lacks the
qualification and capacity might create problems for the organization. So, management should always
recruit staffs based on their competence.
4. Control
For management to have an impact and achieve the goals of the organization, hierarchies should be clearly
defined. In other words, employees should know their place and who they are supposed to report to when
the need arises. And those they report to should have the capacity to carry out a proper review of their
performances and make significant contributions that would guide the subordinates to deliver the best result.
5. Motivation
An effective organizational management plan takes into consideration factors that motivate employees to
perform optimally. It’s not enough to create an enabling environment; lucrative packages should also be
made available. It will help employees to stay motivated and consider working for the company for an
extended period.
Conclusion
Every organization has goals. But then, these goals cannot be achieved without proper management and
execution of the business plan. Effective organization management is critical in any business settings. It
would help to give the superiors and employees a clear direction involving how to run the business and get
everyone to deliver their best.
What Is Management?
There is no universally accepted definition for management. The definitions run the gamut from very simple
to very complex. For our purposes, we define management as “the application of planning, organizing,
staffing, directing, and controlling functions in the most efficient manner possible to accomplish meaningful
organizational objectives.”John M. Ivancevich and Thomas N. Duening, Business: Principles, Guidelines,
and Practices (Mason, OH: Atomic Dog Publishing, 2007), 172. Put more simply, management is all about
achieving organizational objectives through people and other resources.David L. Kurtz, Contemporary
Business (Hoboken, NJ: John Wiley & Sons, 2011), 254.
Management principles apply to all organizations—large or small, for-profit or not-for-profit. Even one-
person small businesses need to be concerned about management principles because without a fundamental
understanding of how businesses are managed, there can be no realistic expectation of success. Remember
that the most common reason attributed to small business failure is failure on the part of management.
 Four Management Functions, Management Roles, Management Skills
Four Management Functions
4 Functions of Management Process: Planning, Organizing, Leading, Controlling
4 Basic Functions of Management is a systematic way of doing things.
We refer to management as a process to emphasize that all managers, irrespective of their aptitude or skill,
engage in some inter-related functions in order to achieve their desired goals.
Management process/functions involve 4 basic activities;
4 basic functions of management process are;
1. Planning and decision making
2. Organizing
3. Leading
4. Controlling

1. Planning and Decision Making – Determining Courses of Action

Looking ahead into the future and predict possible trends or occurrences which are likely to influence the
working situation is the most vital quality as well as the job of a manager.
Planning means setting an organization’s goal and deciding how best to achieve them. Planning is decision
making, regarding the goals and setting the future course of action from a set of alternatives to reach them.
The plan helps to maintain managerial effectiveness as it works as a guide for the personnel for future
activities. Selecting goals as well as the paths to achieve them is what planning involves.
Planning involves selecting missions and objectives and the actions to achieve them, it requires decision-
making or choosing future courses of action from among alternatives.
In short, planning means determining what the organization’s position and the situation should be at some
time in the future and decide how best to bring about that situation.
Planning helps maintain managerial effectiveness by guiding future activities.
For a manager, planning and decision-making require an ability to foresee, to visualize, and to look ahead
purposefully.
2. Organizing – Coordinating Activities and Resources
Organizing can be defined as the process by which the established plans are moved closer to realization.
Once a manager set goals and develops plans, his next managerial function is organizing human and other
resources that are identified as necessary by the plan to reach the goal.
Organizing involves determining how activities and resources are to be assembled and coordinated.
The organization can also be defined as an intentionally formalized structure of positions or roles for
people to fill in an organization.
Organizing produces a structure of relationships in an organization and it is through these structured
relationships that future plans are pursued.
Organizing, then, is that part of managing which involves: establishing an intentional structure of roles for
people to fill in the organization.
It is intentional in the sense of making sure that all the tasks necessary to accomplish goals are assigned to
people who can do the best.
The purpose of an organization structure is to create an environment for the best human performance.
The structure must define the task to be done. The rules so established must also be designed in light of the
abilities and motivations of the people available.
Staffing is related to organizing and it involves filling and keeping filled, the positions in the organization
structure.
This can be done by determining the positions to be filled, identifying the requirement of manpower, filling
the vacancies and training employees so that the assigned tasks are accomplished effectively and
efficiently.
The managerial functions of promotion, demotion, discharge, dismissal, transfer, etc. Are also included
with the broad task “staffing.” staffing ensures the placement of the right person at the right position.
Basically organizing is deciding where decisions will be made, who will do what jobs and tasks, who will
work for whom, and how resources will assemble.
3. Leading – Managing, Motivating and Directing People
The third basic managerial function is leading. The skills of influencing people for a particular purpose or
reason is called leading. Leading is considered to be the most important and challenging of all managerial
activities.
Leading is influencing or prompting the member of the organization to work together with the interest of the
organization.
Creating a positive attitude towards the work and goals in among the members of the organization is called
leading. It is required as it helps to serve the objective of effectiveness and efficiency by changing the
behavior of the employees.
Leading involves a number of deferment processes and activates.
The functions of direction, motivation, communication, and coordination are considered a part of the
leading processor system.
Coordinating is also essential in leading.
Most authors do not consider it a separate function of management.
Rather they regard coordinating as the essence of managership for achieving harmony among individual
efforts towards accomplishing group targets.
Motivating is an essential quality for leading. Motivating is the function of the management process of
influencing people’s behavior based on the knowledge of what cause and channel sustain human behavior in
a particular committed direction.
Efficient managers need to be effective leaders.
Since leadership implies fellowship and people tend to follow those who offer a means of satisfying their
own needs, hopes and aspirations it is understandable that leading involves motivation leadership styles and
approaches and communication.
4. Controlling – Monitoring and Evaluating activities
Monitoring the organizational progress toward goal fulfillment is called controlling. Monitoring the
progress is essential to ensure the achievement of organizational goal.
Controlling is measuring, comparing, finding deviation and correcting the organizational activities which
are performed for achieving the goals or objectives. Controlling consist of activities, like; measuring the
performance, comparing with the existing standard and finding the deviations, and correcting the deviations.
Control activities generally relate to the measurement of achievement or results of actions which were taken
to attain the goal.
Some means of controlling, like the budget for expenses, inspection records, and the record of labor hours
lost, are generally familiar. Each measure also shows whether plans are working out.
If deviations persist, correction is indicated. Whenever results are found to differ from the planned action,
persons responsible are to be identified and necessary actions are to be taken to improve performance.
Thus outcomes are controlled by controlling what people do. Controlling is the last but not the least
important management function process.
It is rightly said, “planning without controlling is useless”. In short, we can say the controlling enables the
accomplishment of the plan.
All the management functions of its process are inter-related and cannot be skipped.
The management process designs and maintains an environment in which personnel’s, working together in
groups, accomplish efficiently selected aims.
All managers carry out the main functions of management; planning, organizing, staffing, leading and
controlling. But depending on the skills and position on an organizational level, the time and labor spent in
each function will differ.
In 1916, a French coal mine director named Henri Fayol wrote a book entitled “Administration Industrielle
et Generale,” which set forth five distinct functions of managing that Fayol insisted were applicable in any
industry. In the 1950’s, management textbooks began to incorporate some of Fayol’s ideas into their
content. The process school of management was born and, today, management courses still use many of
Fayol’s ideas to teach management to business students.
Tip
 Originally, there were five management functions, but management book authors have condensed them
to four: planning, organizing, leading and controlling. The fifth function was staffing.
Function One: Planning
Planning involves deciding where to take a company and selecting steps to get there. It first requires
managers to be aware of challenges facing their businesses, and it then it requires managers to forecast
future business and economic conditions. They then formulate objectives to reach by certain deadlines and
decide on steps to reach them. They re-evaluate their plans as conditions change and make adjustments as
necessary. Planning helps allocate resources and reduce waste as well.
Function Two: Organizing
Managers organize by bringing together physical, human and financial resources to achieve objectives.
They identify activities to be accomplished, classify activities, assign activities to groups or individuals,
create responsibility and delegate authority. They then coordinate the relationships of responsibility and
authority.
Function Three: Leading
Leading requires managers to motivate employees to achieve business objectives and goals. It requires the
use of authority to achieve those ends as well as the ability to communicate effectively. Effective leaders are
students of human personalities, motivation and communication. They can influence their personnel to view
situations from their perspectives. Leading also involves supervision of employees and their work.
Function Four: Controlling
Controlling is a function of management that involves measuring achievement against established objectives
and goals. It also requires managers to be able to identify sources of deviation from successful
accomplishment and to provide a corrective course of action. Managers first establish objectives and goals,
then measure achievement of them, identify anything that is keeping the company from achieving them, and
provide means of correction if necessary.
Controlling does not necessarily involve achieving only monetary goals and objectives. It can also relate to
nontangible goals and objectives like meeting a production quota or reducing customer complaints by a
certain amount.
Functions of Managers
Managers just don't go out and haphazardly perform their responsibilities. Good managers discover how to
master five basic functions: planning, organizing, staffing, leading, and controlling.
 Planning: This step involves mapping out exactly how to achieve a particular goal. Say, for example,
that the organization's goal is to improve company sales. The manager first needs to decide which steps
are necessary to accomplish that goal. These steps may include increasing advertising, inventory, and
sales staff. These necessary steps are developed into a plan. When the plan is in place, the manager can
follow it to accomplish the goal of improving company sales.
 Organizing: After a plan is in place, a manager needs to organize her team and materials according to
her plan. Assigning work and granting authority are two important elements of organizing.
 Staffing: After a manager discerns his area's needs, he may decide to beef up his staffing by recruiting,
selecting, training, and developing employees. A manager in a large organization often works with the
company's human resources department to accomplish this goal.
 Leading: A manager needs to do more than just plan, organize, and staff her team to achieve a goal. She
must also lead. Leading involves motivating, communicating, guiding, and encouraging. It requires the
manager to coach, assist, and problem solve with employees.
 Controlling: After the other elements are in place, a manager's job is not finished. He needs to
continuously check results against goals and take any corrective actions necessary to make sure that his
area's plans remain on track.
All managers at all levels of every organization perform these functions, but the amount of time a manager
spends on each one depends on both the level of management and the specific organization.
Roles performed by managers
A manager wears many hats. Not only is a manager a team leader, but he or she is also a planner, organizer,
cheerleader, coach, problem solver, and decision maker — all rolled into one. And these are just a few of a
manager's roles.
In addition, managers' schedules are usually jam‐packed. Whether they're busy with employee meetings,
unexpected problems, or strategy sessions, managers often find little spare time on their calendars. (And that
doesn't even include responding to e‐mail!)
In his classic book, The Nature of Managerial Work, Henry Mintzberg describes a set of ten roles that a
manager fills. These roles fall into three categories:
 Interpersonal: This role involves human interaction.
 Informational: This role involves the sharing and analyzing of information.
 Decisional: This role involves decision making.
Table 1 contains a more in‐depth look at each category of roles that help managers carry out all five
functions described in the preceding “Functions of Managers” section.
Not everyone can be a manager. Certain skills, or abilities to translate knowledge into action that results in
desired performance, are required to help other employees become more productive. These skills fall under
the following categories:
 Technical: This skill requires the ability to use a special proficiency or expertise to perform particular
tasks. Accountants, engineers, market researchers, and computer scientists, as examples, possess
technical skills. Managers acquire these skills initially through formal education and then further
develop them through training and job experience. Technical skills are most important at lower levels of
management.
 Human: This skill demonstrates the ability to work well in cooperation with others. Human skills
emerge in the workplace as a spirit of trust, enthusiasm, and genuine involvement in interpersonal
relationships. A manager with good human skills has a high degree of self‐awareness and a capacity to
understand or empathize with the feelings of others. Some managers are naturally born with great human
skills, while others improve their skills through classes or experience. No matter how human skills are
acquired, they're critical for all managers because of the highly interpersonal nature of managerial work.
 Conceptual: This skill calls for the ability to think analytically. Analytical skills enable managers to
break down problems into smaller parts, to see the relations among the parts, and to recognize the
implications of any one problem for others. As managers assume ever‐higher responsibilities in
organizations, they must deal with more ambiguous problems that have long‐term consequences. Again,
managers may acquire these skills initially through formal education and then further develop them by
training and job experience. The higher the management level, the more important conceptual skills
become.
Although all three categories contain skills essential for managers, their relative importance tends to vary by
level of managerial responsibility.
Business and management educators are increasingly interested in helping people acquire technical, human,
and conceptual skills, and develop specific competencies, or specialized skills, that contribute to high
performance in a management job. Following are some of the skills and personal characteristics that the
American Assembly of Collegiate Schools of Business (AACSB) is urging business schools to help their
students develop.
 Leadership — ability to influence others to perform tasks
 Self‐objectivity — ability to evaluate yourself realistically
 Analytic thinking — ability to interpret and explain patterns in information
 Behavioral flexibility — ability to modify personal behavior to react objectively rather than
subjectively to accomplish organizational goals
 Oral communication — ability to express ideas clearly in words
 Written communication — ability to express ideas clearly in writing
 Personal impact — ability to create a good impression and instill confidence
 Resistance to stress — ability to perform under stressful conditions
 Tolerance for uncertainty — ability to perform in ambiguous situations
While most positions and departments within a business are tasked with specific duties based on particular
knowledge, expertise, or company needs, managers can have a broader and more complex set of
responsibilities. More than just specialized knowledge, management requires an ability to navigate
numerous procedural, structural, and interpersonal challenges in the process of guiding one's team to the
completion of various goals.
Originally identified by Henri Fayol as five elements, there are now four commonly accepted functions of
management that encompass these necessary skills: planning, organizing, leading, and controlling.1
Consider what each of these functions entails, as well as how each may look in action.

Planning
One main role of a manager is creating a plan to meet company goals and objectives. This involves
allocating employee resources and delegating responsibilities, as well as setting realistic timelines and
standards for completion. Planning requires those in management roles to continuously check on team
progress in order to make small adjustments when necessary, while still maintaining a clear picture of a
company's larger aims and goals.

Much of one's planning function consists of working independently to determine what responsibilities must
be given to which employees, setting priority levels for certain tasks, and creating timelines. However,
communication also plays an important role. For example, managers deal with planning when they meet
with company leadership to discuss short and long-term goals, and when they communicate the specifics of
a new project to their team or check-in periodically to ensure individual objectives are being met on time.

Organizing
Along with planning, a manager's organizational skills can help to ensure a company or departmental unit
runs smoothly. From establishing internal processes and structures to knowing which employees or teams
are best suited for specific tasks, keeping everyone and everything organized throughout daily operations
are important functions of management.

Organization isn't just about delegating tasks efficiently and making sure employees have what they need to
accomplish their tasks, however. Managers also need to be able to reorganize in response to new challenges.
This could come into practice in the form of slightly adjusting the timeline for a project or re-allocating
tasks from one team to another. Or, it could mean significantly altering a team's internal structure and roles
in response to company growth.

Leading
Managers should be comfortable and confident commanding their team members’ daily tasks as well as
during periods of significant change or challenge. This involves projecting a strong sense of direction and
leadership when setting goals and communicating new processes, products and services, or internal policy.

Leadership can manifest itself in a number of ways, including recognizing when employees need an extra
boost of reinforcement and praise to handling conflicts between team members fairly and decisively. Often,
managers may function as leaders even during small personal interactions by modeling supportive,
encouraging, and motivational qualities.
Controlling
To ensure all of the above functions are working toward the success of a company, managers should
consistently monitor employee performance, quality of work, and the efficiency and reliability of completed
projects. Control (and quality control) in management is about making sure the ultimate goals of the
business are being adequately met, as well as making any necessary changes when they aren't.

How to Develop Key Management Skills

While some of the above functions of management can extend logically from experience and skills
developed in entry-level positions, formal training and education may provide advantages. For instance,
pursuing a business management degree can offer the opportunity to study management philosophies and
best practices in order to help one prepare to pursue management positions following graduation.
Within every business structure are managers. No matter the type of business, a manager’s job is essentially
the same across the board but there are four functions of management to consider regardless of
the leadership style.
In short, those four functions are to plan and implement plans to achieve the organization’s goals, to
organize those plans while directing employees in their own roles and ultimately controlling the plan to
function as an effective manager.
Planning: The manager’s main duty is to determine what the organization’s goals are and what actions to
take in order to achieve those goals. Think of it like a football coach creating a playbook to help his team
reach the Super Bowl (or something like that). A manager is responsible for creating a ‘game plan’ to reach
a specific goal. For example: A weekly plan may include meetings, creating employee schedules or
receiving a report that details statistics. These are all actions that a manager plans to implement on a weekly
basis.
Organizing: Whether it is the employees or resources, the manager is responsible for organizing the daily
functions of it all. What shifts are needed? How many employees per shift? Are the employees reaching
their set goals? If not, why? These are only a few of the questions asked in the organization process of the
management functions. This process can also be considered the backbone of all the management functions
due to the fact that this step is more direct. In other words, this is the process employees actually see and are
affected by. If a manager is disorganized there is a ripple effect. Employees will lose respect for
management; making the next function of management harder to achieve.
Directing: Company objectives cannot be achieved if the manager doesn’t provide direction; however, if
you haven’t planned or organized you will not succeed with this function. Direction and motivation are the
key factors in directing. A clear plan that is organized and dispersed to employees is what employees are
seeking. A manager will find themselves to be an effective leader if their workers understand what is
required of them and why.
Controlling: The controlling function of management, in large part, is about monitoring the organization’s
performance to ensure the ultimate goals are being met and correcting any areas of the process that are
restricting the outcome desired. Praise and recognition are controlled at this level. Since the final data is
gathered here the manager generally knows who is and who isn’t excelling in their role of the processes.
You will ensure continued success if you acknowledge those that are exceeding expectations while at the
same time affecting another to strive for the same recognition. It is a win-win for everyone.
While there are many other functions to effective management; planning, organizing, directing and
controlling are the four main functions of management that should be considered the most important.
Learning how to balance each of the four functions simultaneously will lead to effective management.
Four Management Functions
1.) Strategic Planning
Planning alone is not enough. There has to be a solid strategy when doing this function so you have a
fallback when ideas go wrong.
This function can be defined through the FIOA model.
 Facts – list the major problem you need to solve
 Issues – encourage everyone to jot down the issues they have – whether it is internal or external
 Options – look at different options inside and outside the organisation
 Actions – create an action plan consisting realistic timelines & standards for completion
It is important to carefully identify what the responsibilities are, level of priorities and the realistic deadline
to meet goals. Brainstorm with key people from different departments and discuss what needs to be done.
There might be a need to reallocate tasks or making adjustments among the team’s current role.
Where adjustment is needed, identify how the transition affects everyone. The transition process must be
planned ahead. It could be re-training personnel who are affected or setting new rules aligned to the new
process.
2.) Organising
Organisation is not simply about delegation to relevant people within the team. It encompasses re-
organising processes in response to existing challenges.
Your written plan clearly tells you if there’s a need for role alteration or restructuring internal processes.
Organising includes slightly adjusting:
 Timeline of activities
 Resources needed to carry out tasks
 Designation and/or re-allocation of tasks and responsibilities to the key people with expertise to a
particular task
 Organisational structure and chain of communication
 Duties, responsibilities, authority and even relationship amongst team members
3.) Leading
A leading function in management doesn’t only entail motivating team members in achieving business
goals. Leaders must be able to project a strong sense of direction & leadership throughout the process.
However, this should be in accordance with the values and objective of the company.
For example, an organisation values everyone being heard. As a leader, you need to open yourself to ideas
from others – regardless of their roles. Directing them is not limited to being followed at all times. Give
them the free will to create wise decisions as it is what the organisation holds for.
4.) Controlling
Controlling determines if actions are followed according to plan. Leaders and/or those who are in
management roles must check the team’s progress. Begin with these simple questions:
 Are your KPIs met?
 Does everyone provide quality work?
 Are team members efficient when carrying out tasks?
 Is there a need to make adjustments to the current process?
Start asking questions with a yes-or-no answer. It makes pitfalls easier to identify. It also saves time and you
can allot more to finding ways how to resolve them.
The controlling process involves:
 Establishing standards to measure performance and/or quality of work
 Measuring actual performance
 Comparing performance with the organisational standards
 Taking corrective actions when necessary
Always keep in mind that without measurement, there’s no effective control. Controls need to focus on
results and outputs.
Defining a functional team
To define functional team and management is rather academic. However, applying it is very different. Each
involves commitment and dedication to the company’s goal, values and objectives. No matter how difficult
it may be, it results in high-performing team and management.
According to Peter Drucker;
“No institution can possibly survive if it needs geniuses or supermen to manage it. It must be organized in
such a way as to be able to get along under a leadership composed of average human beings.”
Hence, an organisation is not manned by one person but by a team that are dedicated to achieving a common
goal to succeed. A true leader works alongside the team as a coach and mentor.
BMG Outsourcing has included these functions into our core values and believes that these will not only
help us succeed but also to have continuous improvement. We ensure that our core values display all the
functions mentioned above. We would love to share the experience to enable you to reach high
performance. Talk to us at info@beale.net.au for more details about our services offered.
In order to fully grasp the functions of management, each member of the team should aim to be performed
at their best and align actions with the values of the company.
The set of core activities that defines the role of managers in a business environment. The four functions of
management include planning, or deciding upon business goals and the methods to achieve them;
organizing, or determining the best allocation of people and resources; directing, or motivating, instructing,
and supervising workers assigned to the activity; and control, or analyzing metrics during business activities
to ensure completion of tasks and identify areas for improvement.

Read more: http://www.businessdictionary.com/definition/four-functions-of-management.html

Management Roles
Mintzberg's Management Roles
Identifying the Roles Managers Play

As a manager, you probably fulfill many different roles every day.

For instance, as well as leading your team, you might find yourself resolving a conflict, negotiating
new contracts, representing your department at a board meeting, or approving a request for a new
computer system.
Put simply, you're constantly switching roles as tasks, situations, and expectations change.
Management expert and professor Henry Mintzberg recognized this, and he argued that there are ten
primary roles or behaviors that can be used to categorize a manager's different functions.
In this article and video, we'll examine these roles and see how you can use your understanding of
them to improve your management skills.
Click here to view a transcript of this video.
The Roles
Mintzberg published his Ten Management Roles in his book, "Mintzberg on Management: Inside our
Strange World of Organizations," in 1990.
The ten roles are:
1. Figurehead.
2. Leader.
3. Liaison.
4. Monitor.
5. Disseminator.
6. Spokesperson.
7. Entrepreneur.
8. Disturbance Handler.
9. Resource Allocator.
10. Negotiator.
From MINTZBERG ON MANAGEMENT by Henry Mintzberg. Copyright © 1989 by Henry
Mintzberg. Reprinted by permission of Free Press, a division of Simon & Schuster, Inc.
The 10 roles are then divided up into three categories, as follows:

Category Roles

Figurehead
Leader
Interpersonal Liaison

Monitor
Disseminator
Informational Spokesperson

Entrepreneur
Disturbance Handler
Resource Allocator
Decisional Negotiator

Let's look at each of the ten managerial roles in greater detail.

Interpersonal Category
The managerial roles in this category involve providing information and ideas.
1. Figurehead – As a manager, you have social, ceremonial and legal responsibilities. You're
expected to be a source of inspiration. People look up to you as a person with authority, and as a
figurehead.
2. Leader – This is where you provide leadership for your team, your department or perhaps your
entire organization; and it's where you manage the performance and responsibilities of everyone
in the group.
3. Liaison – Managers must communicate with internal and external contacts. You need to be able to
network effectively on behalf of your organization.
Informational Category
The managerial roles in this category involve processing information.
4. Monitor – In this role, you regularly seek out information related to your organization and
industry, looking for relevant changes in the environment. You also monitor your team, in terms
of both their productivity, and their well-being.
5. Disseminator – This is where you communicate potentially useful information to your colleagues
and your team.
6. Spokesperson – Managers represent and speak for their organization. In this role, you're
responsible for transmitting information about your organization and its goals to the people
outside it.
Decisional Category
The managerial roles in this category involve using information.
7. Entrepreneur – As a manager, you create and control change within the organization. This means
solving problems, generating new ideas, and implementing them.
8. Disturbance Handler – When an organization or team hits an unexpected roadblock, it's the
manager who must take charge. You also need to help mediate disputes within it.
9. Resource Allocator – You'll also need to determine where organizational resources are best
applied. This involves allocating funding, as well as assigning staff and other organizational
resources.
10. Negotiator – You may be needed to take part in, and direct, important negotiations within your
team, department, or organization.
Applying the Model
You can use Mintzberg's 10 Management Roles model as a frame of reference when you're thinking
about developing your own skills and knowledge. (This includes developing yourself in areas that you
consciously or unconsciously shy away from.)
First, examine how much time you currently spend on each managerial role. Do you spend most of
your day leading? Managing conflict? Disseminating information? This will help you decide which
areas to work on first.
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Next, get a piece of paper and write out all ten roles. Score yourself from 1-5 on each one, with 1 being
"Very skilled" to 5 being "Not skilled at all."
Once you've identified your weak areas, use the following resources to start improving your abilities
in each role.
Figurehead
Figureheads represent their teams. If you need to improve or build confidence in this area, start with
your image, behavior, and reputation . Cultivate humility and empathy , learn how to set a good
example at work , and think about how to be a good role model .
Leader
This is the role you probably spend most of your time fulfilling. To improve here, start by taking our
quiz, How Good Are Your Leadership Skills? This will give you a thorough understanding of your
current abilities.
Next, learn how to be an authentic leader , so your team will respect you. Also, focus on improving
your emotional intelligence – this is an important skill for being an effective leader.
Liaison
To improve your liaison skills, work on your professional networking techniques. You may also like
to take our Bite-Sized Training course on /community/Bite-
SizedTraining/Networking.phpNetworking Skills.
Monitor
To improve here, learn how to gather information effectively and overcome information overload .
Also, use effective reading strategies , so that you can process material quickly and thoroughly, and
learn how to keep up-to-date with industry news .
Disseminator
To be a good disseminator you need to know how to share information and outside views effectively,
which means that good communication skills are vital.
Learn how to share organizational information with Team Briefings . Next, focus on improving
your writing skills . You might also want to take our communication skills quiz , to find out where else
you can improve.
Spokesperson
To be effective in this role, make sure that you know how to represent your organization at a
conference . You may also want to read our articles on delivering great presentations and working
with the media (if applicable to your role).
Entrepreneur
To improve here, build on your change management skills, and learn what not to do when
implementing change in your organization. You'll also need to work on your problem
solving and creativity skills , so that you can come up with new ideas, and implement them
successfully.
Disturbance Handler
In this role, you need to excel at conflict resolution and know how to handle team conflict . It's also
helpful to be able to manage emotion in your team .
Resource Allocator
To improve as a resource allocator, learn how to manage a budget , cut costs , and prioritize , so that
you can make the best use of your resources. You can also use VRIO Analysis to learn how to get the
best results from the resources available to you.
Negotiator
Improve your negotiation skills by learning about Win-Win Negotiation and Distributive
Bargaining .
You might also want to read our article on role-playing – this technique can help you prepare for
difficult negotiations.
Key Points
Mintzberg's 10 Management Roles model sets out the essential roles that managers play. These are:
1. Figurehead.
2. Leader.
3. Liaison.
4. Monitor.
5. Disseminator.
6. Spokesperson.
7. Entrepreneur.
8. Disturbance Handler.
9. Resource Allocator.
10. Negotiator.
You can apply Mintzberg's 10 Management Roles model by using it as a frame of reference when you
want to develop your management skills. Work on the roles that you fulfill most often as a priority,
but remember that you won't necessarily fulfill every role as part of your job.
We have discussed the types (levels) of managers and some of their responsibilities but not their specific
activities. All managers must be comfortable with three main types of activities or roles. To do their jobs,
managers assume these different roles. No manager stays in any one role all of the time, but shifts back and
forth. These roles are leadership (or interpersonal), informational, and decision making. They were written
about in detail in the 1970s by Henry Mintzberg, a professor at McGill University in Canada. His
classifications are still one of the most studied descriptors of management roles today.[1]
Leadership and Interpersonal Roles
Which type of manager spends more time in leadership activities? The short answer is all effective
managers display leadership characteristics. Leadership is the ability to communicate a vision and inspire
people to embrace that vision.
Top managers are often required to fulfill what Mintzberg described as figurehead activities. They are the
public face of the management team and represent the business in legal, economic, and social
forums.[2] Middle managers are also leaders, although their focus may be more on interpersonal skills, such
as motivating employees, negotiating salaries, and encouraging innovation and creativity. First-line
managers lead both by example when they actively participate in the tasks assigned to their workers and by
modeling the policies and work ethics of the organization.
Informational Roles
Informational roles involve the receiving and sending of information—whether as a spokesperson, a mentor,
a trainer, or an administrator. A top manager is a voice of the organization and has to be aware that even
personal opinions will reflect (for better or worse) on the business. With the free flow of information on the
Internet, it is very difficult for top managers to separate their personal identities from their corporate
positions. For example, there was a consumer backlash in 2017 when Uber CEO Travis Kalanick accepted a
seat on President Trump’s economic advisory council. Kalanick initially said that he was “going to use [his]
position on the council to stand up for what’s right.” He resigned a few days later in response to the
protest.[3]
Middle managers must skillfully determine what information from top management should be shared with
others, how it should be interpreted, and how it should be presented. Similarly, they must weigh the value of
information they receive from first-line managers and employees in order to decide what to forward to top
management. If transmitted information tends to be untrue or trivial, then the manager will be viewed as a
nonreliable source and his or her opinions discounted.
The informational role for first-line managers is primarily one of disseminating what they have been given
and helping the employees to see how their own contributions further organizational goals. They have a
responsibility to see that the employees understand what they need to be successful in their jobs.
Decision Making Roles
All managers are required to make decisions, but managers at different levels make different kinds of
decisions. According to Mintzberg, there are four primary types of management decision roles. These
include the following:
 Entrepreneur. The entrepreneurs in a firm are usually top-level managers. They identify economic
opportunities, lead the initiative for change, and make product decisions.
 Disturbance handler. Top and middle managers will react to disturbances (unexpected events) in the
organization—whether internal or external. They will decide what corrective actions should be taken to
resolve the problems.
 Resource allocator. All levels of management will make resource allocation decisions, depending upon
whether the decision affects the entire organization, a single department, or a particular task or activity.
 Negotiator. Depending on the effect on the organization, most negotiation is done by top and middle-
level managers. Top managers will handle negotiations that affect the entire organization, such as union
contracts or trade agreements. Middle-level managers negotiate most salary and hiring decisions.[4]
To summarize, managers must play many roles. Some are better than others in particular roles and will tend
to be called on for those jobs. Putting a diverse management team in place will ensure that the organization
has enough managers to meet most challenges.
This article explains the Mintzberg Managerial Roles, developed by Henry Mintzberg, in a practical
way. After reading you will understand the basics of this powerful management tool for a manager.
What are managerial roles?
The Canadian management expert Henry Mintzberg is an authority in the field of organizational
structures and organizational design.
He has written many business books on various organisational management theories. Henry
Mintzberg distinguishes ten key managerial roles that managers and executives fulfil. These Mintzberg
Managerial Roles are subsequently divided up into three categories: the interpersonal category, the
informational category and the decisional category.
Six work-related characteristics
In 1973 Henry Mintzberg carried out empirical studies into the managerial behaviour of CEOs in five
private and semi-public organisations. From those first studies he was able to identify six characteristics that
define the work life of managers. Later there had been criticism of these studies, because Henry
Mintzberg had limited himself to five organisations only. It would only involve a small sample size as a
result of which the results could not be representative for organisations in other industries or hierarchical
management positions. The six characteristics are described below:
1. Managers process open-ended workloads;they are capable of doing a lot of work under demanding time
constraints.
2. Managers start up their own activities and subsequent actions. These activities are varied and
fragmented and they are relatively short in duration.
3. Managers prefer to avoid information from reference materials such as notes and documents.
4. Managers prefer verbal communication, such as one-on-one talks, telephone conversations and
meetings.
5. Managers maintain relationships primarily with subordinates and external parties and secondary with
their superiors.
6. Managers like being involved in preparatory decisions.
Environment
The studies show that the actual behaviour of managers is determined by their environment, is action drive
and they do not always show ordered or methodical behaviour.
Managers have to deal with many varied and short-term activities. It appears that managers preferably
transfer information verbally and that they do not always make fact-based decisions.
Even management techniques are not always applied effectively.
10 Mintzberg Managerial Roles
In addition, Henry Mintzberg describes the operational work of managers in terms of managerial roles.
The activities that are carried out by those managers are key elements. The way in which the Mintzberg
Managerial Roles are carried out, are influenced by individual and situational factors. Henry
Mintzberg initially divided the ten managerial Roles roles into three sub categories:
 Interpersonal contact
 Information processing
 Decision making
Interpersonal contact
Interpersonal contact concerns the contact between the manager and the people in his environment. For
example, subordinates, other managers, the board of directors, the works council, customers and suppliers.
The following Mintzberg Managerial Roles are primarily concerned with interpersonal contact:
1. Figurehead
As head of a department or an organisation, a manager is expected to carry out ceremonial and/or symbolic
duties. A manager represents the company both internally and externally in all matters of formality.
He is a networker but he also serves as an exemplary role model. He is the one who addresses people
celebrating their anniversaries, attends business dinners and receptions.
2. Leader
In his leading role, the manager motivates and develops staff and fosters a positive work environment. He
coaches and supports staff, enters into (official) conversations with them, assesses them and offers education
and training courses.
3. Liason
A manager serves as an intermediary and a linking pin between the high and low levels. In addition, he
develops and maintains an external network.
As a networker he has external contacts and he brings the right parties together. This will ultimately result in
a positive contribution to the organization.
Information processing
According to Henry Mintzberg, the managerial role involves the processing of information which means
that they send, pass on and analyze information. Managers are linking pins; they are expected to exchange
flows of vertical information with their subordinates and horizontal flows of information with their fellow
managers and the board of directors. Further more, managers have the responsibility to filter and transmit
information that is important for both groups. The following Mintzberg Managerial Roles fall under process
information:
4. Monitor
As a monitor the manager gathers all internal and external information that is relevant to the organization.
He is also responsible for arranging, analyzing and assessing this information so that he can easily identify
problems and opportunities and identify changes.
5. Disseminator
As a disseminator the manager transmits factual information to his subordinates and to other people within
the organization.
This may be information that was obtained either internally or externally.
6. Spokesman
As a spokesman the manager represents the company and he communicates to the outside world on
corporate policies, performance and other relevant information for external parties.
Decision-making
Managers are responsible for decision-making and they can do this in different ways at different levels. The
leadership style is important in decision-making.
An authoritarian leader is sooner inclined to make decisions independently than a democratic leader. The
following Mintzberg Managerial Roles fall under decision-making:
7. Entrepreneur
As an entrepreneur, the manager designs and initiates changes and strategies.
8. Disturbance handler
In his managerial role as disturbance handler, the manager will always immediately respond to unexpected
events and operational breakdowns. He aims for usable solutions.
The problems may be internal or external, for example conflict situations or the scarcity of raw materials. .
9. Resource allocator
In his resource allocator role, the manager controls and authorizes the use of organizational resources.
He allocates finance, assigns employees, positions of power, machines, materials and other resources so that
all activities can be well-executed within the organization.
10. Negotiator
As a negotiator, the manager participates in negotiations with other organizations and individuals and he
represents the interests of the organization.
This may be in relation to his own staff as well as to third parties. For example salary negotiations or
negotiations with respect to procurement terms.
Skills
According to Henry Mintzberg, the skills of individual managers do not always contribute to the success of
an organization.
Effective managers develop themselves based on protocols for action. In addition, they use their leadership
roles independently and they know to use the right role for the right situation.
The Mintzberg Managerial Roles make it easier to understand what the nature of their work is. Mintzberg’s
objective was to observe and analyze managerial behaviour.
By studying the Mintzberg Managerial Roles, it is possible to find out in which areas managers can improve
themselves and how they can develop the right skills.
Tool for managers
The 10 Mintzberg Managerial Roles provide a tool for managers and other people in leading positions. By
understanding their own roles, they can find out how much time they devote to the activities below:
 Directing subordinates
 Attending meetings as a Liason
 Representing the organization
 Transmitting information
 Analyzing information
 Allocation of resources
 Negotiating resources
 Problem solving
 Developing new ideas
 Promoting the interests of the organization
Furthermore, it is important that the manager answers the following questions. This will provide more
insight into his own qualities:
 Is the time distribution in sync with the manager’s own perception of it?
 Is there a balance between time flow and work distribution?
 Which tasks boost the manager’s energy?
 Which is the most satisfying task of a manager?
 Which task does the manager most unpleasant?
In practice a certain managerial role will more predominant than the other. In addition to preference, this
also has to do with the interdependence of factors, such as the position of the manager within the
organization, the activities, the composition of the team and the size of the organization.
One of the managerial roles mentioned is always visible and in some activities, multiple roles at the same
time are possible.
It’s Your Turn
What do you think? Do you recognize the Mintzberg Managerial Roles in today’s companies? And if so,
how do you understand and develop these? What are your general results and learning lessons? Are the
basics the same or are there additional success factors?
Share your experience and knowledge in the comments box below.
If you liked this article, then please subscribe to our Free Newsletter for the latest posts on Management
models and methods. You can also find us on Facebook, LinkedIn, Google+ and YouTube.
More information
1. Alexander, L. D. (1979). The Effect Level in the Hierarchy and Functional Area Have on the Extent
Mintzberg’s Roles Are Required by Managerial Jobs. In Academy of Management Proceedings (Vol.
1979, No. 1, pp. 186-189). Academy of Management.
2. Bass, B. M., & Stogdill, R. M. (1990). Handbook of leadership. Free Press.
3. Grover, V., Jeong, S. R., Kettinger, W. J., & Lee, C. C. (1993). The chief information officer: A study of
managerial roles. Journal of Management Information Systems, 10(2), 107-130.
4. Mintzberg, H. (1989). Mintzberg on management: Inside our strange world of organizations. Hungry
Minds Inc.
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Note: all her articles are written in Dutch and we translated her articles in English!
Henry Mintzberg proposed an alternative approach to defining what management is about. Instead of
describing in theory what managers should do, he studied what managers actually spend their time doing.
This led him to describe management in terms of the different roles that managers undertake. The ten major
roles that he identified are discussed in 1.2.1 below.
1.2.1 The roles of managers
'Mintzberg shows a substantial difference between what managers do and what they are said to do. On the
basis of work activity studies, he demonstrates that a manager's job is characterised by pace, interruptions,
brevity, variety, and fragmentation of activities, and a preference for verbal contacts. Managers spend a
considerable amount of time in scheduled meetings and in networks of contacts outside meetings.
The fragmentary nature of what managers do leads to the suggestion that they have to perform a wide
variety of roles. Mintzberg suggests that there are ten managerial roles which can be grouped into three
areas: interpersonal, informational and decisional.
Interpersonal roles cover the relationships that a manager has to have with others. The three roles within
this category are figurehead, leader and liaison. Managers have to act as figureheads because of their formal
authority and symbolic position, representing their organisations. As leader, managers have to bring together
the needs of an organisation and those of the individuals under their command. The third interpersonal role,
that of liaison, deals with the horizontal relationships which work-activity studies have shown to be
important for a manager. A manager has to maintain a network of relationships outside the organisation.
Managers have to collect, disseminate and transmit information and have three
corresponding informational roles, namely monitor, disseminator and spokesperson. A manager is an
important figure in monitoring what goes on in the organisation, receiving information about both internal
and external events and transmitting it to others. This process of transmission is the dissemination role,
passing on information of both a factual and value kind. A manager often has to give information
concerning the organisation to outsiders, taking on the role of spokesperson to both the general public and
those in positions of influence.
As with so many writers about management, Mintzberg regards the most crucial part of managerial activity
as that concerned with making decisions. The four roles that he places in this category are based on
different classes of decision, namely, entrepreneurs, disturbance handler, resource allocator, and negotiator.
As entrepreneurs, managers make decisions about changing what is happening in an organisation. They may
have to both initiate change and take an active part in deciding exactly what is to be done. In principle, they
are acting voluntarily. This is very different from their role as a disturbance handler, where managers have
to make decisions which arise from events beyond their control and unpredicted. The ability to react to
events as well as to plan activities is an important managerial skill in Mintzberg's eyes.
The resource allocation role of a manager is central to much organisational analysis. Clearly a manager has
to make decisions about the allocation of money, people, equipment, time and so on. Mintzberg points out
that in doing so a manager is actually scheduling time, programming work and authorising actions. The
negotiation role is put in the decisional category by Mintzberg because it is 'resource trading in real time'. A
manager has to negotiate with others and in the process be able to make decisions about the commitment of
organisational resources.
For Mintzberg these ten roles provide a more adequate description of what managers do than any of the
various schools of management thought. In these roles it is information that is crucial: the manager is
determining the priority of information. Through the interpersonal roles a manager acquires information,
and through the decisional roles it is put into use.
The scope for each manager to choose a different blend of roles means that management is not reducible to
a set of scientific statements and programmes. Management is essentially an art and it is necessary for
managers to try and learn continuously about their own situations. Self-study is vital. At the moment there is
no solid basis for teaching a theory of managing. According to Mintzberg, "the management school has
been more effective at training technocrats to deal with structured problems than managers to deal with
unstructured ones."'
Source: Pugh and Hickson (2007) pp. 30-31.
If you are a manager, how many of Mintzberg's roles do you perform? Which ones are you good at
and which ones do you struggle with? (If you are not a manager, try to think about this in relation to
a manager whose work you know well.)
Which of the two descriptions of management (functions or roles) do you find more helpful? If you have
experience of rural development, try to identify how this has influenced your answer.
Mintzberg's roles were intended to provide a better description of management in practice than the classical
list of management functions. Rather than spending their days planning and organising in an orderly
fashion, many managers live hectic lives in constantly changing contexts. Hence, they have to be adaptable
and responsive, not just pro-active and controlling.
Moreover, managers are not just involved in managing the internal resources of their organisation, but also
spend a great deal of time in maintaining contacts with other people, both within and outside the
organisation. This is partly because they need to be aware of any changes in the environment which may
affect their (part of the) organisation, an activity known as 'boundary scanning'. Managers in business need
to be aware of what their competitors are doing, of trends in consumer demand, and of changes in the
economic environment. Managers in public sector organisations or NGOs in rural development may need to
monitor prices and activity in certain (local or wider) markets, progress with a cropping season, political
developments relevant to their organisation, what other organisations are doing and so on.
Mintzberg's analysis is also valuable in highlighting the importance of various forms of information to an
organisation. Information may be seen as a resource to be set alongside personnel and capital.
However, what managers actually do is not necessarily what they want to be doing or should be doing. Even
if Mintzberg's respondents were all pursuing good management practice, recognition of his ten roles does
not invalidate the importance of planning, organising, leading and controlling. Some of Mintzberg's roles
express 'how' managers inform their plans, lead and motivate their staff etc. Others (eg disturbance handler,
negotiator) could even be seen as skills that managers need to develop, so as not to get sidetracked from the
strategic priorities of their position and of their organisation.
Managerial Roles
A lot of studies have gone behind describing the behavior of a manager in an organization. Traditionally,
most employees believed that a manager was certainly someone who sat comfortably in his office thinking
and planning and giving instructions to employees.
However, over time a manager’s behavior was divided into functions and managerial roles. In this article,
we will look at the various managerial roles that managers perform over the course of a single day.
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Introduction
In 1973, Henry Mintzberg – a Canadian academic and author on business and management published a
book called ‘The Nature of Managerial Work’. A classic now, Mintzberg based his book on data derived
from the time diaries of male executives.
The data suggested that managers actually did not spend a lot of time on planning or strategizing. On the
contrary, they spent most of their day answering telephone calls, solving problems, dealing with people,
responding to crises, and had to deal with interruptions regularly.
He found that managers could not stick to one task since they were constantly being interrupted either by a
phone call or a crisis. Over the years, managerial roles have become busier and more stressful.
So much so, that managers find their days never-ending. With an economy that runs 24x7x365, multiple
chains of command, numerous projects, and frequently changing technology, etc., managers have a tough
time on their jobs.
Managerial Roles
For better understanding, Mintzberg categorized all activities into ten managerial roles performed over the
course of a day. These are as follows:

Interpersonal Roles
 Figurehead – includes symbolic duties which are legal or social in nature.
 Leader – includes all aspects of being a good leader. This involves building a team, coaching the
members, motivating them, and developing strong relationships.
 Liaison – includes developing and maintaining a network outside the office for information and
assistance.
Informational Roles
 Monitor – includes seeking information regarding the issues that are affecting the organization. Also,
this includes internal as well as external information.
 Disseminator – On receiving any important information from internal or external sources, the same
needs to be disseminated or transmitted within the organization.
 Spokesperson – includes representing the organization and providing information about the organization
to outsiders.
Decisional Roles
 Entrepreneur – involves all aspects associated with acting as an initiator, designer, and also an
encourager of innovation and change.
 Disturbance handler – taking corrective action when the organization faces unexpected difficulties
which are important in nature.
 Resource Allocator – being responsible for the optimum allocation of resources like time, equipment,
funds, and also human resources, etc.
 Negotiator – includes representing the organization in negotiations which affect the manager’s scope of
responsibility.
In carrying out the responsibilities of planning, organizing, leading, and controlling, managers take on many
different roles. A role is a set of behavioral expectations, or a set of activities that a person is expected to
perform. Managers’ roles fall into three basic categories: informational roles, interpersonal
roles, and decisional roles. These roles are summarized in (Figure). In an informational role, the manager
may act as an information gatherer, an information distributor, or a spokesperson for the company. A
manager’s interpersonal roles are based on various interactions with other people. Depending on the
situation, a manager may need to act as a figurehead, a company leader, or a liaison. When acting in
a decisional role, a manager may have to think like an entrepreneur, make decisions about resource
allocation, help resolve conflicts, or negotiate compromises.
Managerial Decision Making
In every function performed, role taken on, and set of skills applied, a manager is a decision maker.
Decision-making means choosing among alternatives. Decision-making occurs in response to the
identification of a problem or an opportunity. The decisions managers make fall into two basic categories:
programmed and nonprogrammed. Programmed decisions are made in response to routine situations that
occur frequently in a variety of settings throughout an organization. For example, the need to hire new
personnel is a common situation for most organizations. Therefore, standard procedures for recruitment and
selection are developed and followed in most companies.

The Many Roles Managers Play in an Organization

Role
Description
Example
Information Roles
Monitor
 Seeks out and gathers information relevant to the organization
 Finding out about legal restrictions on new product technology
Disseminator
 Provides information where it is needed in the organization
 Providing current production figures to workers on the assembly line
Spokesperson
 Transmits information to people outside the organization
 Representing the company at a shareholders’ meeting
Interpersonal Roles
Figurehead
 Represents the company in a symbolic way
 Cutting the ribbon at ceremony for the opening of a new building
Leader
 Guides and motivates employees to achieve organizational goals
 Helping subordinates to set monthly performance goals
Liaison
 Acts as a go-between among individuals inside and outside the organization
 Representing the retail sales division of the company at a regional sales meeting
Decisional Roles
Entrepreneur
 Searches out new opportunities and initiates change
 Implementing a new production process using new technology
Disturbance handler
 Handles unexpected events and crises
 Handling a crisis situation such as a fire
Resource allocator
 Designates the use of financial, human, and other organizational resources
 Approving the funds necessary to purchase computer equipment and hire personnel
Negotiator
 Represents the company at negotiating processes
 Participating in salary negotiations with union representatives
Infrequent, unforeseen, or very unusual problems and opportunities require nonprogrammed decisions by
managers. Because these situations are unique and complex, the manager rarely has a precedent to follow.
The earlier example of the Norfolk Southern employee, who had to decide the best way to salvage a five-
mile-long piece of railroad track from the bottom of Lake Pontchartrain, is an example of a nonprogrammed
decision. Likewise, when Hurricane Katrina was forecast to make landfall, Thomas Oreck, then CEO of the
vacuum manufacturer that bears his name, had to make a series of nonprogrammed decisions. Oreck’s
corporate headquarters were in New Orleans, and its primary manufacturing facility was in Long Beach,
Mississippi. Before the storm hit, Oreck transferred its computer systems and call-center operations to
backup locations in Colorado and planned to move headquarters to Long Beach. The storm, however,
brutally hit both locations. Oreck executives began searching for lost employees, tracking down generators,
assembling temporary housing for workers, and making deals with UPS to begin distributing its product
(UPS brought food and water to Oreck from Atlanta and took vacuums back to the company’s distribution
center there). All of these decisions were made in the middle of a very challenging crisis environment.
Whether a decision is programmed or nonprogrammed, managers typically follow five steps in the decision-
making process, as illustrated in (Figure):
1. Recognize or define the problem or opportunity. Although it is more common to focus on problems
because of their obvious negative effects, managers who do not take advantage of new opportunities
may lose competitive advantage to other firms.
2. Gather information so as to identify alternative solutions or actions.
3. Select one or more alternatives after evaluating the strengths and weaknesses of each possibility.
4. Put the chosen alternative into action.
5. Gather information to obtain feedback on the effectiveness of the chosen plan.
It can be easy (and dangerous) for managers to get stuck at any stage of the decision-making process. For
example, entrepreneurs can become paralyzed evaluating the options. For the Gabby Slome, the cofounder
of natural pet food maker Ollie, the idea for starting the company came after her rescue dog began having
trouble digesting store-bought pet food after living on scraps. Slome decided that the pet food industry, a
$30 billion a year business, was ripe for a natural food alternative. She laments, however, that she let perfect
be the enemy of the very good by indulging in “analysis paralysis.”

Megan Bruneau, “Overcome ‘Analysis Paralysis’ and Execute on Your Idea: 5 Tips from Ollie Cofounder
Gabby Slome,” Forbes, https: www.forbes.com, November 19, 2017.

The Decision-Making Process

(Attribution: Copyright Rice University, OpenStax, under CC BY 4.0 license.)

1. What are the three types of managerial roles?

2. Give examples of things managers might do when acting in each of the different types of roles.
3. List the five steps in the decision-making process.
Managerial Roles
Another approach to study management is to examine the roles that managers are expected to perform.
These roles can be defined as the organized sets of behaviors identified with the position. These roles were
developed by Henry Mintzberg in the late 1960s after a careful study of executives at work. All these roles
in one form or another deal with people and their interpersonal relationships.

These ten managerial roles are divided into three categories. The first category of interpersonal roles arises
directly from the manager’s position and the formal authority bestowed upon him. The second category of
informational roles is played as a direct result of interpersonal roles and these two categories lead to the
third category of decisional roles.

Interpersonal Roles
Managers spend a considerable amount of time in interacting with other people both within their own
organizations as well as outside. These people include peers, subordinates, superiors, suppliers, customers,
government officials and community leaders. All these interactions require an understanding of
interpersonal relations. Studies show that interacting with people takes up nearly 80 per cent of a manager’s
time. These interactions involve the following three major interpersonal roles:

Figurehead: Managers act as symbolic figureheads performing social or legal obligations. These duties
include greeting visitors, signing legal documents, taking important customers to lunch, attending a
subordinate’s wedding or speaking at functions in schools and churches. All these/ primarily, are duties of a
ceremonial nature but are important for the smooth functioning of the organization

Leader: The influence of the manager is most clearly seen in his role as a leader of the unit or organization.
Since he is responsible for the activities of his subordinates, he must lead and coordinate their activities in
meeting task-related goals and he must motivate them to perform better. He must be an exemplary leader so
that his subordinates follow his directions and guidelines with respect and dedication.

Liaison: In addition to their constant contact with their own subordinates, peers and superiors, the managers
must maintain a network of outside contacts in order to assess the external environment of competition,
social changes or changes in governmental rules, regulations and laws. In this role, the managers build up
their own external information system.

In addition, they develop networks of mutual obligations with other managers in the organization. They also
form alliances to win support for their proposals or decisions. The liaison with external sources of
information can be developed by attending meetings and professional conferences, by personal phone calls,
trade journals and by informal personal contacts within outside agencies.

Informational Roles
By virtue of his interpersonal contacts, a manager emerges as a source of information about a variety of
issues concerning the organization. In this capacity of information processing, a manager executes the
following three roles:

Monitor: The managers are constantly monitoring and scanning their environment, both internal and
external, collecting and studying information regarding their organization and the outside environment
affecting their organization. This can be done by reading reports and periodicals, by asking their liaison
contacts and through gossip, hearsay and speculation.
Disseminator of Information: The managers must transmit their information regarding changes in policies
or other matters to their subordinates, their peers and to other members of the organization. This can be
done through memorandums, phone calls, individual meetings and group meetings.

Spokesperson: A manager has to be a spokesman for his unit and he represents his unit in either sending
relevant information to people outside his unit or making some demands on behalf of his unit. This may be
in the form of the president of the company making a speech to a lobby on behalf of an organizational cause
or an engineer suggesting a product modification to a supplier.
Decisional Roles
On the basis of the environmental information received, a manager must make decisions and solve
organizational problems. In that respect, a manager plays four important roles.

Entrepreneur: As entrepreneurs, managers are continuously involved in improving their units and facing the
dynamic technological challenges. They are constantly on the lookout for new ideas for product
improvement or products addition.

They initiate feasibility studies, arrange for capital for new products if necessary, and ask for suggestions
from the employees for ways to improve the organization. This can be achieved through suggestion boxes,
holding strategy meetings with project managers and R & D personnel.

Conflict Handler: The managers are constantly involved as arbitrators in solving differences among the
subordinates or the employee’s conflicts with the central management. These conflicts may arise due to
demands for higher pay or other benefits or these conflicts may involve outside forces such as vendors
increasing their prices, a major customer going bankrupt or unwanted visits by governmental inspectors.

Managers must anticipate such problems and take preventive action if possible or take corrective action
once the problems have arisen. These problems may also involve labor disputes, customer complaints,
employee grievances, machine breakdowns, cash flow shortages and interpersonal conflicts.

Resource Allocator: The third decisional role of a manager is that of a resource allocator. The managers
establish priorities among various projects or programs and make budgetary allocations to the different
activities of the organization based upon these priorities. They assign personnel to jobs, they allocate their
own time to different activities and they allocate funds for new equipment, advertising and pay raises.

Negotiator: The managers represent their units or organizations in negotiating deals and agreements within
and outside of the organization. They negotiate contracts with the unions. Sale managers may negotiate
prices with prime customers. Purchasing managers may negotiate prices with vendors.
All these ten roles are important in a manager’s job and are interrelated even through some roles may be
more influential than others, depending upon the managerial position. For example, sales managers may
give more importance to interpersonal roles while the production managers may give more importance to
decisional roles.

The ability to recognize the appropriate role to play in each situation and the flexibility to change roles
readily when necessary, are characteristics of effective managers. Most often, however, the managerial
effectiveness is determined by how well the decisional roles are performed.
Management Skills
What are Management Skills?
Management skills can be defined as certain attributes or abilities that an executive should possess in order
to fulfill specific tasks in an organization. They include the capacity to perform executive duties in
an organization while avoiding crisis situations and promptly solving problems when they occur.
Management skills can be developed through learning and practical experience as a manager. The skills help
the manager to relate with their fellow co-workers and know how to deal well with their subordinates, which
allows for the easy flow of activities in the organization.
Good management skills are vital for any organization to succeed and achieve its goals and objectives. A
manager who fosters good management skills is able to propel the company’s mission and vision or
business goals forward with fewer hurdles and objections from internal and external sources.
Management and leadership skills are often used interchangeably as they both involve planning, decision-
making, problem-solving, communication, delegation, and time management. Good managers are almost
always good leaders as well. In addition to leading, a critical role of a manager is to also ensure that all parts
of the organization are functioning cohesively. Without such integration, several issues can arise and failure
is bound to happen. Management skills are crucial for various positions and at different levels of a company,
from top leadership to intermediate supervisors to first level managers.
Types of Management Skills
According to American social and organizational psychologist Robert Katz, the three basic types of
management skills include:

1. Technical Skills
Technical skills involve skills that give the managers the ability and the knowledge to use a variety of
techniques to achieve their objectives. These skills not only involve operating machines and software,
production tools, and pieces of equipment but also the skills needed to boost sales, design different types of
products and services, and market the services and the products.

2. Conceptual Skills
These involve the skills managers present in terms of the knowledge and ability for abstract thinking and
formulating ideas. The manager is able to see an entire concept, analyze and diagnose a problem, and find
creative solutions. This helps the manager to effectively predict hurdles their department or the business as a
whole may face.

3. Human or Interpersonal Skills

The human or the interpersonal skills are the skills that present the managers’ ability to interact, work or
relate effectively with people. These skills enable the managers to make use of human potential in the
company and motivate the employees for better results.
Examples of Management Skills
There is a wide range of skills that management should possess to run an organization effectively and
efficiently. The following are six essential management skills that any manager ought to possess for them to
perform their duties:

1. Planning
Planning is a vital aspect within an organization. Planning is one’s ability to organize activities in line with
set guidelines while still remaining within the limits of the available resources such as time, money, and
labor. It is also the process of formulating a set of actions or one or more strategies to pursue to achieve
certain goals or objectives with the available resources. The planning process includes identifying and
setting achievable goals, developing necessary strategies, and outlining the tasks and schedules on how to
achieve the set goals. Without a good plan, little can be achieved.

2. Communication
Possessing great communication skills is crucial for a manager. It can determine how well information is
shared throughout a team, ensuring that the group acts as a unified workforce. How well a manager
communicates with the rest of his team also determines how well outlined procedures can be followed, how
well the tasks and activities can be completed, and thus, how successful an organization will be.
Communication involves the flow of information within the organization, whether formal or informal,
verbal or written, vertical or horizontal, and it facilitates smooth functioning of the organization. Clearly
established communication channels in an organization allow the manager to collaborate with the team,
prevent conflicts, and resolve issues as they arise. A manager with good communication skills can relate
well with the employees and thus, able to achieve the company’s set goals and objectives easily.

3. Decision-making
Another vital management skill is decision-making. Managers make numerous decisions, whether
knowingly or not, and making decisions is a key component in a manager’s success. Making proper and
right decisions results in the success of the organization, while poor or bad decisions may lead to failure or
poor performance. For the organization to run effectively and smoothly, clear and right decisions should be
made. A manager must be accountable for every decision that they make and also be willing to take
responsibility for the results of their decisions. A good manager needs to possess great decision-making
skills, as it often dictates his/her success in achieving organizational objectives.

4. Delegation
Delegation is another key management skill. Delegation is the act of passing on work-related tasks and/or
authorities to other employees or subordinates. It involves the process of allowing your tasks or those of
your employees to be re-assigned or re-allocated to other employees depending on current workloads. A
manager with good delegation skills is able to effectively and efficiently re-assign tasks and give authority
to the right employees. When delegation is carried out effectively, it helps facilitate quick and easy results.
Delegation helps the manager to avoid wastage of time, optimizes productivity, and ensures responsibility
and accountability on the part of employees. Every manager must have good delegation abilities to achieve
optimal results and accomplish the required productivity results.

5. Problem-solving
Problem-solving is another essential skill. A good manager must have the ability to tackle and solve the
frequent problems that can arise in a typical workday. Problem-solving in management involves identifying
a certain problem or situation and then finding the best way to handle the problem and get the best solution.
It is the ability to sort things out even when the prevailing conditions are not right. When it is clear that a
manager has great problem-solving skills, it differentiates him/her from the rest of the team and gives
subordinates confidence in his/her managerial skills.

6. Motivating
The ability to motivate is another important skill in an organization. Motivation helps bring forth a desired
behavior or response from the employees or certain stakeholders. There are numerous motivation tactics that
managers can use, and choosing the right ones can depend on characteristics such as company and team
 culture, team personalities, and more. There are two primary types of motivation that a manager can use,
which includes intrinsic and extrinsic motivation.

Bottom Line
Management skills are a collection of abilities that include things such as business planning, decision-
making, problem-solving, communication, delegation, and time management. While different roles and
organizations require the use of various skillsets, management skills help a professional stand out and excel
no matter what their level. In top management, these skills are essential to run an organization well and
achieve desired business objectives.
Organizations of all types require competent management in order to run smoothly and optimize the potential
for profit and growth. Of course, management skills are applied to jobs labeled as "management positions" in
the organizational chart, but are also vital for employees in many other roles.
For example, event planners need management skills to orchestrate events, secretaries need
management skills to manage office processes, and benefits specialists need them to organize information
sessions for employees.
What Are Management Skills?
Management skills are applied to a broad array of functions in areas like production, finance, accounting,
marketing, and human resources. Common components of management in different arenas include: selection,
supervision, motivation and evaluation of staff, scheduling and planning of workflow, developing policies and
procedures, measuring and documenting results for a group or department, solving problems, developing and
monitoring budgets and expenditures, staying abreast of trends in the field, collaborating with other staff and
departments, and leading and motivating employees.
Types of Management Skills
Most management skills are related to six fundamental functions: planning, organizing, coordinating, directing,
leadership, and oversight.

© The Balance, 2018

Planning
Individual managers may or may not be personally involved in drafting company policy and strategy, but even
those who aren’t still must be able to plan. You might be given certain objectives and then be responsible for
developing ways to meet those objectives. You may need to adjust or adapt someone else’s plan to new
circumstances. In either case, you’ll have to understand what your resources are, develop time tables and
budgets, and assign tasks and areas of responsibility.
Aspiring managers should volunteer to help their current supervisors with phases of departmental planning
in order to hone their skills.
Planning programs for professional societies is another way to develop and document planning abilities.
Mastering planning software, like NetSuite OpenAir, and project management software, like Workfront, can
prove that you're able to tap technology that's instrumental to sound planning. College students should take on
leadership positions with campus organizations to hone their planning skills.
  Analyzing Business Problems
 Analyzing Expenditures
 Critical Thinking
 Devising Plans for New Business
 Development, Entrepreneurialism
 Identifying the Interests and Preferences of Stakeholders
 Microsoft Office,
 Proposing Solutions to Business Problems
 Problem Solving
 Research, Qualitative Skills
 Strategic Planning
 Strategic Thinking
 Tapping Information Technology to Facilitate Decision Making
 Writing Proposals for Business Initiatives or Projects, Vision
 Project Management
 Utilizing Planning Software
Organizing
Organizing generally means creating structures to support or accomplish a plan. This might involve creating a
new system of who reports to whom, designing a new layout for the office, planning a conference or event,
building a strategy and planning around how to move through a project, or determining how to move toward
deadlines or how to measure milestones.
Aspects of organization could also mean helping leaders under your guidance to manage their subordinates
well.
Organization is about planning and foresight, and it requires an ability to comprehend the big picture.
Identify processes, procedures, or events related to your department that could be improved, and demonstrate
that you can re-design processes to create greater efficiency or enhance quality. Document procedures in a
manual or spreadsheet for future use.
 Accuracy
 Administrative
 Analytical Ability
 Assessing Factors Impacting Productivity
 Business Storytelling
 Framing Communication Toward Specific Audiences
  Innovation
 Logical Thinking
 Logistics
 Negotiating
 Networking
 Persuasion
 Presentation
 Public Speaking
 Suggesting Ways to Enhance Productivity
 Technical Knowledge
 Technology
 Time Management
Leadership
The best managers are typically inspirational and effective leaders. They set the tone for their areas by
demonstrating—through their actions—norms for staff behavior.
Effective leaders often lead by example as much as by direction. Motivating others to action and productivity is
a crucial element of effective leadership.
Clear communication of goals and expectations is also vital. Good leaders seek input from all stakeholders and
recognize the contributions of other team members, and they give credit where credit is due. Good leaders draw
consensus on group plans whenever feasible, and they delegate strategically to the best-qualified staff.
Develop leadership skills by volunteering to run point on projects. College students should volunteer to take on
a leadership role with group projects, sports teams, and student organizations.
 Delegation
 Presentation
 Humility
 Networking
 Confidence
 High Energy
 Clear Communication
 Writing
 Budgeting
 Motivating Others
 Problem Solving
  Persuasion
 Evaluating Talent
 Supervision
 Charisma
 Integrity
 Passion for Work
 Networking
Coordinating
Managers must know what is happening, what needs to happen, and who and what are available to accomplish
assigned tasks. If someone is miscommunicating, if someone needs help, or if a problem is being overlooked or
a resource underutilized, a manager needs to notice and correct the issue. Coordinating is the skill that lets the
organization act as a unified whole. Coordination across departments and functions is also essential to a well-
run organization that presents a unified face to constituents.
Develop a solid team orientation by close communication and cooperation with co-workers. Seek out
opportunities to collaborate with other staff and departments.
 Adaptability
 Adapting to Changing Business Conditions
 Building Productive Relationships
 Collaboration
 Communication
 Drawing Consensus
 Diplomacy
 Emotional Intelligence
 Empathy
 Facilitating Group Discussions
 Flexibility
 Honesty
 Influencing
 Listening
 Nonverbal Communication
 Patience
 Punctuality
 Relationship Building
  Scheduling
 Screening Applicants for Jobs, Staffing
 Tactfulness
 Teaching
 Team Building
 Team Manager
 Team Player
 Teamwork
 Time Management
Directing and Oversight
Directing is the part where you take charge and delegate (tell people what to do), give orders, and make
decisions. Someone has to do it, and that someone could be you.
Organization is about planning and foresight, and it requires an ability to comprehend the big picture.
It might include anything from reviewing business models and checking for inefficiencies to checking to make
sure a project is on time and on budget. Oversight is the maintenance phase of management.
 Achieving Goals,
 Assessing Progress Towards Departmental Goals
 Conflict Management
 Creating Budgets for Business Units
 Creating Financial Reports
 Conflict Resolution
 Decision Making
 Delegation
 Delivering Presentations
 Division of Work
 Empowerment
 Engagement
 Evaluating Job Candidates
 Evaluating Employee Performance
 Execution
 Focus, Goal Orientation
 Goal Setting
  Hiring
 Interacting with Individuals from Diverse Backgrounds
 Interpersonal
 Interpreting Financial Data
 Interviewing Candidates for Jobs
 Leadership
 Motivation
 Overcoming Obstacles
 Productivity
 Problem Solving
 Professionalism
 Providing Constructive Criticism
 Recommending Cost-Cutting Measures
 Recommending Process Improvements
 Responding Favorably to Criticism
 Responsibility
 Training Employees
 Verbal Communication
Management Skills List
The following is a comprehensive list of management skills to use in resumes, job applications, cover letters,
and during job interviews.
 Accuracy
 Achieving Goals
 Adaptability
 Administrative
 Analytical Ability
 Assertiveness
 Budget Management
 Business Management
 Business Storytelling
 Collaboration
 Communication
 Conflict Management
 Conflict Resolution
 Coordination
 Critical Thinking
 Decision Making
 Delegation
 Development
 Diplomacy
 Discipline
 Division of Work
 Dynamic
 Emotional Intelligence
 Empathy
 Empowerment
 Energetic
 Engagement
 Execution
 Facilitating
 Finance
 Financial Management
 Flexibility
 Focus
 Genuine
 Goal-oriented
 Goal Setting
 Hiring
 Honesty
 Influencing
 Innovation
 Interpersonal
 Leadership
 Legal
 Listening
 Logical Thinking
 Logistics
 Microsoft Office
 Motivation
 Negotiating
 Networking
 Nonverbal Communication
 Obstacle Removal
 Organizing
 Patience
 Persuasion
 Planning
 Presentation
 Productivity
 Problem Solving
 Professionalism
 Product Management
 Project Management
 Process Management
 Public Speaking
 Punctuality
 Research
 Responsibility
 Qualitative Skills
 Sales
 Scheduling
 Staffing
 Strategic Planning
 Strategic Thinking
  Success
 Tactfulness
 Teaching
 Team Building
 Team Manager
 Team Player
 Teamwork
 Technical Knowledge
 Technology
 Time Management
 Training
 Uncertainty Removal
 Writing
 Verbal Communication
 Vision
Do you have all the required managerial skills to manage your own company? What do you think about your
management skills? Can you be a real manager with all the skills necessary for you and your company?

Business owners are entrepreneurs until they become managers. When they become managers, they will felt
frustrated because then they will need to deal with new problems, managerial problems.

Management is not a simple task. It needs knowledge and experience. Because of that, there is the existence of
hierarchy, organizational structure, and possibilities for each organizational member with adequate knowledge,
experience, and skills to move from the bottom to the middle and top level of the managerial pyramid.

I have already written about entrepreneurial skills, and you can read more in ten smart skills all entrepreneurs
need now.

Here, I want to talk about the three primary managerial skills as well as their link to the hierarchical structure of
the company.

What Are Managerial Skills?

Simply, managerial skills are the knowledge and ability of the individuals in a managerial position to fulfill
some specific management activities or tasks. This knowledge and ability can be learned and practiced.
However, they also can be acquired through practical implementation of required activities and tasks.
Therefore, you can develop each skill through learning and practical experience as a manager.

There are many definitions of skills that talk about talent. Talent is something personal related to an individual
and shows a natural gift from nature about something inside that talented person. All persons cannot be artists.
Usually, artists are born with the gift of art, but despite their talent, they continue to develop their talent to
improve their art skills.

When we talk about managerial skills, we talk about the skills of a manager to maintain high efficiency in the
way how his or her employees complete their everyday working tasks. Because of that, managers will need
skills that will help them to manage people and technology to ensure an effective and efficient realization of
their working duties.

Three Types of Managerial Skills

Robert Katz identifies three types of skills that are essential for a successful management process:

Technical skills,
Conceptual skills and
Human or interpersonal management skills.
Managerial Skills according to Robert Katz
Technical Skills as One Part of Management Skills
As the name of these skills tells us, they give the manager’s knowledge and ability to use different techniques to
achieve what they want to achieve. Technical skills are not related only for machines, production tools or other
equipment, but also they are skills that will be required to increase sales, design different types of products and
services, market the products and services, etc.

For example, let’s take an individual who works in the sales department and has highly developed sales skills
achieved through education and experience in his department or the same departments in different
organizations. Because of these skills that he possesses, this person can be a perfect solution to become a sales
manager. This is the best solution because he has excellent technical skills related to the sales department.

On the other hand, the person who becomes sales manager will start to build his next type of required skills. It is
because if his task until now was only to work with the customers as a sales representative, now he will need to
work with employees in the sales department in addition to the work with customers.
Technical skills are most important for first-level managers. Whet it comes to the top managers, these skills are
not something with high significance level. As we go through a hierarchy from the bottom to higher levels, the
technical skills lose their importance.

Conceptual Skills
Conceptual skills present knowledge or ability of a manager for more abstract thinking. That means he can
easily see the whole through analysis and diagnosis of different states. In such a way they can predict the future
of the business or department as a whole.

Why managers need these skills?

As a first, a company includes more business elements or functions as selling, marketing, finance, production,
etc. All these business elements have different goals even completely opposed goals. Think about marketing
and production as a business function and their specific goals. You’ll see the essential difference. The
conceptual skills will help managers to look outside their department’s goals. So, they will make decisions that
will satisfy overall business goals.

Conceptual skills are vital for top managers, less critical for mid-level managers, and not required for first-level
managers. As we go from the bottom of the managerial hierarchy to the top, the importance of these skills will
rise.

Human or Interpersonal Managerial Skills

Human or interpersonal management skills present a manager’s knowledge and ability to work with people.
One of the most critical management tasks is to work with people. Without people, there will not be a need for
the existence of management and managers.

These skills will enable managers to become leaders and motivate employees for better accomplishments. Also,
they will help them to make more effective use of human potential in the company. Simply, they are the
essential skills for managers.

Interpersonal management skills are essential for all hierarchical levels in the company.

Are There More Management Skills

These are the three necessary skills required for successful management as a process. Some authors also
mention other skills related to management skills. But, when I think about, they are simply part of these three
types of primary skills.
Let’s take the example of controlling skills. The controlling can’t be a skill, but rather a process, or one of the
managerial functions. Managers are controlling their employees through their interpersonal managerial skills
that we already described. Other additional skills that I find in theory are decision-making skills. Again,
decision making is a process and not the skill. When we have conceptual skills, we will make a better decision.
Furthermore, when we have technical skills, we will make a better technical decision. I think that the primary
skills all managers will need are skills explained as technical, conceptual, and interpersonal managerial skills.

In the end, I want to note something about managerial skills and business potential energy. Better management
skills in your company will produce more considerable business potential energy. So, these three types of skills
are in the category of business elements that can increase your business potential energy.

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he business world is changing fast. Probably faster than ever. Clients are more demanding, markets are adapting
and changing all the time.
As a manager you need to be agile, resilient and really on the ball. You can’t just sit and wait any more for
things to get better. You need to make sure that you have all the right skills to be a great manager and manage
your future.
So what are the Top 10 Skills that Every Manager Needs?
1. People Management Skills
The first skills focuses on your team. Your team consists of some great people, but they can get stressed and
they have a lot to do. So you have to deal with conflicts and demotivation. So what should you do?
This is where you have to manage your people with emotional intelligence. You have to adapt your people
management skills to different situations, different people and often in international environments. This also
means giving feedback, understanding values and understanding each person in your team. They are individuals
with different needs from you as their manager. So you need to have a full range of skills to support each
member of your team. Managing people is not easy, but with the right tools and skills you can get there.

2. Business Finance for Non-Financial Managers

As a manager, you need to understand all the basic financial reports of the company – including the Profit &
Loss, the Balance Sheet and the Annual Reports. This is important for your role and for your strategy.
You are also expected to master cost analysis for your team, department or division. And of course, let’s not
forget budgeting and forecasting – this is probably one of the toughest parts of a manager’s role. We are all
experts in our areas, but very often we haven’t learnt all the Business Finance Skills we need. In the end it is all
about the numbers!
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3. Influencing Skills
You don’t always have direct control over all the people and processes, and still you need to reach your goals.
So you have to work with lots of different people across the company to implement your strategy. This is where
you need to focus on collaboration and getting buy-in to your goals. Unfortunately, you are also probably facing
internal politics and sometimes people just blocking your progress.
It is very important to be able to positively influence your colleagues, get them to buy in to your goals and
implement your strategy. This doesn’t happen automatically, so you have to develop your influencing skills
and impact.

4. Communication Skills
As a manager, you have to communicate up, down and across the organization. You need to make
presentations and communicate to the senior management one minute and then communicate to your peers
the next minute.
You need to be able to get people to listen to you, remember and buy in to your goals and act on the information
that you communicate to them. And you need to do all of this with diplomacy and tact. Being a manager is not
easy. But these are skills you can learn and practice to get them right. Do you want to become a great
communicator?

5. Negotiation Skills
Negotiation Skills are a key part of every managers’ role. You have to negotiate with colleagues, business
partners, suppliers and clients. This is not something you can ignore.
You need to be able to develop win-win strategies using the best practice of negotiations. You need to know
when to negotiate and when to stop. Negotiating is a skill you can learn but don’t forget to practise, practise and
practise. Are you a great negotiator?
6. Project Management Skills
Managing projects is part of every manager’s role today. Projects might be client focused, internal processes or
even cross departmental.
Whatever the project, you need to be able to structure, plan and implement your projects. You need to
understand all the costs and set milestones to make sure your deliver your project on cost and on time.
This is not something that you can just guess or try – you need to do this systematically with the right project
management tools and planning. So maybe it time for you to develop your project management skills?

7. Understanding How All Parts of the Company Work Together

It is not enough to just focus on your team or department, no one works in a silo. So you need to be a great “all-
round manager” who understands how all the different parts of the organization work together and achieve the
overall results.
But we very often don’t spend enough time trying to understand what our colleagues do and why they do it and
that contributes to the success of the company.
So it is important to understand the overall strategy, the financial goals, the role of marketing and sales, the
impact of leadership and the supply chain management process. That is a lot to understand, but if you don’t then
you will never become a great “all-round manager”.

8. Business Strategy and Planning

Now that you have a lot of the key skills in place, it is time to focus on the strategy. Whether it is at team,
department or division level, you probably have to brainstorm, develop and then execute your strategy.
You have to create strategies that work and create value for your company. So you need to learn all about
strategic planning – including the key steps in the process and the tools you need to execute your strategy.
What are the pitfalls and how can you avoid them?

9. Leadership Skills
By now you are a great “all-round manager” and it is time to start thinking about becoming a great leader.
The first thing to learn is “what is the difference between management and leadership?” Then you need to learn
and practice lots of new leadership skills to take you to the next level including: methods to approach the first
day, week, month and year of leadership, leading with emotional intelligence, creating your own voice as
leader and growing further from established senior manager to inspiring leader.

10. Fundamental Management Skills

Yet, if you are starting, you need to start with the basics. You need to understand your role as a manager today.
This is very different to being a manager 20 years ago. Just telling people what to do, doesn’t work anymore. It
might be necessary sometimes, but it won’t get you very far.
So you have to make sure you have all your basic management skills in place. First, you need to be a good
coach and learn how to get the most out of your team. Motivation is a key part of performance, so you need to
be able to motivate your team all the time. Don’t forget you also need to motivate yourself every day. You also
can’t do everything yourself, so you have to be able to delegate and know what to delegate and when to
delegate. You can’t control everything any more either, so you have to trust your team too.
We know that is not easy, but you to have to do it. And let’s not forget about performance management – as a
manager you need to make sure that you and your team are on track, delivering the results and know where you
are going. This means having the right Key Performance Indicators and also rewarding the team when they
achieve them. So how well prepared are you? Do you have all the basic management skills you need for your
role as a manager?
 Organizational Internal-External Environment
Internal & External Factors That Affect an Organization
by Patrick Gleeson, Ph. D.,; Reviewed by Michelle Seidel, B.Sc., LL.B., MBA; Updated March 11, 2019

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Every organization has its own culture. Almost everything that affects an organization's ability to compete and
respond successfully to changes in the external environment – ultimately, the organization's success or failure –
is an aspect of that culture. The internal factors determine how the organization moves forward, both as a self-
contained organizational entity and in response to its external environment.
Internal Factors: Mission
Why does an organization exist? What is its purpose? Answering these fundamental questions describes an
organization's mission. A successful organization has a clear sense of its ultimate purpose and knows how it
intends to fulfill that purpose.
Steve Jobs' original mission statement for Apple is a great example that describes in a few words both the
company's ultimate goal, "To make a contribution to the world," and how it intends to reach that goal, "by
making tools for the mind that advance humankind."
Internal Factors: Leadership
Great leaders inspire and direct. Often the way they do that most persuasively is by example. After 30 years of
brutal and isolating imprisonment, Nelson Mandela returned to South Africa to lead the country. It would have
been understandable if upon gaining power Mandela had retaliated for the brutality of South Africa's Apartheid
regime.
Instead, he advocated communication, understanding and forgiveness. Consequently, South Africa achieved
independence with a minimum of violence and retained and utilized the skills of the majority of its citizens.
Internal Factors: Communication
Successful organizations thrive on robust communication practices, where teams and team leaders communicate
freely and often to improve results. This two-way communication up and down the hierarchical structure
extends from top to bottom. Organizations with communication deficiencies often have rigid leadership
structures that destroy trust.
Internal Factors: Organizational Structure
At one time, most organizations had highly hierarchical structures, with many layers of leadership and
management defining the organization from top to bottom. More recently, there is a growing understanding that
organizations with flat structures – few hierarchical layers from top to bottom – outperform organizations with
hierarchical structures. W. L. Gore, a highly successful global materials science company that is focused on
discovery and product innovation, has more than 10,000 employees, but only three hierarchical levels: a
democratically elected CEO, a few group heads and everyone else.
Internal Factors: Learning
Learning is one of the most fundamental human activities and accounts directly or indirectly for the success of
any organization. As technological advances lead to faster rates of change, successful organizations need to find
a way to respond that encourages innovation and builds into every employee's experience the opportunity to
learn and explore.
Today's most successful organizations, like Google, Apple, Amazon and the cluster of companies led by Elon
Musk, are essentially learning organizations. Musk's willingness to explore areas where he's not already an
expert has given him a tremendous advantage because what he's learning in one field often has an immediate
application in another.
External Factors Affecting an Organization
External factors that affect an organization may be political, economic, social or technological. The same
internal factors that lead to an organization's success inevitably characterize that organization's relationship to
the external environment in these broad areas.
An organization with a clear sense of mission, for example, can explain itself better to the world and can align
itself with the positive elements in each area.
Leaders who can learn and communicate what they've learned within their organizations also can learn from the
organization's external environment and communicate successfully with it, resulting in an ongoing exchange of
ideas to the benefit of both the organization and its environment.
Amazon, a single company that is transforming the way goods are bought and sold all over the world, has a
reputation for communicating effectively with its suppliers and customers. Amazon is a customer-driven idea
machine that believes the customer is always right. Determining what is right for each of its millions of
customers and creating and maintaining a fast-growing organization that responds effectively to what each
customer wants is Amazon's almost unprecedented triumph of 21st-century organization.
Companies are also impacted by external changes throughout society, like the impact of the #MeToo movement
aimed at eliminating sexual harassment. Numerous firms have seen high level executives leave the company
after credible charges had been leveled. Companies are also responding to gender equity issues by reviewing
salaries of male and female employees to make sure comparable jobs receive comparable pay.
Internal and External Environment Factors that Influences Organizational Decision Making
Every organization, whether business or non-business, has its own environment. Organizational environment is
always dynamic. It is ever-changing.
Changes today are so frequent and every change brings so many challenges that it is highly essential for
managers and leaders of the organization to be vigilant about the environmental changes. The environment of
an organization consists of its surroundings – anything that affects its operations, favorably or unfavorably.
Environment embraces such abstract thing as an organization’s image and such remote visible issues as
economic conditions of the country and political situations.
The environmental forces -abstracts and visible need careful analysis. The systematic and adequate analysis
produces the information necessary for making judgments about what strategy to pursue.
Managers cannot make appropriate and sound strategy simply on the basis of their guesses and instincts. They
must use relevant information that directly flows from the analysis of their organization’s environment.
Types of Organizational Environment
By the word “environment” we understand the surrounding or conditions in which a particular activity is carried
on.
And we know that organization is a social entity that has a hierarchical structure where all necessary items are
put together and they act within it to reach the collective goal.
Organization or more specific business organization and it activates are always being affected by the
environment. In an organization, every action of the management body is influenced by the environment.

Organizations have an external and internal environment;

1. External Environment.
a. General environment.
b. Industry environment.
2. Internal Environment.
An organization’s operations are affected by both types of environment.
Therefore, it is essential for the managers to make an in-depth analysis of the elements of the environments so
that they can develop in themselves an understanding of the internal and external situations of the organization.
Based on their understanding, they will be better able to establish the required objectives for their organization
and formulate appropriate strategies to achieve those objectives.
In this post, we will look at the elements of the organizations’ environment.
External Environment of Organization
In a simple way factor outside or organization are the elements of the external environment. The organization
has no control over how the external environment elements will shape up.
External environment embraces all general environmental factors and an organization’s specific industry-related
factors. The general environmental factors include those factors that are common ir\ nature and generally affect
all organizations.
Because of their general nature, an individual organization alone may not be able to substantially control their
influence on its business operations.
The external environment can be subdivided into 2 layers;
1. General Environment.
2. Task / Industry Environment.
General Environment of Organization
The general environment usually includes political, economic, sociocultural, technological, legal, environmental
(natural) and demographic factors in a particular country or region. The general environment consists of factors
that may have an immediate direct effect on operations but nevertheless influences the activities of the firm.
The dimensions of the general environment are broad and non-specific whereas the dimensions of the task
environment are composed of the specific organization.
Elements of the general environment are;
1. Economic Dimension.
2. Technological Dimension.
3. Socio-cultural dimension.
4. Political-Legal Dimension.
5. International Dimension.
Let’s see the elements or dimensions of the general environment.
1. Economic Dimension
The economic dimension of an organization is the overall status if the economic system in which the
organization operates. The important economic factors for business are inflation, interest rates, and
unemployment.
These factors of the economy always affect the demand for products. During inflation, the company pays more
for its resources and to cover the higher costs for it, they raise commodity prices.
When interest rates are high, customers are less willing to borrow money and the company itself must pay more
when it borrows. When unemployment is high, the company is able to be very selective about who it hires, but
customers’ buying power is low as fewer people are working.
2. Technological Dimension
It denotes to the methods available for converting resources into products or services. Managers must be careful
about the technological dimension. Investment decision must be accurate in new technologies and they must be
adaptable to them.
3. Socio-cultural dimension
Customs, mores, values and demographic characteristics of the society in which the organization operates are
what made up the socio-cultural dimension of the general environment.
The socio-cultural dimension must be well studied by a manager. It indicates the product, services, and
standards of conduct that society is likely to value and appreciate. The standard of business conduct vary from
culture to culture and so does the taste and necessity of products and services.
4. Political-Legal Dimension
The politico-legal dimension of the general environment refers to the governing law of business, business-
government relationship and the overall political and legal situation of a country. Business laws of a country set
the dos and don ts of an organization.
A good business-government relationship is essential to the economy and most importantly for the business.
And the overall situation of law implementation and justices in a country indicates that there is a favorable
situation in of business in a country.
5. International Dimension
Virtually every organization is affected by the international dimension. It refers to the degree to which an
organization is involved in or affected by businesses in other countries.
Global society concept has brought all the nation together and modern network of communication and
transportation technology, almost every part of the world is connected.
Industry/Task Environment of Organization
The industry environmental factors, on the other hand, are those factors in the external environment that
specifically reside in a particular industry and affect competition such as suppliers, customers, competitors, and
substitute products
The task environment consists of factors that directly affect and are affected by the organization’s operations.
These factors include suppliers, customers, competitors, regulators and so on.
A manager can identify environmental factors of specific interest rather than having to deal with a more abstract
dimension of the general environment.
Elements of the industry or task environment are;
1. Competitors.
2. Customers.
3. Suppliers.
 4. Regulators.
5. Strategic Partners.
The different elements of the task environment may be discussed as under:
1. Competitors
Policies of the organization are often influenced by the competitors.
Competitive marketplace companies are always trying to stay and go further ahead of their competitors. In the
current world economy, the competition and competitors in all respects have increased tremendously.
The positive effect of this is that the customers always have options and the overall quality of products goes
high.
2. Customers
“Satisfaction of customer”- the primary goal of every organization. The customer is who pays money for the
organization’s product or services. They are the peoples who hand them the profit that the companies are
targeting.
Managers should pay close attention to the customers’ dimension of the task environment because its customers
purchase that keeps a company alive and sound.
3. Suppliers
Suppliers are the providers of production or service materials. Dealing with suppliers is an important task of
management.
A good relationship between the organization and the suppliers is important for an organization to keep a steady
following of quality input materials.
4. Regulators
Regulators are units in the task environment that have the authority to control, regulate or influence an
organization’s policies and practices.
Government agencies are the main player in the environment and interest groups are created by its members to
attempt to influence organizations as well as the government. Trade unions and the chamber of commerce are
common examples of an interest group.
5. Strategic Partners
They are the organization and individuals with whom the organization is to an agreement or understanding for
the benefit of the organization. These strategic partners in some way influence the organization’s activities in
various ways.
Internal Environment of Organization
Forces or conditions or surroundings within the boundary of the organization are the elements of the internal
environment of the organization.
The internal environment generally consists of those elements that exist within or inside the organization such
as physical resources, financial resources, human resources, information resources, technological resources,
organization’s goodwill, corporate culture and the like.
Elements of internal environment are;
 1. Owners and Shareholders.
2. Board of Directors.
3. Employees.
4. Organizational Culture.
5. Resources of the Organization.
The internal environment consists mainly of the organization’s owners, the board of directors, employees and
culture.
1. Owners and Shareholders
Owners are people who invested in the company and have property rights and claims on the organization.
Owners can be an individual or group of person who started the company; or who bought a share of the
company in the share market.
They have the right to change the company’s policy at any time.
Owners of an organization may be an individual in the case of sole proprietorship business, partners in a
partnership firm, shareholders or stockholders in a limited company or members in a cooperative society. In
public enterprises, the government of the country is the owner.
Whoever the owners, they are an integral part of the organization’s internal environment. Owners play an
important role in influencing the affairs of the business. This is the reason why managers should take more care
of the owners of their organizations.
2. Board of Directors
The board of directors is the governing body of the company who are elected by stockholders, and they are
given the responsibility for overseeing a firm’s top managers such as the general manager.
3. Employees
Employees or the workforce, the most important element of an organization’s internal environment, which
performs the tasks of the administration. Individual employees and also the labor unions they join are important
parts of the internal environment.
If managed properly they can positively change the organization’s policy. But ill-management of the workforce
could lead to a catastrophic situation for the company.
4. Organizational Culture
Organizational culture is the collective behavior of members of an organization and the values, visions,
beliefs, habits that they attach to their actions.
An organization’s culture plays a major role in shaping its success because the culture is an important
determinant of how well their organization will perform.
As the foundation of the organization’s internal environment, it plays a major role in shaping managerial
behavior.
An organization’s culture is viewed as the foundation of its internal environment. Organizational culture (or
corporate culture) significantly influences employee behavior.
Culture is important to every employee including managers who work in the organization.
A strong culture helps a firm achieve its goals better than a firm having a weak culture. Culture in an
organization develops and ‘blossoms’ over many years, starting from the practices of the founder(s).
Since culture is an important internal environmental concern for an organization, managers need to understand
its influence on organizational activities.
5. Resources of the Organization
An organization s resources can be discussed under five broad heads: physical resources, human resources;
financial resources, informational resources, and technological resources. Physical resources include land and
buildings, warehouses, all kinds of materials, equipment and machinery.
Examples are office buildings, computers, furniture, fans, and air conditioners.
Human resources include all employees of the organization from the top level to the lowest level of the
organization. Examples are teachers in a university, marketing executives in a manufacturing company, and
manual workers in a factory.
Financial resources include capital used for financing the operations of the organization including working
capital. Examples are investment by owners, profits, reserve funds, and revenues received out of a sale.
Informational resources encompass ‘usable data needed to make effective decisions.
Examples are sales forecasts, price lists from suppliers, market-related data, employee profile, and production
reports.
The environment irrespective of its external or internal nature, a manager must have a clear understanding of
them.
Normally, you would not go for a walk in the rain without an umbrella, because you understand the
environment and you know when it rains you can get wet.
Similarly, if a manager does not know and understand the environment of the organization, he or she will
definitively get wet or dry and the organization also in today’s fast and hyper-moving organizational
environment.
Conclusion: Influence of Environment on Business
Business managers must understand the various facets of the impacts of the external environment.
They need to recognize that the external environment has many aspects that can have a significant impact on the
operations of a firm. They need to undertake analysis of environment on a regular basis.
This is particularly important for the reason that developments/changes in the remote environment influence the
business organizations. They also need to understand the influences of changes in the industry environment.
Managers are benefited in several ways when they have a deep understanding and appreciation of the impact of
environmental factors on business:
 Knowledge of the environment helps managers identify the direction to which they should proceed.
They will travel along with a distinct way of changing direction, whenever necessary. Without an
understanding of the environment, managers are like a bicycle without a handlebar – no way of
maneuvering while riding on a street.
 Managers can isolate those factors, especially in the external environment, which are of specific interest
to the organization.
  Managers can take preparation to deal with a predicted crisis in any of the factors in the environment.
They can develop crisis plans for overcoming crises that affect an organization.
 The key to achieving organizational effectiveness is understanding of the environment in which the firm
operates its
No knowledge or inadequate knowledge is very likely to lead managers to ineffectiveness because of
‘running on the wrong road for reaching the goals.
Managers must recognize and respond to all factors that affect their organizations. This lesson describes how
the internal and external environments of an organization drive change within the company.
Navigating Change in Organizations
Navigating in today's chaotic business environments is much like trying to steer a tiny boat back to shore while
caught in the center of a hurricane. There are many forces at work that a person will need to respond to in order
to make it safely back to port. Just like this tiny ship, today's organizations and their managers are faced with a
significant amount of factors that require an immediate response, often in the form of organizational change.
The forces that drive this change in business are known as the internal and external environments. This lesson
will discuss how both the internal and external environments of an organization induce change.

The Internal Environment

The internal environment of an organization refers to events, factors, people, systems, structures, and conditions
inside the organization that are generally under the control of the company. The company's mission statement,
organizational culture, and style of leadership are factors typically associated with the internal environment of
an organization. As such, it is the internal environment that will influence organizational activities, decisions,
and employee behavior and attitudes. Changes in the leadership style, the organization's mission, or culture can
have a considerable impact on the organization.

The External Environment

The external environment are those factors that occur outside of the company that cause change inside
organizations and are, for the most part, beyond the control of the company. Customers, competition, the
economy, technology, political and social conditions, and resources are common external factors that influence
the organization. Even though the external environment occurs outside of an organization, it can have a
significant influence on its current operations, growth, and long-term sustainability. Ignoring external forces can
be a detrimental mistake for managers to make. As such, it is imperative that managers continually monitor and
adapt to the external environment, working to make proactive changes earlier on rather than having to take a
reactive approach, which can lead to a vastly different outcome.

Environmental Scanning and Change

SWOT analysis is a type of environmental scanning
SWOT Analysis List
In order for managers to react to the forces of internal and external environments, they rely on environmental
scanning. Environmental scanning refers to the monitoring of the organization's internal and external
environments for early signs that a change may be needed, to accommodate potential opportunities or threats,
and to make adjustments to allow the company's strengths to combat its weaknesses. If you recall, one common
type of environmental scan is the SWOT analysis, which looks specifically into the strengths, weaknesses,
opportunities, and threats of the internal and external environments. A manager will begin analyzing the internal
environment by looking into inefficiencies inside the organization, and will then look outside to the external
environment and things occurring independent of the organization. Environmental scans allow managers to use
the knowledge gained during the scanning process to decide what strategic steps,
What Are Internal & External Environmental Factors That Affect Business

If a business wants to be successful in the marketplace, it is necessary for them to fully understand what factors
exert impact on the development of their company. Once they know about both positive and negative effects
within and outside the company, they can produce suitable strategies to handle any predicted situation.
Therefore, examining internal and external factors is considered the most important task for an enterprise
before launch any strategic marketing plan.
Table of content
 Understanding of Business Environment
 The Importance of Business Environment Understanding
 Internal and External Factors - What are They?
 Internal Environment Factors
 Definition
 Types
 External Environment Factors
 Definition
 Types
 Method of study
 Internal impacts
 Human resources
 Capital resources
  Operational efficiency
 Organizational structure
 Infrastructure
 Innovation
 External impacts
 Economic situation
 Laws
 Technological factors
 Customer demands
 Competition
 Conclusion

Understanding of Business Environment

To get a proper understanding of the business environment, we should step by step analyze individual elements
of this term.
First of all, “environment” can be acknowledged as the surroundings or conditions in which a specific activity is
carried on.
Secondly, because we know that a business firm is a social entity which is formed by a hierarchical structure
where all necessary items of its own are activated together to reach the collective goal.
Therefore, it is absolutely that every factor inside or outside a business organization has a profound influence on
business activities.
In other words, internal and external environment create a business environment.
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The Importance of Business Environment Understanding
Because business environment inserts its impacts on business success, scale, vision, and development strategy,
having fully understanding about this issue should be prioritized by leaders.
Once they know about both positive and negative effects within and outside the company, they can produce
suitable strategies to handle any predicted and unpredicted situation.
Internal and External Factors - What are They?
First, you need to understand that there is a variation of internal and external factors depending on the size, type,
and business status. However, you can find those key factors by analyzing the business environment using the
following categories:
Internal Environment Factors
Definition
The internal factors refer to anything within the company and under the control of the company no matter
whether they are tangible or intangible. These factors after being figured out are grouped into the strengths and
weaknesses of the company. If one element brings positive effects to the company, it is considered as strength.
On the other hand, if a factor prevents the development of the company, it is a weakness. Within the company,
there are numerous criteria need to be taken into consideration.
Types
There are 14 types of internal environment factors:
1. Plans & Policies
2. Value Proposition
3. Human Resource
 4. Financial and Marketing Resources
5. Corporate Image and brand equity
6. Plant/Machinery/Equipments (or you can say Physical assets)
7. Labour Management
8. Inter-personal Relationship with employees
9. Internal Technology Resources & Dependencies
10. Organizational structure or in some cases Code of Conduct
11. Quality and size of Infrastructure
12. Task Executions or Operations
13. Financial Forecast
14. The founders relationship and their decision making power.

External Environmental Factors

Definition
On the contrary to internal factors, external elements are affecting factors outside and under no control of the
company. Considering the outside environment allows businessmen to take suitable adjustments to their
marketing plan to make it more adaptable to the external environment.
There are numerous criteria considered as external elements. Among them, some of the most outstanding and
important factors need to listed the are current economic situation, laws, surrounding infrastructure, and
customer demands.
Types
Micro factors:
1. Customers
2. Input or Suppliers
3. Competitors
4. Public
5. Marketing & Media
6. Talent
Macro factors:
1. Economic
2. Political/legal
3. Technology
4. Social an
5. Natural
To understand more about micro and macro factors which affect your business, read our guest blog here

Method of study
There are many factors affecting business have been studied, among them, we provide you a deep insight of the
most decisive factors, which are at the center of every business today
Internal impacts
The internal factors refer to anything within the company and under the control of the company no matter they
are tangible or intangible. These factors after being figured out are grouped into strengths and weaknesses of the
company. If one element brings positive effects to company, it is considered as strength. On the other hand, if a
factor prevents the development of the company, it is a weakness. Within the company, there are numerous
criteria need to be taken into consideration.
Human resources
In the modern global economy, where ideas and digital skills - rather than physical resources are increasingly
where economic value is realised, human resource can be a company’s greatest treasure. In general, the
employees can be either a strength or weakness of the company depending on the level of practical skills,
attitudes toward work, performance and so on. For example, if a business has skilled and motivated workers,
they are sure to be the biggest asset of this enterprise.
Conversely, employees without carefully trained and have negative attitudes to their task will be an enormous
challenge for the company to address. In short, the CEO should have a strategic and effective human
management not only for the sake of company benefits but also for the positive development of their
employees.

Capital resources
From a general view, financial capital is the funds necessary to grow and sustain a business. CEO takes
financial capital to invest in not only tangible goods such as factories, machines, tools and other productive
equipment to produce an output but also intangible resources such as marketing, employee training, etc.
No company can survive without having capital resources. Once a company has enough budget, they can easily
launch their projects, expand its scale and even achieve impressive result. For instance, in 2010 Coca Cola -
“the 84 biggest economy” spent 2.9 billion USD for marketing, which was more than that total marketing
investment of Microsoft and Apple. It can be said that without the big investment and stable financial resource,
Coca Cola success would not be guaranteed.
There are also several ways for an enterprise to maintain stable budgets by some resources such as investment
opportunities, funding, and annual income.

Operational efficiency
The concept of operational efficiency encompasses the practice of improving all of your processes, which are
all your company’s activities leading to your final product or service.
Because Operational efficiency directly affects the company’s success in the marketplace, a businessman needs
to truly know his company’s processes and follow them to discover whether they’re being performed in the
correct manner or not. Here are some suggestions for you to achieve this efficiency :
 Study the business situation
 Pay attention to product cost
 Map process failure and discover failure
 Use technology for better operation productivity
Organizational structure
To have a suitable organizational structure requires the owners have to consider carefully set up a system to
work smoothly within the company. Whether it is a centralized or decentralized system, the most important
thing is how effective the structure is when applied for the company. The heads of departments need to make
sure that the information flow is widely conveyed to all customers. Suitable rules and regulations are being
applied to ensure the benefits of employees, and the business as well.

Infrastructure
When you already have well-trained and motivated workers, an effective operational and organizational system,
make sure that the infrastructure of the company are good enough for all your functions. With the modern and
high quality facilities, stable power, internet and wifi connection, and so on your company is likely to perform
better. In other words, the better your infrastructure, the more opportunities for your company to perform
successfully.
Innovation
In the competitive marketplace and industrial revolution we are living now, no company can survive without
upgrade new ideas and technology served overall success.
Fundamentally, innovation refers to the introduction of something new into your business with the ideas come
from inside the business such as from employees, developers, managers or from the outside world like
suppliers, customers, etc. Successful innovation can bring about productivity, cost reduction, higher
competitiveness, brand value, turnover increase. In contrast, companies which fail to apply innovation will
surely face the risks of losing market share to competitors, underlying profit loss and losing key staff.
Innovation is rewarding for your business only when you step by step start to holistically approach to
innovation, plan and encourage innovation and spread investment for innovation in your business.

External factors
On the contrary to internal factors, external elements are affecting factors outside and under no control of the
company. Considering the outside environment allows businessmen to take suitable adjustments to their
marketing plan to make it more adaptable to the external environment. There are numerous criteria considered
as external elements. Among them some most outstanding and important factors need to listed are current
economic situation, laws, surrounding infrastructure, and customer demands.
Economic situation
Economy is one of the most determining factors to the success of the company even though it is an external
element. Within the economy, some contributing factors such as the fluctuation of interest rate, economic crisis,
and so on directly and strongly affects the consumption of buyers, and consequently, the profits of businesses.
No external factors affect business more than an economic condition, which is the present state of the economy.
As the economy goes through expansion and contraction, it’s condition changes over time. Positive economy
condition can be favorable for business development and adverse ones may generate negative consequences
such as narrow down business scale, capital shortage or even bankrupt.
There are 7 factors that have direct impacts on business firm.
 Tax rate
 Exchange rate
  Inflation
 Labor
 Demand/supply
 Wages
 Recession
Laws
The rules and regulations from local government play an integral role in the development of the company.
There are some countries which their laws prevents the development of some certain industries. That can be a
threat to the company. On the other hand, some industries receive positive and continuous support from local
government via their rules and regulations. Besides, if the laws allow organization outside the countries invest
in local industries, they will indirectly create an enormous source of financial support for local business.

Technological factors
Artificial intelligence, smart internet searches, and other high tech functions- all kind of technology has been at
the forefront of many business for ages. For instance, American Airlines started using a computerized flight
booking system and Bank of America took on an automated check-processing system. No matter what the size
of your enterprise is, both tangible and intangible benefits of technology are well-known.
Because it can help you generate profits and produce the results as your customers’ needs. In particular, the
culture, efficiency and relationships of a business are obviously affected by technology infrastructure.
Furthermore, it also exerts impacts on the security of confidential information and trade advantages.
Today it is so decisive to entrepreneurs that technology can be their best friend or worst friend depending on
how it is used in the competitive digital business market.
Customer demands
One of the most fundamental factors we learn in economics is that satisfying customer demand is a must for
every business survival. It is obvious that your product is served for the needs of customers then under any
circumstance, your business can develop without following this mission. Beside to be the leading company
entrepreneurs should not only identify but also tailor their customer’s interest.
We all know that what people want, what people need, and what they demand are usually different from each
other. Customers need something to communicate with their family member outside their countries, they want
to a smartphone which can perform multi-function; however, they cannot afford that smartphone with a limited
budget. Therefore, their demand is just a typical phone which can perform basic functions. If your company is
not able to figure out what are your customer demands, you will face difficulty in how to make your products
consumed by customers. (Learn how to build loyal customers for your business)

In the digital age, the face of customer’s preference has changed dramatically under the influence of different
factors. Having a complete understanding of these factors can help business man build up an effective strategy
in producing and marketing process. Here are noticable changes in customer demand:
 Quality is customer’s preference than price
 Sales process is more and more under customer’s control
 Customer’s loyalty decrease
 The rise of middle-income customer spender
 Female consumption power
  Advancement of new technology
 Intergenerational consumption
There is a lot of legwork to be done to recognize customer’s requirements and generate new trends in the
marketplace. Basically , you should carry out research to determine what consumers’ needs are, establish
yourself as a leader in your industry and then repeatedly demonstrate your products’ quality.
Competition
Competition exists in any field of our life, even in business. When it comes to competition, entrepreneurs may
thrive to be successful or be hurt to lose its position in the marketplace.
For the good side, competition brings about innovation, better customer service, complacency, core market
understanding and understanding of your own business- your strength and your weakness.
For the downside, if you are not prepared to change in competitive market, your company may be negatively
influenced due to scaring investors, market expectations increase, competitive price and customer disloyalty.
Conclusion
In conclusion, there is a bunch of contributing factors the success of the company which comes from both
outside and inside a business. Either outside or inside factors are of utmost importance for the development of
the company. If a business hopes to perform smoothly and successfully, they need to take all these elements into
consideration before making any decision.
very organization needs to be perceived as operating in an environment. Organizations are neither self-sufficient
not self-contained. Rather they exchange resources with and dependent upon external environment. External
environment can be defined as all the forces and conditions outside the organization that are relevant to its
operation and influence the organization. Organizations take inputs(raw materials, money, labor and energy)
from the external environment, transform them into products or services, and send back as output to the external
environment. The other environment is internal which can be defined as all the forces and conditions within the
organization that influences its behavior. Thus, environment can be broadly classified into (1) Internal
environment, and (2) External environment.

(1) Internal Environment

Each business organization has an internal environment, which includes all the elements within the
organization's boundaries. Strictly speaking they are part of the organization itself. The major components of
the internal environment are :

a. Employees
b. Shareholders and Board of Directors
c. Culture

(2) External Environment

According to James Stoner, External environment can be defined as all elements outside an organization that
are relevant to its operation. This environmental context becomes more clear if the external environment is
further divided into two distinct segments:(1) general environment and (2) task environment.

(a) General Environment

The general environment consists of interrelated forces that can be categorized into four elements:

1. Economic Environment
2. Socio-Culture Environment
3. Political Legal Environment
4. Technological Environment

(b) Task Environment

The task environment puts indirect pressures on business management through the institutional processes of
following elements:

1. Customers
2. Suppliers
3. Competitors
4. Financial Institution
5. Government
6. Media
The Internal Environment
An organization's internal environment is composed of the elements within the organization, including current
employees, management, and especially corporate culture, which defines employee behavior. Although some
elements affect the organization as a whole, others affect only the manager. A manager's philosophical or
leadership style directly impacts employees. Traditional managers give explicit instructions to employees, while
progressive managers empower employees to make many of their own decisions. Changes in philosophy and/or
leadership style are under the control of the manager. The following sections describe some of the elements that
make up the internal environment.
An organization's mission statement describes what the organization stands for and why it exists. It explains
the overall purpose of the organization and includes the attributes that distinguish it from other organizations of
its type.
A mission statement should be more than words on a piece of paper; it should reveal a company's philosophy,
as well as its purpose. This declaration should be a living, breathing document that provides information and
inspiration for the members of the organization. A mission statement should answer the questions, “What are
our values?” and “What do we stand for?” This statement provides focus for an organization by rallying its
members to work together to achieve its common goals.
But not all mission statements are effective in America's businesses. Effective mission statements lead to
effective efforts. In today's quality‐conscious and highly competitive environments, an effective mission
statement's purpose is centered on serving the needs of customers. A good mission statement is precise in
identifying the following intents of a company:
Customers — who will be served
Products/services — what will be produced
Location — where the products/services will be produced
Philosophy — what ideology will be followed
Company policies are guidelines that govern how certain organizational situations are addressed. Just as
colleges maintain policies about admittance, grade appeals, prerequisites, and waivers, companies establish
policies to provide guidance to managers who must make decisions about circumstances that occur frequently
within their organization. Company policies are an indication of an organization's personality and should
coincide with its mission statement.
The formal structure of an organization is the hierarchical arrangement of tasks and people. This structure
determines how information flows within the organization, which departments are responsible for which
activities, and where the decision‐making power rests.
Some organizations use a chart to simplify the breakdown of its formal structure. This organizational chart is a
pictorial display of the official lines of authority and communication within an organization.
The organizational culture is an organization's personality. Just as each person has a distinct personality, so
does each organization. The culture of an organization distinguishes it from others and shapes the actions of its
members.
Four main components make up an organization's culture:
Values
Heroes
Rites and rituals
Social network
Values are the basic beliefs that define employees' successes in an organization. For example, many universities
place high values on professors being published. If a faculty member is published in a professional journal, for
example, his or her chances of receiving tenure may be enhanced. The university wants to ensure that a
published professor stays with the university for the duration of his or her academic career — and this
professor's ability to write for publications is a value.
The second component is heroes. A hero is an exemplary person who reflects the image, attitudes, or values of
the organization and serves as a role model to other employees. A hero is sometimes the founder of the
organization (think Sam Walton of Wal‐Mart). However, the hero of a company doesn't have to be the founder;
it can be an everyday worker, such as hard‐working paralegal Erin Brockovich, who had a tremendous impact
on the organization.
Rites and rituals, the third component, are routines or ceremonies that the company uses to recognize high‐
performing employees. Awards banquets, company gatherings, and quarterly meetings can acknowledge
distinguished employees for outstanding service. The honorees are meant to exemplify and inspire all
employees of the company during the rest of the year.
The final component, the social network, is the informal means of communication within an organization. This
network, sometimes referred to as the company grapevine, carries the stories of both heroes and those who have
failed. It is through this network that employees really learn about the organization's culture and values.
A byproduct of the company's culture is the organizational climate. The overall tone of the workplace and the
morale of its workers are elements of daily climate. Worker attitudes dictate the positive or negative
“atmosphere” of the workplace. The daily relationships and interactions of employees are indicative of an
organization's climate.
Resources are the people, information, facilities, infrastructure, machinery, equipment, supplies, and finances at
an organization's disposal. People are the paramount resource of all organizations. Information, facilities,
machinery equipment, materials, supplies, and finances are supporting, nonhuman resources that complement
workers in their quests to accomplish the organization's mission statement. The availability of resources and the
way that managers value the human and nonhuman resources impact the organization's environment.
Philosophy of management is the manager's set of personal beliefs and values about people and work and as
such, is something that the manager can control. McGregor emphasized that a manager's philosophy creates a
self‐fulfilling prophecy. Theory X managers treat employees almost as children who need constant direction,
while Theory Y managers treat employees as competent adults capable of participating in work‐related
decisions. These managerial philosophies then have a subsequent effect on employee behavior, leading to the
self‐fulfilling prophecy. As a result, organizational philosophies and managerial philosophies need to be in
harmony.
The number of coworkers involved within a problem‐solving or decision‐making process reflects the
manager's leadership style. Empowerment means delegating to subordinates decision‐making authority,
freedom, knowledge, autonomy, and skills. Fortunately, most organizations and managers are making the move
toward the active participation and teamwork that empowerment entails.
When guided properly, an empowered workforce may lead to heightened productivity and quality, reduced
costs, more innovation, improved customer service, and greater commitment from the employees of the
organization. In addition, response time may improve, because information and decisions need not be passed up
and down the hierarchy. Empowering employees makes good sense because employees closest to the actual
problem to be solved or the customer to be served can make the necessary decisions more easily than a
supervisor or manager removed from the scene
Internal and external factors have a huge effect on the success or failure of a business. Business owners can’t
control external factors, but they must be able to anticipate and adjust to these factors to keep their
organizations on track. However, business owners and leaders do have significant influence over internal factors
that affect a business, and how they handle these internal factors will have a major impact on the future of their
companies.
Internal Factor: Leadership
Leadership refers to the people in your organization that make all the major decisions regarding financing,
budget, sales, marketing, and human resources. Companies with strong leadership have a clear vision for the
future, a plan of how to achieve their goals and a quantifiable way of measuring success. They have also
developed the kind of management structure that enables employees to feel empowered, while also meeting
production and sales goals. Weak leadership is like a ship without a rudder that has no direction and is in danger
of sinking. Leaders that lack a strong vision and that are unable to properly manage their teams will find it
difficult to achieve their goals.
Internal Factor: Employees
Strong businesses feature motivated workers that understand management’s expectations and are given the
tools, training, support, and encouragement to not only meet those expectations but to exceed them. It’s not
enough for leaders to hire qualified employees, because every good company does the same thing. For a
company to consistently produce high results, managers must ensure that they are in constant communication
with employees and that any problems or dissatisfaction within the rank-and-file is handled in a timely manner.
When employees feel valued and rewarded, they will go above and beyond to maintain a high organizational
standard.
Internal Factor: Mission Statement
Do your employees understand why your company exists? In other words, has management communicated the
mission statement of your business, which is the underlying reason that you make specific products and offer
specific services? Defining the ‘why’ of a company rather than the ‘what’ of a company is the key to providing
your employees with the motivation and buy-in that affects how hard they work, and how much they believe in
what they do. For example, the shoe company Zappos developed a mission statement that it was always about
pleasing the customer, no matter what it took. That mission enabled Zappos’ management to give employees the
discretion to give discounts and freebies to customers without supervisor approval. As a result, Zappos soon
became known as one of the best customer service companies in the world.
External Factor: Competitors
Unless you’ve invented something unique, there are other companies in your industry that sell what you sell.
That means you have to be aware of your competition and what they’re doing in the marketplace, and use that
information to distinguish yourself in as many ways as possible. Although you can’t control what your
competitors do, you can find areas of weakness in their marketing and use that to your advantage.
External Factor: Customers
Customers are flaky and unpredictable, and just when you think you’ve got their loyalty, they move on to the
next big thing. You can’t control customer behavior, but you can study it and learn how to adapt to changes that
could impact your sales. When customers indicate they want something you’re not offering, you may want to
listen and start offering what they’re asking for, before your competitors do.
External Factor: Economy
Business owners can’t control the economy, but they must respond to indicators that trend upward or
downward, then adjust their own operations accordingly. For example, if economists forecast a recession, it
could be time to tighten budgets, eliminate some projects, and remain in a holding pattern until things improve.
However, when the economy grows and interest rates are low, that could make it easier for you to obtain low-
interest loans to help expand your business.
anagers must recognize and respond to all the factors that can influence their organizations.
Navigating through the modern chaotic work environments is like trying to drive a small boat to shore during a
hurricane.
Just like this small boat, the modern organizations and their managers are faced with a significant amount of
factors that require immediate response.
The forces that drive this change in the business are known as internal and external environmental factors.
CONTENT INDEX
The internal environment
 The staff
 The budget
 Corporate culture
The external environment
 The economy
  The competition
 Politics
 Customers and suppliers
Conclusions
The internal environment
The internal environment of an organization refers to events, factors, people, systems, structures and
conditions inside an organization that are generally under the direct control of the company.
Corporate mission, corporate culture, and leadership style are factors that are typically associated with an
organization’s internal environment.
As such, it is the internal environment that will influence the organizational activities, decisions, behaviors and
attitudes of employees.
Changes in leadership style, in the corporate mission or in culture can have an important impact on the
organization.
Let’s see in detail what are the internal corporate environmental factors.
Internal environmental factors: the staff
Employees are an important part of the internal environment of an organization.
Managers must be able to manage lower-level employees and, at the same time, supervise the other factors of
the internal environment.
Indeed, even when everyone is capable and talented, politics and internal conflicts can destroy a good
organization from within.

Internal environmental factors: the budget

In business, even the lack of money can determine the survival – or not – of a company.
When cash resources are too limited, that can affect the number of people you can hire, the quality of equipment
and the type and amount of advertising you can buy.
If you have enough money instead, you have much more flexibility to grow and expand the business, or to
endure an economic downturn.

Internal environmental factors: Corporate culture

The internal corporate culture consists of the values, attitudes and priorities that employees live every day.
A ruthless culture in which every employee competes with his colleagues certainly creates a different, and more
toxic, environment than that of a company that emphasizes collaboration and teamwork.

The external environment

The external environment is composed by factors that occur outside the organization but which can cause
internal changes and are, for the most part, beyond the company’s control.
Customers, competition, economy, technology, political and social conditions, and resources are common
external factors that influence the organization.
Even if the external environment occurs outside an organization, it can have a significant influence on its
current operations, growth and long-term sustainability.
Ignoring external forces can be a damaging mistake for managers. As such, it is necessary that managers
continue to monitor and adapt to the external environment.
The key is to work in order to make proactive changes rather than having to take a reactive approach and solve
problems rather than preventing them.
So, let’s see in detail what are the external corporate environmental factors.

External corporate environmental factors: The economy

In a bad economy, even a well managed organization may not be able to survive.
If customers lose their jobs or take jobs that can barely support them, they will spend less on sport activities,
recreation, gifts, luxury goods, and new cars.
It is not possible to control the economy, but understanding it can help identify threats and opportunities.

External corporate environmental factors: The competition

Unless the organization is a monopoly, you will always have to deal with the competition.
When you open a company, you normally find yourself fighting against established and more experienced
organizations in the same sector.
On the other hand, when a company has established itself, it will find itself fighting against new organizations
trying to steal a slice of the market.
In short, competition never dies.

External corporate environmental factors: Politics

Changes in government policy can have a huge impact on an activity.
A classic example is the tobacco industry.
Since the 1950s, cigarette manufacturers have been asked to put warning labels on their products and have lost
the right to advertise on television. Smokers have less and less places where they are allowed to smoke.
Therefore, the percentage of people who smoke is diminished, with a corresponding effect on the sector’s
revenues.

External corporate environmental factors: Customers and suppliers

Next to employees, customers and suppliers are, in most cases, the most important people with which an
organization has to deal.
Suppliers have a huge impact on costs. The weight of a given supplier depends on the scarcity of his service or
product and, consequently, on the possibility of negotiation with him.
The power of customers depends on the fact that they are free to choose between a specific organization and its
competition.

Conclusions
In project management, you can influence those factors that are closer and more directly related to management,
such as resources or project management systems.
It will be more difficult to influence the more general factors external to the organization.
In every situations, the project manager must be aware of these factors. This will also apply to the risks of the
project related to harmful environmental factors on which the project manager can not exercise any control. In
any case, the project manager has to be ready to act accordingly.
Moreover, the project manager is also responsible for communicating and informing the team of factors
influencing a project, both internal as well as external.
It is therefore essential that every organization knows which of the internal factors represent limiting conditions
and which are the drivers of the projects for their correct management.
Mastering some of the forces that impact your business is more challenging than handling others. The extent to
which you can control them differs. You can change how internal and external factors affect your firm. You
cannot make the economy grow. But, you can encourage spending. Learning more about the factors at work will
better equip you.
In this article, I will not go into much detail about external factors. I will discuss elaborately how internal
factors can impact a business. I will talk about the most popularly assessed internal factors.
The internal business environment comprises of factors within the company which impact the success and
approach of operations. Unlike the external environment, the company has control over these factors. It is
important to recognize potential opportunities and threats outside company operations. However, managing the
strengths of internal operations is the key to business success.
The role of company leadership is an essential internal factor. Your leadership style and other management style
impact organizational culture. Often, firms provide a formal structure with its mission and vision statements.
Some cultural implications which result from leadership approaches are:
 Value of employees
 The positive or negative nature
 Effectiveness of communication level of family-friendliness
The strength of employees is also an essential internal business factor. Check if employees are motivated,
hard-working and talented. They will produce better results compared to an unmotivated and less talented
workforce. The processes and relationships between and within departments can also improve effectiveness and
efficiency.
In a high performing workplace, the workers not only have talent, but they also work better together. The
employees and departments collaborate on ideas and resolutions.
The internal factors basically include the inner strengths and weaknesses. Internal factors can affect how a
company meets its objectives. Strengths have a favorable impact on a business. Weaknesses have a harmful
effect on the firm.
Some examples of areas which are typically considered in internal factors are:
 Financial resources like funding, investment opportunities and sources of income.
 Physical resources like company’s location, equipment, and facilities
 Human resources like employees, target audiences, and volunteers
 Access to natural resources, patents, copyrights, and trademarks
 Current processes like employee programs, software systems, and department hierarchies
Companies must also consider softer elements like company culture and image, the role of key staff,
operational efficiency and potential.
Below, I have mentioned the most common internal factors. These might affect your business in various ways.
 Organizational and operational
These are a part of the operational and administrative procedures. This includes disorganized or inaccurate
record keeping. Interruptions to your supply chain and outdated or faulty IT systems are also factors you should
evaluate. If you do not overcome these, your customers might see you as unreliable. You can also lose all your
data.
 Strategic risks
These affect your firm’s ability to reach the goals in the business plan. They could be due to the impacts of
changes in technological evolutions or customer demand. These factors could pose as threats as they can alter
how customers perceive your product. Based on these, customers might think a product is overpriced, dull and
outdated.
 Innovation
Your business needs innovation in order to keep up with competitors. It is essential to get one step ahead.
Innovation could come in the form of marketing. It could also be through promotional initiatives in the
marketing plan, staff training, and welfare. Embracing new technology is the best way to keep up with
technological advancements.
A lack of innovation can pose a serious risk to a growing business. No innovation will cause a company to
remain boring. The company will become dull, stagnant and irrelevant.
 Financial
The financial risks depend on the financial structure of your business. It is also dependent on your business
transactions and the financial systems. For example, changes in interest rates or being overly reliant on one
customer could affect business.
 Employee risks
Employees are vital to business success. But, there are risks associated with them. For an industry, strike action
could lead to a lot of problems.
INTERNALS FACTORS IN SWOT
The internal factors of a business are often studied in a SWOT analysis. The SWOT matrix is a structured
planning method. You can use SWOT analysis to analyze your company and its environment. It assesses the
strengths, weaknesses, opportunities, and threats. The strengths and weaknesses of a project or business are
internal factors. Opportunities and threats are external elements.
STRENGTHS
Strengths are the features of your business which allow you to work more effectively than competitors. Your
specialist technical knowledge could be your strength. You will have to consider your strengths from own point
of view. You should also give importance to customers’ and clients’ view.
You must be honest and realistic. When you try to find company’s strengths, try to answer the below questions:
 What is it that you do well?
 What benefits do you have over your competitors?
 What makes you stand out from the competitors?
WEAKNESSES
Weaknesses are the areas which have scope for improvement. Find out if your business is new products or
skills. Also, try to find if you have a lower productivity or higher cost base than your competitors.
You will have to face the unpleasant truths about your firm and be realistic. Ask the following questions:
 What are you bad at?
 Is there anything you could be better at?
  What should you avoid?
 What leads to problems or complaints?
The greatest thing about internal factors is that you have control over most of them. Changing internal factors
often involves some indirect costs. Some of the factors are a result of the way you run your business. Example
of this includes reputation, credit worthiness, and image. Other factors depend on your business decisions.
Example of this includes management structure and staffing.

 Management Planning, Goal Setting, and Decision Making

Strategic Planning & Goal Setting ASSESSMENTS: STRATEGIC PLANNING GOAL SETTING White
Paper STRATEGIC PLANNING Strategic planning is a disciplined effort. In the end, it produces
fundamental decisions and actions that shape and guide what an organization is, who it serves, what it
does and why. With a focus on the future, effective strategic planning also articulates how an
organization will know if it is successful. A successful strategic plan sets priorities, focuses energy and
resources, strengthens operations, and ensures that employees and other stakeholders are working
toward common goals. Strategic planning answers three key questions: • Where are we? • Where are we
going? • How will we get there? Where are we? Consider the foundational elements of your mission
statement, values and/or guiding principles, and SWOT (strengths, weaknesses, opportunities, threats) to
assess where your business is — what is happening internally and externally — and determine what
changes you need to make. Where are we going? The future is impossible to predict, but contemplating
scenarios will focus your attention and help you define the future for your business. Specifically, compare
your organization to your competitors. What do you do best? What makes you unique? What can your
organization potentially do better than any other organization? Answering these questions will help you
formulate a picture of what your future make up will be and where you are headed. How will we get
there? This is the meat of your strategic plan. It’s also the most time consuming. There are a number of
routes from your current position to your vision, and picking the right one will determine how quickly or
slowly you get to your final destination. Determine your strategy, set short and long term goals, and
develop action items to get you there. Identify issues that surround management and monitoring of the
action items. Remember, strategic planning is about growing and improving your company. When you
don’t plan, the best you can hope for is maintenance of the status quo. Further down the line, you can
expect challenges that will significantly damage or destroy your organization. The Seven Rules In
addition to answering the three questions above, effective strategic planning requires following 7 critical
rules. 1. Pick the right players. Selecting who should be part of the planning team is an important
question. It is essential that planning team members are people who are committed to the growth of the
company, and who can provide valuable input to the process. Unless there is a key employee or manager
you want to develop, this is not a time to include every member of your staff. Vet each team member,
ensuring each is of the quality and stature (i.e. gets work done and is respected within the company)
required to be part of the planning group. Members of the planning team must maintain complete 2.
Strategic Planning & Goal Setting 6 confidentiality and be fully engaged in the growth and well being of
the company. Employees who are passionate about growing the company, developing an extraordinary
organization, and being the CEO’s partner in accomplishing will provide positive and constructive input.
Accept nothing less. 2. Design planning sessions that yield actual results. Most strategic planning today
consists of the following: Once a year, team members check into a nice hotel and lock themselves in the
conference room for a few days to “strategize”. They emerge every once and awhile for a round of golf, a
team building game, or other such “fun”. This kind of planning is a novel idea, but it just does not work.
More often than not, planning in a single session like this yields zero opportunities for critical thinking,
and results only in repeating current business practices. Instead, design a planning process that takes
place over two to three months, with 3-4 day strategy sessions each month. Extending the process will
allow you to research, dialogue, and listen more effectively. From this place a valuable strategic plan is
created. 3. Finish what you started. That is, complete the previous year. At the very first session of the
planning process, the past goes into the past. To accomplish this, team members should brainstorm
information, good and bad, from the previous year – breakdowns, breakthroughs, disappointments,
accomplishments, and so on. In doing so, employees get to review all the work that got done during the
past 12 months, examine the practices and challenges of the previous year, and determine how to move
forward. The new year is met with greater enthusiasm when the previous year is properly completed. 4.
Big vision, then laser-like focus. Start big by creating a vision of the future of the company. Where do you
want to be in the next five years? This is your vision and, when you have one, you are creating a future
for the company that employees can believe in and work toward. Answer the following questions to
arrive at your future vision: In five years… …what will the world look like? …what will be the important
trends affecting our industry? …what is our industry dealing with and what does it look like? …what is
our image? …what are customers saying about us and why are they loyal to us? …what have we done
that no one else has done? …how big is our company? How many employees do we have? Planning like
this allows you to run growth scenarios. Have at least one aggressive, one medium, one sluggish, and one
no-growth plan. Get familiar with many possibilities, and then narrow the focus as you get back to
present and address what to do immediately and how to implement change. 7 STRATEGIC PLANNING
& GOAL SETTING 5. Be brutally honest. Face the facts that confront your organization. Do not deny or
sugar coat the issues that plague growth. Face them honestly and deal with them in an intelligent way.
Planning teams effectively face issues by defining the ones that are currently hindering growth. Typically,
these critical issues are addressed through the writing of a white paper, a three- to five-page document,
written between planning sessions by the members of the planning team, which addresses the problems at
hand. The paper should deal directly with the issues and provide the “answer” to the problems. The
entire planning team will read the paper prior to the next session and then debate it during the session.
Problem solving ensues. Direction is determined. 6. Play nice. The planning team has to be able to
actually work and create together. There can be no pretense. Remember, the group has to be able to
implement the plan it creates. It is not on a mission to create a plan that sits on a shelf. Rather, through
collaboration and problem solving, the group becomes an agent for change. There must be trust within
the planning team. People should be able to speak their minds. Nothing should be taken personally, and
petty politics and gossip should not be tolerated. A focused environment like this gives the leadership
team a great advantage when competing against other business leadership teams. 7. Be disciplined and
take continued action. It is important that the leadership team completes its work. To really participate
in a good breakthrough planning/ guessing process, the planning team has to take to develop a plan. But
once you have the plan, then you need to make sure that it is acted upon. Monthly meetings of one to
three hours and spending time on objectives and action plans will ensure focus. Then, once a quarter,
allow the team to go off site and review what happened in the quarter and focus on what needs to happen
in the next quarter. This will keep everyone aligned on what needs to take place to push the company
forward. ASSESSMENT: STRATEGIC PLANNING Print this page and place a check mark next to each
sentence that speaks to your organization. For each section, 1 check or less = severe problem area; 2 =
area needs major improvement; 3 = area needs moderate improvement; 4 = area needs minimal
improvement; 5 = system is world-class in this area. The Planning Team _____ The size of the planning
team is nine to 15 members. _____ The CEO assumes an active role in leading the planning team with
senior management. _____ The planning team represents different segments of the company, not only
executive level staff reporting directly to the CEO. _____ Members of the planning team are chosen
because of merit, not rank or entitlement. _____ The team includes an outside facilitator and an internal
coordinator. 8 BOATSMAN GILLMORE WAGNER The Planning Process _____ Planning sessions take
place offsite. _____ Team members practice creative and critical thinking. _____ The planning team
assesses the external environment and internal competencies. _____ The planning team pinpoints
measurable objectives reflecting the company’s overall goals. _____ Objectives are logically arranged in a
way that leads to achievement of goals. _____ The team identifies clear, well-defined action steps for
implementing each core strategy. _____ Each functional area builds a yearly work plan under each core
strategy. Vision and Mission _____ The company’s vision is shared at the very bottom of the
organization. _____ The company has a written statement of corporate values and beliefs. _____ The
company’s mission statement defines the scope of business, who its customers are and its benefits to these
customers. _____ The mission statement empowers all employees. _____ The mission statement guides
day-to-day operations and serves as a foundation for decision-making. _____ The mission statement is
periodically reviewed and updated as necessary. SWOT and Competitive Analysis _____ The CEO can
list four or five key strengths of the business. _____ The CEO is aware of key weaknesses in the business.
_____ The company has a coherent system for capturing, reporting and analyzing information on
customer choices. _____ The company knows the strengths, weaknesses and strategies of its key
competitors. _____ Data is stored or filed in ways that allow easy retrieval of useful planning information.
_____ The executive team regularly addresses the company’s future competitive status. Implementation
_____ The CEO communicates the final plan to employees and responds to their concerns. _____ The
timetable for implementation is realistic. _____ Checkpoints have been scheduled for assessing progress
toward strategic planning goals. _____ Regular follow-up meetings by senior management take place
after the plan is created. _____ The management team has consensus on the company’s strategic
direction. _____ The organizational structure supports the strategic plan. _____ The strategic plan drives
budgets, human resources and other operations. 9 STRATEGIC PLANNING & GOAL SETTING 10
GOAL SETTING You can accomplish more and go farther if you dedicate yourself to written goals. Goal
setting begins after the strategic planning is complete and aligns with the organization’s mission and
vision statements. Keep your goals on your personal and business radar screens at all times and follow
through on the steps required to make them happen. Before you can begin goal setting, it’s essential to
create a blueprint for how the process will unfold. Address the following: • Mission statement • Vision
statement • Fiscal year priorities • Strategies • Monthly monitoring and managing meetings Goal setting
begins after the mission and vision statements are finished. Keep the process simple and enjoyable, and
set “SMART” goals – simple, measurable, achievable, results oriented, time sensitive. Most importantly,
however, do not set goals that are “too easy” or do not boost performance. It is best to challenge
employees, expect them to challenge themselves, with attainable goals that require considerable effort.
Consider the following categories of goals: • Financial • Customer service • Employee-based • Internal
business process • Image • Reputation • Community relations and philanthropy • Sales and marketing
You may not specify your goals in each one of these areas at one time, but whichever you choose, be sure
they reflect your corporate purpose and path. Additionally, while no one goal setting style is better than
another, pay special attention to it. The more closely a manager can match the employees’ wishes with
the goal-setting style, the better the chances for a successful outcome. Leadership and Cascading Goals
Goals must be brought to life. Unfortunately, there is often a “disconnect” between what an executive
staff understands about an organization’s goals, and what the CEO believes it understands. In many
cases, the staff truly doesn’t even know what the goals are. To remedy this, set cascading goals – goals at
different levels of the company that must spill over (cascade) throughout the organization to be
implemented. This creates horizontal alignment in a company. Once the vision and main categorical goals
are set at the CEO and managerial level, select a person who will champion the process of cascading
goals. He or she works to ensure that each department will create goals and action plans that support the
goals of the company’s leadership. Updating people on their progress is critical. Goals must be visible
and repeated to keep the commitment alive. Besides scheduled meetings, goals may be touted in: monthly
e-mail messages, company newsletters, bulletin boards, and “surprise” coffee breaks, among others.
BOATSMAN GILLMORE WAGNER 11 Ensuring Goal Implementation When everyone returns to
their jobs after goal setting exercises, enthusiasm for the goals can be buried by the demands of day-to-
day business. The first step is to develop action plans based on the goals -- complete with incentives and
consequences for non-performance. Accountability Discussing consequences is critical in any goals-to-
action plan. Consider adopting a “three strikes and you’re off the team” approach. Peer pressure and the
threat of humiliation create intense expectations of performance, enough to cause significant action.
Monthly Management Meetings Once your goals and action plans are set, schedule monthly management
meetings to monitor progress. The original planning group should meet for a 90-minute session to recap
the previous month, acknowledge progress and examine shortfalls, amend the plan if it needs to be
changed, and clarify the action plan for the next 30 days. Coaching for Goals Implementing goals that
were set months ago requires discipline. The planning group has to follow through with its direct reports.
The managers need the discipline to make the goals a priority over day-to-day troubles in a business.
When Goal Setting Goes Wrong Too often organizations set goals that are quickly set aside. Examine
roadblocks if you have a pattern of abandoning organizational or corporate goals. Ten Organizational
Roadblocks 1. Lack of clear-cut responsibilities around the goals 2. Lack of a tracking system 3. Lack of
an accountability system 4. Lack of commitment 5. Lack of buy-in from people who are expected to fulfill
the goals 6. Ineffective communication 7. Lack of time or resources 8. Too many goals are financially
driven 9. Focusing on too many or too few goals 10. Goals aren’t tied to a longer-term vision Obstacles in
Goal Setting When an organization fails to meet goals, many factors may be at play. Typically, one of the
following common denominators is present: a CEO with no passion for the goals that have been set; the
goals are not precise; the goals are at cross-purposes with the CEO’s self-image; fear of failure. Examine
any and all obstacles to your organization’s goals, looking particularly at any old patterns you, your
team, or the organization as a whole has in abandoning specific goals. STRATEGIC PLANNING &
GOAL SETTING 12 ASSESSMENT: GOAL SETTING Print this page and place a check mark next to
each sentence that speaks to your organization. For each section, fill in a score based on the following
scale: 5 – adhere to best practices, no improvement needed 4 -- area needs minimal improvement 3 - area
needs moderate improvement 2 - area needs major improvement 1 – major problem area requiring new
approach Organizational Goal-setting Style _____ We set goals annually, review them monthly,
communicate them frequently and revise plans based on progress. _____ We meet most of our goals.
_____ We apply the SMART test whenever we set goals. _____ Not all of our goals are financially driven.
Approximately one-third of them are. _____ We connect our goals and action plans to an accountability
system, and we follow through with rewards and consequences. Personal Goal-setting Style _____ I set
goals, write them down, review them regularly, and complete them on time. _____ My goals are on my
personal “radar” at all times.
Baylor Universityís Community Mentoring for Adolescent Development 75 GOAL-SETTING AND
DECISION-MAKING ìIf you have made mistakes, there is always another chance for you. You may have a
fresh start any moment you choose, for this thing we call ëfailureí is not the falling down, but the staying down.î
óMary Pickford Baylor Universityís Community Mentoring for Adolescent Development 76 GOAL-SETTING
Introduction Goal-setting is a powerful technique for helping a mentee develop a solid foundation for future
planning and organization. By knowing what he/she wants to achieve in life, a mentee may know where they
want to concentrate and what to improve. If mentees can set well-defined goals, they can measure and take
pride in the achievement of those goals. However, one of the most important tasks of the mentor is to assist the
mentee in setting short-term goals (less than a year) and long-term goals (more than five years). Aspiring to
achieve long-term goals gives the mentee short-term motivation. For instance, a mentee may want to attend a
major university (long-term goal). First, he/she needs to do well on the S.A.T. (short-term goal). According to
Joan K. Carter (1993), a mentee should establish a long-term goal before a short-term goal can be explored. A
mentee may not see the need to work toward a goal without understanding the relationship between the short-
term goal and the long-term goal. For example, graduating from high school may be a motivating factor to help
a mentee work toward the short-term goal of passing the eighth grade. There are several important factors to
consider before goal-setting with a mentee (Carter, 1993): • Establish a relationship of trust over time. •
Establishing confidentiality is prerequisite to goal-setting. • The mentee should be directly involved in setting
goals. With the mentorís guidance, the mentee must articulate each goal, and it must be genuinely his/her goal. •
A short-term goal that can be easily achieved is a good starting point; for example, simply to complete all math
homework assignments for the next week. • Goals must be specific and measurable. For instance, ìMary will
complete and turn in all English assignments next week.î • To assure that an attempt will be made by mentees to
meet their goals, a written commitment contract should be established between the mentor and the mentee. If a
mentee fails to achieve his/her goal, examine these possible factors: • The goal may have been too difficult to
achieve. • The goal may have been developed without the active involvement and commitment of the mentee. •
The mentee may be fearful of achieving a self-enhancing goal. Many at-risk adolescents have low self-esteem
and believe they are ìlosers.î They often become accustomed to making poor choices, reinforcing their negative
self-image. • The mentor may need to speak to the mentee about his/her fears of being successful and making
self-enhancing decisions. Purpose of Goal-Setting Goal-setting helps the mentee to strive to achieve. Although
goal-setting may be challenging, it is generally worthwhile. Its intention is to increase efficiency and
effectiveness by specifying the Baylor Universityís Community Mentoring for Adolescent Development 77
menteeís desired outcomes. Hellriegel, Slocum, and Woodman & Martens (1992) (1987) find the following to
be the most important purposes of goal-setting: • Goals guide and direct behavior. • Goals provide clarity. •
Goals provide challenges and standards. • Goals reflect what the goal setters consider important. • Goals help
improve performance. • Goals increase the motivation to achieve. • Goals help increase menteeís pride and
satisfaction in his/her achievements. • Goals improve menteeís self-confidence. • Goals help decrease negative
attitude. People who use goal-setting effectively suffer less from stress, are better able to concentrate, show
more self-confidence, and seem to feel happier. Deciding Your Goal Mentors should help guide mentees when
deciding goals, making sure that the mentee considers broadly all aspects of his/her life. For instance, a
menteeís goal should take into account the following issues: • Artistic Does your mentee want to achieve any
artistic goals? Does he have/need any training to achieve them? • Attitude Is any aspect of your menteeís
mindset holding him/her back? Are any personal behaviors upsetting to him/her? If so, set goals to improve or
cure the problem, even if the goal is only to get help. • Education Is there any specific knowledge that the
mentee wants to acquire? What information and skill will the mentee need to achieve other goals? • Pleasure
What does your mentee want to enjoy? Mentee should ensure that some time is reserved for personal pleasure
or satisfaction! • Social Does your mentee have any social ambitions? • Physical Are there any athletic goals
that your mentee wants to achieve, or does he/she want good health deep into old age? What steps will your
mentee choose to achieve this? • Career What career is your mentee seeking? • Family How does your mentee
want to be seen by members of his/her immediate family? • Financial How much does your mentee want to earn
and by what career stage? (Taken from Mind Tools LTD 1996. Mind ToolsóPlanning & Goal-Setting [online].
Available: www.mindtools.com/index.html) Baylor Universityís Community Mentoring for Adolescent
Development 78 As soon as the mentee has decided on goals in these categories, he/she should prioritize them.
The mentor should ensure that the goals that have been selected by mentee, not by parent, teacher, peers, or by
mentor. Baylor Universityís Community Mentoring for Adolescent Development 79 Goal-Setting Model A
mentee must formulate goals to travel the road to success. The SMART guidelines can help to set effective
goals. SMART S-Specific A goal of graduating from high school is too general. Specify how this will be
accomplished. (Study more in order to receive better grades.) M-Measurable Establish criteria for how a goal is
to be achieved. Measurable does not refer to a timeline; it means determining a way to measure the menteeís
success in completing the long-range goal. A-Action-oriented Be proactive in taking action that will result in
reaching the desired goal. R-Realistic Strive for attainable goals, considering the resources and constraints
relative to the situation. T-Timely Allow reasonable time to complete each goal, but not so much time the
mentee loses focus or motivation. (Adapted from Discovery Focus on Your Values and Accomplish Your
Goals. Franklin Quest, 1996) Baylor Universityís Community Mentoring for Adolescent Development 80
Assignment Sheet Subjects Monday Tuesday Wednesday Thursday Friday Test Date Next Report Due Baylor
Universityís Community Mentoring for Adolescent Development 81 Activity Directions: Place a check in the
column to indicate which are of value to you. (Check five) Going to college is a good decision. Finding a job
right out of high school is more important. Finishing high school is important to me. Having a car is important.
Liking my job is important. Living in a clean, safe area is important to me. It is important to have spending
money. Having friends is important. Spending time with your family is important. Something other than what is
listed above is of value. (Specify) Baylor Universityís Community Mentoring for Adolescent Development 82
Baylor Universityís Community Mentoring for Adolescent Development 83 Baylor Universityís Community
Mentoring for Adolescent Development 84 Baylor Universityís Community Mentoring for Adolescent
Development 85 Baylor Universityís Community Mentoring for Adolescent Development 86 Name
___________________________________ Date ___________________ What Will the Future Bring?
Directions: Answer each of the following questions about your future. What Do You Want to Achieve Five
Years from Now? High school diploma? _____ Part-time job? _____ Doing what?
______________________________ Full-time job? _____ Doing what? ______________________________
Have your own apartment? _____ Where? __________________________________ Own a used car? _____
Paying for a new car? ________________________ Accepted into college? _____ College choice?
________________________ A one-week vacation in
____________________________________________________ A longer trip to
___________________________________________________________ What Do You Want to Achieve
Fifteen Years from Now? College degree? _____ From ______________________ Major
__________________ Masterís degree? _____ From ______________________ Major __________________
Full-time job? _____ Occupation ____________________________________________ Own your home?
_____ Location ______________________________________________ Salary range: $10,000ñ$20,000
_____ Married? ____ $21,000ñ$40,000 _____ Children? ____ $50,000ñ$75,000 _____ How many? ____ $ ?
_____ Two-week vacation each year _____ One-month trip to (location) __________________ Own new car
(no payments) _____ Help in the community? _____ How? ____________________________________
Baylor Universityís Community Mentoring for Adolescent Development 87 Decision-Making Introduction
Decision-making may not always be an easy task for adolescents (e.g., staying out late with friends the night
before exams). The mentorís role is to advise mentees that they need to be the key decision-maker under any
circumstances. Mentees will also need to learn to acknowledge the responsibilities that go along with those
decisions. With that in mind, the ìEight Steps in Making a Decisionî (Robbins, 1991) will help guide the
mentees to make rational decisions. • State the problem objectively. (Define what is happening.) • Gather
information about the problem. (Do not try to solve problem.) • List pros and cons of the problem. • Develop
alternatives. (Do not force yourself into only one choice, and be sure that each • solution solves the problem.) •
Analyze alternatives. (Look at pros and cons.) • Select an alternative. (Mentee makes a decision based on what
is best for him/her in this • situation, keeping the goal in mind.) • Implement the alternative. (Test.) • Evaluate
end results of decision made. (Make changes as necessary.) If mentee follows through these steps with
assistance from mentor often enough, the mentee will become familiar with the process and will be capable of
applying it to any future complicated decision. There are three different types of decision-making styles:
Inactive, Reactive, and Proactive. An inactive decision-maker is someone who fails to make choices. A mentee
who has this style of decision-making usually procrastinates until a future time because of indecision.
Eventually, one option merely plays itself out. Mentees who have this style have difficulty developing
selfconfidence, and feel that they have no control of their destiny. A reactive-decision maker is someone who
allows peers, siblings, parents, etc. to make the decision for them. Mentees with this style are easily influenced
by what others think, do, or suggest. They are easily persuaded by peer-pressure, develop a negative self-
esteem, and have a need to be liked by others. Mentors should not make decisions without the participation of
the mentee; otherwise, the menteeís needs and wants go unfulfilled. A proactive-decision maker is someone
who follows the eight steps of decision-making and assumes responsibility for the consequences. In this case,
the mentee takes on responsibility rather than being driven by circumstances and conditions or being influenced
by others. Mentees with this style of decision-making often experience a feeling of empowerment or inspiration
because they know that they are in control of their own destinies. Baylor Universityís Community Mentoring
for Adolescent Development 88 Goal-Setting/Decision-Making Lesson Plan Objectives: To help the mentor
develop a solid foundation of planning, organizing his/her future, and making sound decisions by setting short-
and long-term goals using the Smart Goals model. Icebreaker: The instructor should ask mentors the following
questions: • How did you go about making decisions? • Did you rely on your parentsí opinion or your own? •
What goals did you set for yourself? Lesson: The instructor will discuss: • The purpose of goal-setting •
Deciding your goal • Smart Goals model • Decision-making Materials: • Assignment sheet: Goal-setting •
Activity Handouts: Goals, Goal-Planning, Step by Step, Defining Your Goals, What Will The Future Bring? •
Goal-Planning Activity • Activity: Decision-Making: Weighing Your Options • Eight Steps to Decision-Making
• Activity II • A Problem-Solving Worksheet • Forced Choice Activity Baylor Universityís Community
Mentoring for Adolescent Development 89 Activity I Use the ìEight Stepî method for this activity. Participants
will divide into small groups and each group will be given a certain ìproblemî (e.g., a mentee wants to run away
from home). Together, the participants in the group will go through each of the eight steps and discuss how they
would help to solve the problem. In the steps listed below, write your response for each statement. • Mentee
gets pregnant and does not know what to do. • Mentee wants to drop out of school. • Mentee wants to start
drinking and using drugs because his/her friends are doing it. • Mentee wants to join a popular gang that
commits petty crimes. • Mentee feels pressured into having sex with a boyfriend/girlfriend. Baylor Universityís
Community Mentoring for Adolescent Development 90 Eight Steps to Decision-Making 1. State the problem. 2.
Gather information about the problem. 3. List pros and cons of the problem. 4. Develop alternatives. 5. Analyze
alternatives. 6. Make a decision based on what is best for you and the situation. (Select alternative.) 7.
Implement an alternative. (Test.) 8. Evaluate end results of decision made. Baylor Universityís Community
Mentoring for Adolescent Development 91 Activity II Mentor will read the following story to the class or
mentee. Then go through the eight steps of decision-making and discuss how the mentee might solve the
problem. Joseph is a hard working young man and an excellent student with high grades. He has worked as a
stock boy at a neighborhood grocery store since he was 14 years old and has saved almost every paycheck he
has earned at the store. Now that Joseph is 16, he wants to buy a car with his savings. However, Joseph has a
problem. He also wants to go to college and has only one more year of high school to graduate with honors.
Even though his parents are very proud of him, they have told him that he will have to decide what to do with
his money. Josephís parents have made it very clear to him that he will not receive any financial support from
them. Baylor Universityís Community Mentoring for Adolescent Development 92 A Problem-Solving
Worksheet Often a problem seems difficult to solve because you limit your options for solutions. This exercise
allows you to come up with more solutions than you may have thought possible. First, identify the problem (Be
specific). Now the solution. Use all the blanks. Write any solution you think of, even if itís not practical.
Remember, a ìcrazyî idea can trigger the most innovative solutions. This is a good time to take a break. Set this
aside for a day or two. Let these solutions roll around in your mind. When you pick up this list again, choose
those that seem like the three best solutions. Write down your choices. Solution: Why? Look over your solution
lists again. Take another break if you can. Then pick your favorite solution and write about it in more detail.
Solution: Baylor Universityís Community Mentoring for Adolescent Development 93 Activity: Forced Choice
This activity will have students recognize the effects of personal values and peer pressure when making a
decision. 1. Place signs in each corner of the room to designate four different choices: Strongly Agree, Agree,
Disagree, and Strongly Disagree. 2. Have the students stand in the middle of the room. 3. Read the first
statement: ìWomen are generally more sensitive than men.î 4. The students are then to choose a corner of the
room that represents their choice. NOTE: It is important that they make their choices with NO talking. 5.
Repeat, using the following statements, each time having the students choose the corner of the room that best
fits their choice of each statement. Statements: • Women are generally more sensitive than men. • I would ditch
school and go with my friends. • If the principal announces that a window is broken and asks for information
about the perpetrator, and I knew who did it, I would tell. • I think it is OK to push and shove people I donít
like. • School is more work than fun. • Students donít give each other enough respect. • Boys are better at sports
than girls. • Adults donít give kids enough respect. • Scientists should not be allowed to carry out experiments
on animals. • People can be judged by the clothes that they wear. • It is better to give than to receive. • It is
necessary to have a college education to make it in life. • Teachers are usually right. Ask the following
questions: 1. Notice the four signs. Which choice is not represented here? (Answer: ìI donít know or care.î) 2.
How did it feel when you were forced to make a decision? 3. Did you always go with your friends to the same
corner or was the choice your own? 4. Did you feel any pressure from your friends to select a particular corner?
5. What kinds of pressure did you feel? 6. Did anyone make a decision that was different from everyone in the
class? How did that feel for the student and the rest of the class? Baylor Universityís Community Mentoring for
Adolescent Development 94 Baylor Universityís Community Mentoring for Adolescent Development 95
Baylor Universityís Community Mentoring for Adolescent Development 96 Baylor Universityís Community
Mentoring for Adolescent Development 97 Baylor Universityís Community Mentoring for Adolescent
Development 98 Baylor Universityís Community Mentoring for Adolescent Development 99 Bibliography
Begun, R. W. (Ed.). (1996). Ready-to-use social skills lessons & activities for grades 7-12. New York: The
Center for Applied Research in Education. Discovery focus on your value and accomplish your goals (1996).
Franklin Quest Co. USA. Hellriegel, D., Slocum, J. W. Jr., & Woodman, R. W. (1992). Organizational
Behavior (6th ed.). St. Paul: West Publishing Company. Martens, R. (1987). Coaches guide to sports
psychology. Champaign: Human Kinetics Publishers, Inc. Mind Tools LTD. (02/1996). Mind toolsósetting
goals effectively. [7 sections]. Available online: www.mindtools.com/index.html. Robbins, S. (1991).
Management (3rd ed.). New Jersey: Prentice Hall. Volusia County School Board. (1993). VIPS youth motivator
handbook. (Available from Volusia County Schools, P.O. Box 2410, Daytona Beach, Florida 32115-2410).

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Nielsen Media Research
David Calhoun left a job he loved as a star execu-tive at General Electric to step into a mess as CEOof the A. C.
Nielsen Corporation. His immediatechallenge: The media research unit, which is underheavy fire from
television clients such as NBC andCBS for chronic delays in reporting television rat-ings. Nielsen held a
conference call with major cli-ents acknowledging the delays and promising to do better, but the following
Monday, the company againfailed to report any ratings at all for the previousday. Nielson was not delivering
data to customers aspromised. What’s the big deal? Calhoun and chief ofresearch Susan Whiting know that
about $70 bil-lion a year in advertising revenues for the televisionindustry depends on Nielsen ratings. Viewers
mightthink TV networks are in the business of providingentertainment, but management’s primary goal
isproviding eyeballs for advertisers. When televisionmanagers and advertisers don’t get timely, accuratedata
from Nielsen, they’re shooting in the dark withdecisions about how to allocate resources. Daily meet-ings at
some companies are scheduled based on get-ting the information from Nielsen when promised.“There is so
much revenue involved over which wehave no quality control,” said Alan Wurtzel, presi-dent of research for
NBC. “We don’t just use this datafor analytical purposes. This is the currency of
the business.” Calhoun and other top managers are analyz-ing what went wrong at Nielsen. Originated in
1923to perform surveys of the production of industrialequipment, Nielsen became a household name whenit
launched its television ratings system in 1950.More than 60 years later, Nielsen still functions as anear-
monopoly in the ratings business. Yet the com-pany could be facing a serious threat from cable andsatellite
companies that are working on a way to getset-top boxes to provide real-time TV viewing data torival
Nielsen’s. Managers see several factors involved in theproblems at Nielsen, but the biggest one is that
theamount of data the company processes doubled in ayear, overloading computer servers and straining
thecompany’s human systems. The increase has come both because of changes in how people are
watchingtelevision, such as over the Internet and other digitaldevices, and in the amount of information
networkswant. As the television business gets cut into thinnerslices, clients need even more precise data to
makegood decisions. Nielsen is pursuing a strategy it calls“Anytime, Anywhere Media Measurement” to
stayrelevant and address new competition, but it has toget its quality problems fixed
fast. Clients understand the strain, but they have littlesympathy. They want to know why Nielsen
managersdidn’t anticipate the spike in data demands and planaccordingly.
Questions
1. Where do you think the problems lie at Nielsen?For example, are they primarily with the com-pany’s
strategic goals and plans, tactical goals andplans, or operational goals and plans? With align-ment of goals and
plans?2. Do you think developing a strategy map would bea good idea for Nielsen? Why or why not?3. If you
were David Calhoun, what kind of planningprocesses might you implement right now to fixthis problem?
SOURCE: Based on Bill Carter, “Nielsen Tells TV Clients It Is Workingon Ending Delays in Ratings,”
The New York Times
, February 9, 2008;Richard Siklos, “Made to Measure,”
Fortune
(March 3, 2008): 68–74;and Louise Story, “Nielsen Tests Limits of Wider Tracking,”
International Herald Tribune
, February 28, 2008.
ch6
CASE FOR CRITICAL ANALYSIS
the more it didn’t quite sit well with her conscience.Time was running out. She needed to decide what to do.
What Would You Do?
1. Donate the $1,000 to Central High, and considerthe $10,000 bonus a good return on your gift.2. Accept the
fact you didn’t quite make your salesgoal this year. Figure out ways to work smarternext year to increase the
odds of achieving yourtarget.3. Don’t make the donation, but investigate whetherany other ways were available
to help Central Highraise the funds that would allow them to purchasethe much-needed educational software.
SOURCE: Based on Shel Horowitz, “Should Mary Buy Her Own Bo-nus?”
Business Ethics
(Summer 2005): 34.
C
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ON THE JOB VIDEO CASE
Flight 001: Planning andGoal Setting
“We came up with this concept out of need,” saidBrad John, co-founder of Flight 001. John and fellowco-
founder John Sencion had, until the late 90s, beenworking in different aspects of the fashion industryin New
York. Both traveled often between the UnitedStates, Europe, and Japan for work. No matter howmany times
they began a trip, they spent the days andhours before they left racing all over town picking uplast-minute
essentials. By the time they got to the air-port, they were sweaty, stressed, and miserable—notliving the
glamorous existence they envisioned whenthey got into the fashion
industry. On a 1998 flight from New York to Paris, theweary travelers came up with an idea for a one-stoptravel
shop targeted at fashion-forward globe-trotterslike themselves. Flight 001 sells guidebooks, cos-metics, laptop
bags, luggage, electronics and gad-gets, passport covers, and other personal consumerproducts. Sencion
summed up their mission: “We’retrying to bring a little fun and glamour back in
totravel.” When asked who does the planning at Flight 001, John automatically replied, “John Sencion.”
Whenpressed, he admitted that it’s really more of a decen-tralized approach, with everyone contributing
withinhis or her area of expertise and experience. At thetop, John focused on financial forecasts, planning
forexpansion, and retailing issues. Sencion focused onnew product and design. At the retail level, John
alsosought input from store managers to provide a three-dimensional perspective on his purchasing plans
andsales data. One of John’s current strategic goals is expan-sion. The company, now in its tenth year, has7
stores in the United States and 1 boutique inHarvey Nichols, an upscale department store in theUnited Arab
Emirates. It wants to be in every majorcity in the United States, Europe, and Asia. In total, John hopes to open
20 to 30 shops worldwide at arate of 5 to 10 per year. Confident in his ability toopen individual stores, his new
challenge will beopening multiple stores simultaneously. Location,start-up costs, and cash flow are currently
the biggest hurdles. “In retail, as soon as you sign thatlease, money starts going out, so you need to get thatstore
open quickly,” John said. Managing humanresources plays an important role in getting up tospeed. New stores
are staffed with employees fromexisting Flight 001 shops to save time and money intraining. Plus, the company
reduces its risk by hiringemployees it knows. Financial planning is another tricky aspect of any business,
especially during economic downturnswhen consumers curtail spending and sales fallshort of forecasts. “We
had planned to do a certainamount of business in 2008,” John explained. “But because of the current economy,
we’re falling shortof our sales goals.” As a result, Flight 001 had to cutunnecessary spending. Until consumer
confidenceimproves, John will carefully control inventory
andhiring. Also integral to the strategic plan is a transitionfrom boutique to brand. The company recently
beganwork on an exclusive product line designed and man-ufactured by Flight 001. This goal works to
supportits expansion plans as Flight 001 strives to differenti-ate itself and add value to the brand in a retail
spacedominated by larger, one-stop shopping outlets suchas Target and online retailers offering the
convenienceof 24/7 shopping.

With all the talk about expansion and new productlines, it will be increasingly important for Flight 001to not
become distracted from what makes it specialin the first place: location, design, and an impeccableproduct line.
Discussion Questions
1. How was the concept of Flight 001 created?2. In what ways might the introduction of the Flight001 brand of
products be considered a stretch goal?3. What external factors might trigger the need forcontingency planning at
small specialty retailerssuch as Flight 001?

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Quoted in Oren Harari, “Good/Bad1.News About Strategy,”
ManagementReview
(July 1995): 29–31. Amitai Etzioni,2.
Modern Organiza-tions
(Englewood Cliffs, NJ: PrenticeHall, 1984), p. 6.Ibid.3.Max D. Richards,4.
Setting StrategicGoals and Objectives,
2nd ed.(St. Paul, MN: West, 1986).C. Chet Miller and Laura B. Cardinal,5.“Strategic Planning and Firm Per-
formance: A Synthesis of More ThanTwo Decades of Research,”
Academyof Management Journal
37, no. 6(1994): 1649–1685.This discussion is based on Richard6.L. Daft and Richard M. Steers,
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(Glenview, IL: Scott,Foresman, 1986), pp. 319–321;Herbert A. Simon, “On the Conceptof Organizational
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Journal of General Manage-ment
5 (1980): 3–13.Marc Gunther, “Tree Huggers, Soy7.Lovers, and Profits,”
Fortune
(June23, 2003): 98–104.Paul Sloan, “The Sales Force That8.Rocks,”
Business 2.0
(July 2005):102–107.Mary Klemm, Stuart Sanderson,9.and George Luffman, “MissionStatements: Selling
Corporate Values to Employees,”
Long-RangePlanning
24, no. 3 (1991): 73–78; John A. Pearce II and Fred David,“Corporate Mission Statements:The Bottom Line,”
Academy of Management Executive
(1987):109–116; Jerome H. Want, “CorporateMission: The Intangible Contributorto Performance,”
Management Review
(August 1986): 46–50; and Forest R.David and Fred R. David, “It’s Timeto Redraft Your Mission Statement,”
Journal of Business Strategy
(January–February 2003): 11–14.“Tennessee News and Notes from10.State Farm,”State Farm Mutual Au-
tomobile Insurance Company, 2004. Jeffrey A. Trachtenberg, “Borders11.Business Plan Gets a Rewrite; It Will
Reopen Web Site, Give UpMost Stores Abroad, Close Many Waldenbooks,”
Wall Street Journal
,March 22, 2007, B1. Copyright 2007by Dow Jones & Company, Inc.Reproduced with permission ofDow
Jones & Company, Inc. inthe format Textbook via CopyrightClearance Center.Paul Meising and Joseph
Wolfe, “The12. Art and Science of Planning at theBusiness Unit Level,”
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31 (1985): 773–781.Based in part on information about13.1-800-Flowers, in Jenny C. McCune,“On the Train
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ch6
ENDNOTES
Inside Man
New York City detective Keith Frazier (DenzelWashington) leads an effort to remove Dalton Russell(Clive
Owen) and his armed gang from the ManhattanTrust Bank building. Complexities set in when bankchairman
Arthur Case (Christopher Plummer) seeksthe help of power broker Madeline White (Jodie Foster)to prevent the
thieves from getting a particular safedeposit box. This fast-paced action film goes in manydirections to reach its
unexpected ending.
Planning
This scene starts as Captain John Darius (WillemDafoe) approaches the diner. Detectives Keith Frazierand Bill
Mitchell (Chiwetlel Ejiofor) leave the dinerto join Captain Darius. The scene ends after the threemen enter the
New York Police Department commandpost after Captain Darius says, “Your call.” The filmcuts to Madeline
White and Arthur Case walkingalong a river.
What to Watch for and Ask Yourself
▪
Does this scene show strategic or tactical planning?
▪
What pieces of the planning type does it specifi-cally show? Give examples from the scene.
▪
Do you expect this plan to succeed? Why or whynot?
 Strategic Management Process: Strategy Formulation and Implementation
The Five Stages of the Strategic Management Process
by Jim Clayton; Reviewed by Jayne Thompson, LLB, LLM; Updated January 29, 2019

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  4What Kind of Information Is Important to the Business Decision-Maker?
The strategic management process is more than just a set of rules to follow. It is a philosophical approach to
business. Upper management must think strategically first, then apply that thought to a process. The strategic
management process is best implemented when everyone within the business understands the strategy.
Tip
 The five stages of the process are goal-setting, analysis, strategy formation, strategy implementation and
strategy monitoring.
Clarify Your Vision
The purpose of goal-setting is to clarify the vision for your business. This stage consists of identifying three key
facets: First, define both short- and long-term objectives. Second, identify the process of how to accomplish
your objective. Finally, customize the process for your staff, give each person a task with which he can succeed.
Keep in mind during this process your goals to be detailed, realistic and match the values of your vision.
Typically, the final step in this stage is to write a mission statement that succinctly communicates your goals to
both your shareholders and your staff.
Gather and Analyze Information
Analysis is a key stage because the information gained in this stage will shape the next two stages. In this stage,
gather as much information and data relevant to accomplishing your vision. The focus of the analysis should be
on understanding the needs of the business as a sustainable entity, its strategic direction and identifying
initiatives that will help your business grow. Examine any external or internal issues that can affect your goals
and objectives. Make sure to identify both the strengths and weaknesses of your organization as well as any
threats and opportunities that may arise along the path.
Formulate a Strategy
The first step in forming a strategy is to review the information gleaned from completing the analysis.
Determine what resources the business currently has that can help reach the defined goals and objectives.
Identify any areas of which the business must seek external resources. The issues facing the company should be
prioritized by their importance to your success. Once prioritized, begin formulating the strategy. Because
business and economic situations are fluid, it is critical in this stage to develop alternative approaches that
target each step of the plan.
Implement Your Strategy
Successful strategy implementation is critical to the success of the business venture. This is the action stage of
the strategic management process. If the overall strategy does not work with the business' current structure, a
new structure should be installed at the beginning of this stage. Everyone within the organization must be made
clear of their responsibilities and duties, and how that fits in with the overall goal. Additionally, any
resources or funding for the venture must be secured at this point. Once the funding is in place and the
employees are ready, execute the plan.
Evaluate and Control
Strategy evaluation and control actions include performance measurements, consistent review of internal and
external issues and making corrective actions when necessary. Any successful evaluation of the strategy begins
with defining the parameters to be measured. These parameters should mirror the goals set in Stage 1.
Determine your progress by measuring the actual results versus the plan.
Monitoring internal and external issues will also enable you to react to any substantial change in your business
environment. If you determine that the strategy is not moving the company toward its goal, take corrective
actions. If those actions are not successful, then repeat the strategic management process. Because internal and
external issues are constantly evolving, any data gained in this stage should be retained to help with any future
strategies.
Steps in Strategy Formulation Process
Strategy formulation refers to the process of choosing the most appropriate course of action for the realization
of organizational goals and objectives and thereby achieving the organizational vision. The process of strategy
formulation basically involves six main steps. Though these steps do not follow a rigid chronological order,
however they are very rational and can be easily followed in this order.
1. Setting Organizations’ objectives - The key component of any strategy statement is to set the long-
term objectives of the organization. It is known that strategy is generally a medium for realization of
organizational objectives. Objectives stress the state of being there whereas Strategy stresses upon the
process of reaching there. Strategy includes both the fixation of objectives as well the medium to be
used to realize those objectives. Thus, strategy is a wider term which believes in the manner of
deployment of resources so as to achieve the objectives.
While fixing the organizational objectives, it is essential that the factors which influence the selection of
objectives must be analyzed before the selection of objectives. Once the objectives and the factors influencing
strategic decisions have been determined, it is easy to take strategic decisions.
2. Evaluating the Organizational Environment - The next step is to evaluate the general economic and
industrial environment in which the organization operates. This includes a review of the organizations
competitive position. It is essential to conduct a qualitative and quantitative review of an organizations
existing product line. The purpose of such a review is to make sure that the factors important for
competitive success in the market can be discovered so that the management can identify their own
strengths and weaknesses as well as their competitors’ strengths and weaknesses.
After identifying its strengths and weaknesses, an organization must keep a track of competitors’ moves and
actions so as to discover probable opportunities of threats to its market or supply sources.
3. Setting Quantitative Targets - In this step, an organization must practically fix the quantitative target
values for some of the organizational objectives. The idea behind this is to compare with long term
customers, so as to evaluate the contribution that might be made by various product zones or operating
departments.
4. Aiming in context with the divisional plans - In this step, the contributions made by each department
or division or product category within the organization is identified and accordingly strategic planning is
done for each sub-unit. This requires a careful analysis of macroeconomic trends.
5. Performance Analysis - Performance analysis includes discovering and analyzing the gap between the
planned or desired performance. A critical evaluation of the organizations past performance, present
condition and the desired future conditions must be done by the organization. This critical evaluation
identifies the degree of gap that persists between the actual reality and the long-term aspirations of the
organization. An attempt is made by the organization to estimate its probable future condition if the
current trends persist.
6. Choice of Strategy - This is the ultimate step in Strategy Formulation. The best course of action is
actually chosen after considering organizational goals, organizational strengths, potential and limitations
as well as the external opportunities.
Strategy Formulation
Definition: Strategy Formulation is an analytical process of selection of the best suitable course of action to
meet the organizational objectives and vision. It is one of the steps of the strategic management process. The
strategic plan allows an organization to examine its resources, provides a financial plan and establishes the most
appropriate action plan for increasing profits.
It is examined through SWOT analysis. SWOT is an acronym for strength, weakness, opportunity and threat.
The strategic plan should be informed to all the employees so that they know the company’s objectives, mission
and vision. It provides direction and focus to the employees.
Steps of Strategy Formulation
The steps of strategy formulation include the following:

1. Establishing Organizational Objectives: This involves establishing long-term goals of

an organization. Strategic decisions can be taken once the organizational objectives are determined.
2. Analysis of Organizational Environment: This involves SWOT analysis, meaning identifying the
company’s strengths and weaknesses and keeping vigilance over competitors’ actions to understand
opportunities and threats.
Strengths and weaknesses are internal factors which the company has control over. Opportunities and threats,
on the other hand, are external factors over which the company has no control. A successful organization builds
on its strengths, overcomes its weakness, identifies new opportunities and protects against external threats.
3. Forming quantitative goals: Defining targets so as to meet the company’s short-term and long-term
objectives. Example, 30% increase in revenue this year of a company.
4. Objectives in context with divisional plans: This involves setting up targets for every department so
that they work in coherence with the organization as a whole.
 5. Performance Analysis: This is done to estimate the degree of variation between the actual and the
standard performance of an organization.
6. Selection of Strategy: This is the final step of strategy formulation. It involves evaluation of the
alternatives and selection of the best strategy amongst them to be the strategy of the organization.
Strategy formulation process is an integral part of strategic management, as it helps in framing effective
strategies for the organization, to survive and grow in the dynamic business environment.
Levels of strategy formulation
There are three levels of strategy formulation used in an organization:

 Corporate level strategy: This level outlines what you want to achieve: growth, stability, acquisition or
retrenchment. It focuses on what business you are going to enter the market.
 Business level strategy: This level answers the question of how you are going to compete. It plays a
role in those organization which have smaller units of business and each is considered as the strategic
business unit (SBU).
 Functional level strategy: This level concentrates on how an organization is going to grow. It defines
daily actions including allocation of resources to deliver corporate and business level strategies.
Hence, all organisations have competitors, and it is the strategy that enables one business to become more
successful and established than the other.
Strategic Management & Strategic Planning Process
Ovidijus Jurevicius | February 13, 2013 Print

A set of icons illustrating a process.

Definition
Strategic management process
is a method by which managers conceive of and implement a strategy that can lead to a sustainable competitive
advantage.
[1]

Strategic planning process

is a systematic or emerged way of performing strategic planning in the organization through initial assessment,
thorough analysis, strategy formulation, its implementation and evaluation.
What is that strategic planning process?
The process of strategic management lists what steps the managers should take to create a complete strategy and
how to implement that strategy successfully in the company. It might comprise from 7 to nearly 30 steps[4] and
tends to be more formal in well-established organizations.
The ways that strategies are created and realized differ. Thus, there are many different models of the process.
The models vary between companies depending upon:
 Organization’s culture.
 Leadership style.
 The experience the firm has in creating successful strategies.
All the examples of the process in this article represent top-down approach and belong to the ‘design school’.
Components of strategic planning process
There are many components of the process which are spread throughout strategic planning stages. Most often,
the strategic planning process has 4 common phases: strategic analysis, strategy formulation, implementation
and monitoring (David[5], Johnson, Scholes & Whittington[6], Rothaermel[1], Thompson and Martin[2]). For
clearer understanding, this article represents 5 stages of strategic planning process:
 Initial Assessment
 Situation Analysis
 Strategy Formulation
 Strategy Implementation
 Strategy Monitoring
Initial Assessment
Components: Vision statement & Mission statement
Tools used: Creating a Vision and Mission statements.
The starting point of the process is initial assessment of the firm. At this phase managers must clearly identify
the company’s vision and mission statements.
Business' vision answers the question: What does an organization want to become? Without visualizing the
company’s future, managers wouldn’t know where they want to go and what they have to achieve. Vision is the
ultimate goal for the firm and the direction for its employees.
In addition, mission describes company’s business. It informs organization’s stakeholders about the products,
customers, markets, values, concern for public image and employees of the organization (David, p. 93)[5].
Thorough mission statement acts as guidance for managers in making appropriate (Rothaermel, p. 34)[1] daily
decisions.
Situation Analysis
Components: Internal environment analysis, External environment analysis and Competitor analysis
Tools used: PEST, SWOT, Core Competencies, Critical Success Factors, Unique Selling Proposition, Porter's 5
Forces, Competitor Profile Matrix, External Factor Evaluation Matrix, Internal Factor Evaluation
Matrix, Benchmarking, Financial Ratios, Scenarios Forecasting, Market Segmentation, Value Chain
Analysis, VRIO Framework
When the company identifies its vision and mission it must assess its current situation in the market. This
includes evaluating an organization’s external and internal environments and analyzing its competitors.
During an external environment analysis managers look into the key external forces: macro & micro
environments and competition. PEST or PESTEL frameworks represent all the macro environment factors that
influence the organization in the global environment. Micro environment affects the company in its industry. It
is analyzed using Porter’s 5 Forces Framework.
Competition is another uncontrollable external force that influences the company. A good example of this was
when Apple released its IPod and shook the mp3 players industry, including its leading performer Sony. Firms
assess their competitors using competitors profile matrix and benchmarking to evaluate their strengths,
weaknesses and level of performance.
Internal analysis includes the assessment of the company’s resources, core competencies and activities. An
organization holds both tangible resources: capital, land, equipment, and intangible resources: culture, brand
equity, knowledge, patents, copyrights and trademarks (Rothaermel, p. 90)[1]. A firm’s core competencies may
be superior skills in customer relationship or efficient supply chain management. When analyzing the
company’s activities managers look into the value chain and the whole production process.
As a result, situation analysis identifies strengths, weaknesses, opportunities and threats for the organization and
reveals a clear picture of company’s situation in the market.
Strategy Formulation
Components: Objectives, Business level, Corporate level and Global Strategy Selection
Tools used: Scenario Planning, SPACE Matrix, Boston Consulting Group Matrix, GE-McKinsey Matrix,
Porter’s Generic Strategies, Bowman’s Strategy Clock, Porter’s Diamond, Game Theory, QSP Matrix.
Successful situation analysis is followed by creation of long-term objectives. Long-term objectives indicate
goals that could improve the company’s competitive position in the long run. They act as directions for specific
strategy selection. In an organization, strategies are chosen at 3 different levels:
 Business level strategy. This type of strategy is used when strategic business units (SBU), divisions or
small and medium enterprises select strategies for only one product that is sold in only one market. The
example of business level strategy is well illustrated by Royal Enfield firms. They sell their Bullet
motorcycle (one product) in United Kingdom and India (different markets) but focus on different market
segments and sell at very different prices (different strategies). Firms may select between Porter’s 3
generic strategies: cost leadership, differentiation and focus strategies. Alternatively strategies from
Bowman’s strategy clock may be chosen (Johnson, Scholes, & Whittington, p. 224[6]).
  Corporate level strategy. At this level, executives at top parent companies choose which products to sell,
which market to enter and whether to acquire a competitor or merge with it. They select between
integration, intensive, diversification and defensive strategies.
 Global/International strategy. The main questions to answer: Which new markets to develop and how to
enter them? How far to diversify? (Thompson and Martin, p. 557[2], Johnson, Scholes, & Whittington, p.
294[6])
Managers may choose between many strategic alternatives. That depends on a company’s objectives, results of
situation analysis and the level for which the strategy is selected.
Strategy Implementation
Components: Annual Objectives, Policies, Resource Allocation, Change Management, Organizational chart,
Linking Performance and Reward
Tools used: Policies, Motivation, Resistance management, Leadership, Stakeholder Impact Analysis, Changing
organizational structure, Performance management
Even the best strategic plans must be implemented and only well executed strategies create competitive
advantage for a company.
At this stage managerial skills are more important than using analysis. Communication in strategy
implementation is essential as new strategies must get support all over organization for effective
implementation. The example of the strategy implementation that is used here is taken from David’s book,
chapter 7 on implementation[5]. It consists of the following 6 steps:
 Setting annual objectives;
 Revising policies to meet the objectives;
 Allocating resources to strategically important areas;
 Changing organizational structure to meet new strategy;
 Managing resistance to change;
 Introducing new reward system for performance results if needed.
The first point in strategy implementation is setting annual objectives for the company’s functional areas. These
smaller objectives are specifically designed to achieve financial, marketing, operations, human resources and
other functional goals. To meet these goals managers revise existing policies and introduce new ones which act
as the directions for successful objectives implementation.
The other very important part of strategy implementation is changing an organizational chart. For example, a
product diversification strategy may require new SBU to be incorporated into the existing organizational chart.
Or market development strategy may require an additional division to be added to the company. Every new
strategy changes the organizational structure and requires reallocation of resources. It also redistributes
responsibilities and powers between managers. Managers may be moved from one functional area to another or
asked to manage a new team. This creates resistance to change, which has to be managed in an appropriate way
or it could ruin excellent strategy implementation.
Strategy Monitoring
Components: Internal and External Factors Review, Measuring Company’s Performance
Tools used: Strategy Evaluation Framework, Balanced Scorecard, Benchmarking
Implementation must be monitored to be successful. Due to constantly changing external and internal
conditions managers must continuously review both environments as new strengths, weaknesses, opportunities
and threats may arise. If new circumstances affect the company, managers must take corrective actions as soon
as possible.
Usually, tactics rather than strategies are changed to meet the new conditions, unless firms are faced with such
severe external changes as the 2007 credit crunch.
Measuring performance is another important activity in strategy monitoring. Performance has to be measurable
and comparable. Managers have to compare their actual results with estimated results and see if they are
successful in achieving their objectives. If objectives are not met managers should:
 Change the reward system.
 Introduce new or revise existing policies.
The key element in strategy monitoring is to get the relevant and timely information on changing environment
and the company’s performance and if necessary take corrective actions.
Different models of the process
There is no universal model of the strategic management process. The one, which was described in this article,
is just one more version of so many models that are established by other authors. In this section we will
illustrate and comment on 3 more well-known frameworks presented by recognized scholars in the strategic
management field. More about these models can be found in the authors’ books.
Figure 1. David’s Model of the Strategic Management’s Process

Source: David (p. 46)

Stages
 Strategy Formulation
 Strategy Implementation
 Strategy Evaluation
Steps
1. Develop vision and mission
2. External environment analysis
3. Internal environment analysis
4. Establish long-term objectives
5. Generate, evaluate and choose strategies
6. Implement strategies
7. Measure and evaluate performance
Benefits
  Indicates all the major steps that have to be met during the process.
 Illustrates that the process is a continuous activity.
 Arrows show the two way process. This means that companies may sometimes go a step or two back in
the process rather than having to complete the process and start it all over from the beginning. For
example, if in the implementation stage the company finds out that the strategy it chose is not viable, it
can simply go back to the strategy selection point instead of continuing to the monitoring stage and
starting the process from the beginning.
Drawbacks
 Represents only strategy formulation stage and does separate situation analysis from strategy selection
stages.
 Confuses strategy evaluation with strategy monitoring stage.
Figure 2. Rothaermel’s The Analysis-Formulation-Implementation (AFI) Strategy Framework

Source: Rothaermel (p. 20)

Stages
 Analysis
 Formulation
 Implementation
Steps
1. Initial analysis
2. External and internal analysis
3. Business or corporate strategy formulation
4. Implementation
Benefits
 Shows that the process is a continuous activity.
 Separates initial analysis (in this articles it’s called initial assessment) from internal/external analysis.
 Emphasizes the main focus of strategic management: “Gain and sustain competitive advantage”.
Drawbacks
 Does not include strategy monitoring stage.
 Arrows indicate only one way process. For example, after the strategy formulation the process continues
to the implementation stage while this is not always the truth. Companies may go back and reassess their
environments if some conditions had changed.
Figure 3. Thompson’s and Martin’s Strategic Management Framework
Source: Thompson and Martin (p.36)
Stages
 Where are we?
 Where are we going?
 How are we getting there?
 How are we doing?
Steps
1. Situation appraisal: review of corporate objectives
2. Situation assessment
3. Clarification of objectives
4. Corporate and competitive strategies
5. Strategic decisions
6. Implementation
7. Monitor progress
Benefits
 Indicates all the major steps that have to be met during the process.
 Shows that the process is a continuous activity.
 The model is supplemented by 4 fundamental strategic management questions.
Drawbacks
 Arrows indicate only one way process.
Limitations
It is rare that the company will be able to follow the process from the first to the last step. Producing a quality
strategic plan requires time, during which many external and even internal conditions may change. This results
in the flawed strategic plan which has to be revised, hence requiring even more time to finish.
On the other hand, when implementing the strategic plan, the actual results do not meet the requirements of the
strategic plan so the plan has to be altered or better methods for the implementation have to be discovered. This
means that some parts of strategic management process have to be done simultaneously, which makes the whole
process more complex.
Saylor URL: www.saylor.org/bus208 The Saylor Foundation Saylor.org Page 1 of 6 Strategy Formulation
Introduction Strategy formulation is the process by which an organization chooses the most appropriate courses
of action to achieve its defined goals. This process is essential to an organization’s success, because it provides
a framework for the actions that will lead to the anticipated results. Strategic plans should be communicated to
all employees so that they are aware of the organization’s objectives, mission, and purpose. Strategy
formulation forces an organization to carefully look at the changing environment and to be prepared for the
possible changes that may occur. A strategic plan also enables an organization to evaluate its resources, allocate
budgets, and determine the most effective plan for maximizing ROI (return on investment). A company that has
not taken the time to develop a strategic plan will not be able to provide its employees with direction or focus.
Rather than being proactive in the face of business conditions, an organization that does not have a set strategy
will find that it is being reactive; the organization will be addressing unanticipated pressures as they arise; and
the organization will be at a competitive disadvantage. Strategy formulation requires a defined set of six steps
for effective implementation. Those steps are: 1. define the organization, 2. define the strategic mission, 3.
define the strategic objectives, 4. define the competitive strategy, 5. implement strategies, and 6. evaluate
progress. In this reading, we will explore each of the six steps for strategy formulation. Step 1. Define the
Organization The first step in defining an organization is to identify the company’s customers. Without a strong
customer base, whose needs are being filled, an organization will not be successful. A company must identify
the factors that are valued by its customers. Is the value based on a superior product or service relative to the
competition? Are your customers buying your products for your low prices? Do you produce products that meet
image needs of your customers? Saylor URL: www.saylor.org/bus208 The Saylor Foundation Saylor.org Page 2
of 6 Let’s review some of the ways in which companies can define themselves. End Benefit Organizations must
remember that people are buying benefits not features. For example, if an airline only defined itself as being in
the business of flying people from one place to another, then it would view its competition as being only other
airlines. However, if it views itself as being in the transportation business, then it will recognize that its
competition includes not only other airlines, but also trains, buses, car rental companies, and other ways of
getting people from one place to another place. An airline must highlight the benefits of using its method of
transportation as a means of persuading customers to purchase its service. Furthermore, an organization can
explain how its product works or how it is built. Inevitably, customers will ask the question, “What’s in it for
me?” Companies must be able to answer this question in order to meet the needs of their customers. They must
be able to respond effectively to the “so what?” in order to influence customers to buy their product or service.
Target Market Companies can become successful by identifying themselves with a particular target group. This
focus should not be limited only to demographic segmentation (i.e., age, income, education, gender, income,
family life-cycle, culture) but also by psychographic indicators. For example, by understanding the values,
attitudes, opinions, and lifestyles of a company’s customers, the organization can better provide ways in which
to meet its customers’ needs. For example, Nike has successfully identified itself not only with professional
athletes, but with those who want to be part of the athlete world. Nike’s marketing message has made everyone
who wishes to participate in sports feel as if they can achieve their athletic goals. While most people who
purchase Nike products are not professional athletes, the people who buy Nike’s products are able to identify
with Nike’s culture and feel like they are part of an exclusive group. Technology Computer companies, medical
research companies, and other companies that identify themselves with the tech world will find that they must
be able to quickly adapt to changes in the marketplace. New products, services, and inventions are frequently
introduced, making this a very difficult and challenging business environment in which to operate. For example,
Genentech, Inc. conducts genetic engineering and medical research for the pharmaceutical industry. This
company uncovers and discovers new advances every day, making it challenging to develop a specific strategy
plan for its products and services. However, by Saylor URL: www.saylor.org/bus208 The Saylor Foundation
Saylor.org Page 3 of 6 defining the company as being in the biotech industry, it can develop a strategy for its
overall corporate goals. Step 2. Define the Strategic Mission An organization’s strategic mission offers a long-
range perspective of what the organization strives for going forward. A clearly stated mission will provide the
organization with a guide for carrying out its plans. Elements of a strong strategic mission statement should
include the values that the organization holds, the nature of the business, special abilities or position the
organization holds in the marketplace, and the organization’s vision for where it wants to be in the future. Step
3. Define the Strategic Objectives This third step in the strategic formulation process requires an organization to
identify the performance targets needed to reach clearly stated objectives. These objectives may include: market
position relative to the competition, production of goods and services, desired market share, improved customer
services, corporation expansion, advances in technology, and sales increases. Strategic objectives must be
communicated with all employees and stakeholders in order to ensure success. All members of the organization
must be made aware of their role in the process and how their efforts contribute to meeting the organization’s
objectives. Additionally, members of the organization should have their own set of objectives and performance
targets for their individual roles. Step 4. Define the Competitive Strategy The next step in strategy formulation
requires an organization to determine where it fits into the marketplace. This applies not only to the
organization as a whole, but to each individual unit and department throughout the enterprise. Each area must
be aware of its role within the company and how those roles enable the organization to maintain its competitive
position. Another step in the competitive strategy process requires an organization to develop proactive
responses to potential changes in the marketplace. As discussed in earlier readings, an organization must not
wait for events in the marketplace to occur before taking steps; they must identify possible events and be
prepared to take action. The final step in defining a competitive strategy is identifying an organization’s
resources and determining how those resources will be used. Each department, division, or location will have its
own set of needs, and a company must determine how it will allocate resources in order to meet those needs.
Saylor URL: www.saylor.org/bus208 The Saylor Foundation Saylor.org Page 4 of 6 Three factors must be
considered when determining the overall competitive strategy: the industry and marketplace, the company’s
position relative to the competition, and the company’s internal strengths and weaknesses. The Industry When
evaluating the overall industry, factors to be looked at include:  size of the market,  past and potential market
growth,  competitive profitability,  new market entries, and  industry threats. These market factors must be
evaluated on a regular basis, as small changes may have a large impact on an organization’s business activities.
For example, if an organization becomes aware of new technology that is on the verge of being introduced into
the marketplace, then it can avoid making any new plans that would involve the older, existing technology
available. Also, if an organization is considering global expansion, then it would be beneficial to be aware of
emerging markets, other areas of potential growth, and what other companies have already entered in those
markets. The Competition An organization cannot be successful unless it has a full understanding of the other
players in marketplace. A company must be able to identify the strengths and weaknesses of the competition
and analyze the ways in which the competition’s products or services meet the needs of its customer base. Has
the competition created a significant product differentiation strategy? Has the competition cornered a specific
target market? Is the competition in full-scale competition with another company? It is essential for these
questions to be answered in order to develop the appropriate strategy for successful competition. As mentioned
earlier, we discussed how competition for an airline is not only other airlines, but also other modes of
transportation. Evaluating competition requires a company to look at organizations that provide substitutes for
its product or service as well as those who provide the same products and services. Strengths & Weaknesses
Let’s go back to the traditional, well-known marketing tool of the SWOT analysis. As you may recall, SWOT is
an acronym for Strengths, Weaknesses, Saylor URL: www.saylor.org/bus208 The Saylor Foundation Saylor.org
Page 5 of 6 Opportunities, and Threats. Opportunities and threats are external factors; strengths and weaknesses
are internal factors. When developing a competitive strategy, it is vital for an organization to be fully aware of
its internal strengths and how those strengths relate to the competition. These strengths should be maximized
and leveraged to the company’s advantage as well as highlighted in all business and marketing activities that the
company undertakes. It is equally important for an organization to take an honest look at its areas of weakness.
This is where a company can become vulnerable to outside market conditions, such as competitive gains,
advances in technology, economic shifts, and other factors. By identifying areas in need of improvement and
taking steps to remedy those areas, a company will be in a stronger competitive position. Step 5. Implement
Strategies Developing a strategy is only effective if it is put into place. An organization may take all the
necessary steps to understand the marketplace, define itself, and identify the competition. However, without
implementing the strategy, the organization’s work will be of little to no value. The methods employed for
implementing strategies are known as tactics. These individual actions enable an organization to build a
foundation for implementation. Companies are able to identify which of their efforts are more successful than
others and will uncover new methods of implementation, if necessary. Step 6. Evaluate Progress As in any plan,
a regular evaluation of processes and results is vital to ongoing success. An organization must keep track of the
progress it is making as defined by its strategic plan. If goals are not being met, the organization must be
adaptable and flexible to recognize that changes may be needed. An organization should consider the following
questions on a continuous basis in order to evaluate progress: Have market conditions changed that may require
a change in corporate direction? Are there new entries in the marketplace to pose a competitive threat? Has the
organization been successful in translating their strategy into actionable steps? An organization will be able to
successfully implement its strategy both now and in the future through evaluating feedback. Saylor URL:
www.saylor.org/bus208 The Saylor Foundation Saylor.org Page 6 of 6 Conclusion A strategic plan is a living
document that changes and grows as the conditions around it change. If an organization recognizes that it must
constantly be aware of the business world around it and must be flexible to the changes that will inevitably
occur, then it will be in a position to adapt and modify its plans to achieve maximum success. Summary: 
Strategy formulation is the course of action companies take to achieve their defined goals.  All employees of
an organization should be aware of the company’s objectives, mission, and purpose.  A strategic plan enables a
company to evaluate resources, allocate budgets, and maximize ROI (return on investment).  The lack of a
strategic plan will result in an organization being without direction or focus. The company will be reactive
rather than proactive.  The six steps for strategy formulation are: define the organization, define the strategic
mission, define the strategic objectives, define the competitive strategy, implement strategies, and evaluate
progress.  Defining the organization requires a company to identify its customers by end benefits sought, by
specific target markets, or by technology.  Defining the strategic mission ensures that the company is able to
identify its values, the nature of its business, its competitive advantage, and its vision for the future.  Strategic
objectives should be defined based on performance targets and may include increases in market share, customer
service improvements, corporate expansion, sales increases, production methods, etc.  Competitive strategy
includes an evaluation of the overall industry and marketplace, the nature of the competition’s position, and the
company’s internal strengths and weaknesses.  A company must implement its strategic plan in order to
achieve success. It must develop appropriate tactics, which are the action steps for meeting the strategies
directives.  Strategies must be evaluated and revised on a regular basis in order to meet the changing needs and
challenges of the marketplace and business environment.

Saturn’s main purpose is to focus on the small-car niche market, whichwants to buy a small, inexpensive, and
reliable car.The mission statements of both companies strongly emphasize commit-ment to providing the
customer with a quality product through enthusiastic,productive teamwork. This should enable these firms to
remain strong andcontinuetogrow.Bothcompanieshavereachedahighdegreeofsuccessformany reasons, but
chiefly due to excellent employees, continuous improve-ment, and dedication to achieving worthwhile goals.
This dedication bene-fits customers, the company, and employees’personal lives.The mission of a financial
institution could be to meet the financial ser-vice needs of its customers (individuals and businesses). The
institutionpursues a leadership position in the markets where it chooses to compete byproviding high-quality,
differentiated products and exceptional
customerservice.Theinstitutionseekstopenetrateexistingmarkets,deliverproductsand services to new
geographical markets, and strategically manage
thebusinessmixtoachievesuperiorresults.Noticethatthegoalsofthisinstitu-tion are directed to its customers, future
expansion, and industry domi-nance. It plans to meet customer needs by providing superior customer ser-
viceandbyofferingdifferenttypesofproductsandservices.Theinstitutionplans to dominate the industry by
expanding market share in the
currentmarketandexpandingintonewgeographicalareas.Italsoplanstomaintainstability while doing this by the use
of strategic management.Everyorganizationmusthaveapurposeandstatedmission.PeterDruckerasserts that even
though the question “What is our business?” is simple, it isone that causes the most “frustration and failure” in
an organization. Druckersaid that the answer to “What is our business?” begins by investigating cus-tomers’
needs and wants.
17
Derek Abell expanded this idea by using threedimensions: “(1) customer groups, or
who
is being satisfied, (2) customerneeds or
what
is being satisfied, and (3) technologies, or
how
customerneedsaresatisfied.”
18
Aclearandconcisemissionstatementisinvaluable.Itwill give the company a firm foundation on which to stand.
Objectives and Goals
Thecompany’smissionmustbeturnedintoobjectivesandgoals,thesec-ond step in strategic planning.
Goals
are broad statements that present whatneeds to be pursued in certain areas. Most businesses express their
maingoal as maximizing stockholder wealth. The focus on maximizing short-term
return on investment (ROI)
will overlook corporate competitiveness.American managers are accused of focusing on short-term results
ratherthan a company’s long-term survival as a vital entity. They tend to establish
IntroductiontoStrategicManagement 15

strategies that expand the size of the company rather than profitability
andstockholdersatisfaction.Anorganization’sgoalsdependonthenatureofitsbusiness and will stem from its
mission. The organization’s market share,technology, productivity, and profitability are all components of a
desiredgoal.Saturn’sgoalistoinfiltrateanddominatethemarket.Theywanttosellcars at a very affordable price from
extremely well-staffed and maintainedshowrooms, with the auto industry’s best after-sales service. They
also planto keep things simple and easy for their customers. Microsoft’s main goal isto produce a product that
customers want.Acompanyalwayshasalargenumberofobjectives,whicharestatedinahierarchical fashion, from the
most to the least important. They indicate thedesired result of planned activity. Not-for-profit organizational
objectivesmight not be specific or measurable. The objectives of for-profit organiza-tions are the specific
intended results. They are measurable and have a timeframe. There are three levels of objectives within
an organization:1.
Strategic or long-term objectives
are usually set for the entire organi-zation and broadly stated.2.
Intermediate objectives
are usually more specific and increasinglycomplex and detailed. They are set for various strategic units or func-
tions.3.
Operational or short-term objectives
are more specific than the previ-ous two and should be done on an individual or group level.Objectives and
strategies are formed from strategists’ consideration of mission, strategic policy, and appropriate information.
When a firm oper-ates outside its parent country, the objectives and other strategies might bedifferent. While
the strategic management process is the same for domesticand international management, the environment is
often different. For ex-ample, companies must adhere to different rules when operating abroad.Therefore,
strategies must be altered. Many multinational companies de-pend on the superiority of some resources abroad
such as capital, labor, ortechnology. These organizations capitalize on advantage in order to over-come
weaknesses at home.Corporations conduct business abroad to achieve economies of scale, in-crease market
share, and reduce overall cost. Operating abroad may imposelimitations on organizations in setting objectives
and designing strategiesbecause the host country’s needs and priorities may be different from thoseof the parent
country. For example, the host government, because of extracost, may limit efficiency levels. The utilization
of certain resources may beset at specified levels. Growth may be legislatively set, etc.
16 STRATEGIC MANAGEMENT

Corporate Philosophy
Corporate philosophy is an important element of the corporate
missionstatement.Corporatephilosophyrepresentsthebasicbeliefs,values,andas-pirations of the chief executive
officer and top-level management. It showshow the company proposes to conduct business in the future as well
as itspriorities.A
philosophicalcreed
isoftendevelopedtoreflectthecompany’scorporateculture.Thecreedusuallydescribesacompany’sresponsibilitytoits
stakeholders (i.e., stockholders, employees, customers, management, andcommunitiesat large). For example, a
company’s responsibility to its stock-holders can be to provide them with a fair return on their investment, to in-
troduce a new product, to purchase new equipment, etc. A company’s re-
sponsibilitytoitsemployeescanbetoprovidethemwithasenseofsecurityon the job, give them safe working
conditions, honor their dignity, appreci-ate their merit, and provide fair compensation. Delivering immediate
andqualityservice,continuingtoreducecosts,andmaintainingreasonablepricesare good examples of corporate
responsibilities toward customers.The
learning-curve theory
stipulates that efficiency (and thus cost sav-ings) results when people continuously repeat a task. This applies to
man-agement decision making, as well as to assembly-line labor. There is evi-dence, however, that the learning
curve has limits—the significance of thelearning curve effect is greater in complex tasks and tends to decrease
overtime.
19
The Learning Organization
Organizationsneedtocontinuouslylearnfromtheirpastexperiencesandneed to be willing to adapt a new position if
they are to survive and prosper.The
learning organization
is relatively a new trend in business that empha-
sizessystematicproblemsolving.Thismeansthateveryoneintheorganiza-tion is engaged in identifying and solving
problems, enabling the organiza-tion to continuously improve and increase its capability. The
interactingsystemsthatmakeupthelearningorganizationresembleanetworkinwhicheach group communicates
to and influences every other group. While top-
levelmanagementprovidesthevisionforthedevelopmentofstrategies,em-
ployeesassistinscanningtheenvironmentforcriticalinformationthatisvi-tal to the process. Information sharing
requires adjustments on the part of managers for the inclusion of employees, suppliers, and customers. Em-
ployee empowerment will encourage participation in the process of design-ing strategies as well as in
implementation. Transformational change in-volves redesign and renewal of the total organization in which
horizontal
© Dr. N·br·di Andr·s DE-AVK By: Prof. Dr. Andr Prof. Dr. Andr·s N·br·di PhD, MBA PhD, MBA Strategic
Management Process: Strategy formulation Strategy formulation University of Debrecen Faculty Faculty of Ag.
Economics and of Ag. Economics and Rural Development Development Dept.: Business Management and
Marketing .: Business Management and Marketing HUNGARY HUNGARY © Dr. N·br·di Andr·s DE-AVK
Tasks of strategic management Outline ï Strategy formulation ïDevelop vision ïDevelop mission ïWhy mission
statement ïExternal assessment ïInternal assessment ïEstablish long term objectives Strategy formulation
Strategy Implementation Strategy Evaluation © Dr. N·br·di Andr·s DE-AVK Strategy formulation Business
mission Internal analysis External analysis Establishing long term objectives ANALYSIS ANALYSIS Outline ï
Strategy formulation ï Develop vision ï Develop mission ï Why mission statement ï External assessment ï
Internal assessment ï Establish long term objectives © Dr. N·br·di Andr·s DE-AVK First stage of the strategic
management Develop Vision and Mission Statements Establish long term objectives Generate, evaluate, and
select strategies Strategy formulation (Strategic planning) Outline ï Strategy formulation ï Develop vision ï
Develop mission ï Why mission statement ï External assessment ï Internal assessment ï Establish long term
objectives © Dr. N·br·di Andr·s DE-AVK Strategy formulation ïDeveloping vision and mission ïIndetifying
external opportunities and threats ïDetermining internal strenghts and weaknesses ïEstablishing long term
objectives ïGenerating alternative strategies ïChoosing particular strategies to pursue ïDeciding what new
business to enter ïHow to allocate resources ïExpand or diversify operations ïEntering or not international
market ïMerge or form joint venture ïHow to avoid a hostile takeover Outline ï Strategy formulation ï Develop
vision ï Develop mission ï Why mission statement ï External assessment ï Internal assessment ï Establish long
term objectives © Dr. N·br·di Andr·s DE-AVK Strategy formulation Developing vision and mission Outline ï
Strategy formulation ï Develop vision ï Develop mission ï Why mission statement ï External assessment ï
Internal assessment ï Establish long term objectives © Dr. N·br·di Andr·s DE-AVK Terms to remember
STRATEGIC VISION STRATEGIC VISION A view of an organizationís future direction and busines course;
a guiding for what the organization is trying to do and to become. What do we want to become? Outline ï
Strategy formulation ï Develop vision ï Develop mission ï Why mission statement ï External assessment ï
Internal assessment ï Establish long term objectives © Dr. N·br·di Andr·s DE-AVK Vision Henkel is want to be
a leader with brands and technologies that make people's lives easier, better and more beautiful. We will
provide knowledge and take action to ensure the national security of the United States and the preservation of
American life and ideals. Outline ï Strategy formulation ï Develop vision ï Develop mission ï Why mission
statement ï External assessment ï Internal assessment ï Establish long term objectives What do we want to
become? © Dr. N·br·di Andr·s DE-AVK Vision To be the leading food company in knowledge, consumer
relations and revenues among companies headquartered in the region of Southeast, Central and Eastern Europe,
as well as a pharmaceutical company which achieves more through a distinctive partnership approach. Outline ï
Strategy formulation ï Develop vision ï Develop mission ï Why mission statement ï External assessment ï
Internal assessment ï Establish long term objectives What do we want to become? © Dr. N·br·di Andr·s DE-
AVK Terms to remember A mission statement broadly outlines the organizationís future direction and serves as
aquiding concept for what the organization is to do and to become. Overriding premise in line with the values or
expectations of stakeholders. STRATEGIC MISSION STRATEGIC MISSION What is our business? Outline ï
Strategy formulation ï Develop vision ï Develop mission ï Why mission statement ï External assessment ï
Internal assessment ï Establish long term objectives © Dr. N·br·di Andr·s DE-AVK Az ¸zleti k¸ldetÈs The
mission We believe our first responsibility is to the doctors nurses to mothers who use our products and
services. We offer a wide range of home furnishings with good design and function at prices so low that as
many people as possible will be able to afford them. Outline ï Strategy formulation ï Develop vision ï Develop
mission ï Why mission statement ï External assessment ï Internal assessment ï Establish long term objectives
What is our business? © Dr. N·br·di Andr·s DE-AVK Az ¸zleti k¸ldetÈs The mission We are the eyes and ears
of the nation and at times its hidden hand . Outline ï Strategy formulation ï Develop vision ï Develop mission ï
Why mission statement ï External assessment ï Internal assessment ï Establish long term objectives To create
high-quality branded products that acquire the trust of clients and consumers. To pioneer the future in space
exploration, scientific discovery and aeronautics research. What is our business? © Dr. N·br·di Andr·s DE-
AVK Personal mission statement Az ¸zleti k¸ldetÈs Throughout each day in my life I strive to be loyal to my
friends and family, lead a successful career that I will enjoy, stay healthy, and take on any challenges that come
my way. I value my family members, friends, spiritual fulfillment, sense of accomplishment, and respect for
others. Outline ï Strategy formulation ï Develop vision ï Develop mission ï Why mission statement ï External
assessment ï Internal assessment ï Establish long term objectives © Dr. N·br·di Andr·s DE-AVK Strategic
management principle Az ¸zleti k¸ldetÈs Outline ï Strategy formulation ï Develop vision ï Develop mission ï
Why mission statement ï External assessment ï Internal assessment ï Establish long term objectives Profit NOT
mission or Profit NOT mission or vision is a primary vision is a primary corporate motivator corporate
motivator! © Dr. N·br·di Andr·s DE-AVK Az ¸zleti k¸ldetÈs The process of developing a mission statement ï
First to select several articles about mission statements and ask all managers to read these as background
information ï Ask managers themselves to prepare a mission statement for the organization ï Committee of top
managers should then merge these statements into a single documents, ï Than distribute this draft mission
statement to all managers as a request for modifications ï Finalize the modified statement in front of CEOís
Outline ï Strategy formulation ï Develop vision ï Develop mission ï Why mission statement ï External
assessment ï Internal assessment ï Establish long term objectives © Dr. N·br·di Andr·s DE-AVK Az ¸zleti
k¸ldetÈs The process of developing a mission statement An effective mission statement An effective mission
statement ï should not too lengthy; recommended is less than 200 words ï arouses positive feelings and
emotions about an organization ï generates the impression that a firm is successful, has direction ï distinguish a
given organization from all others ï widely understood throughout the organization ï identify the utility of a
firmís products to its consumers >>>> Outline ï Strategy formulation ï Develop vision ï Develop mission ï Why
mission statement ï External assessment ï Internal assessment ï Establish long term objectives © Dr. N·br·di
Andr·s DE-AVK Do not offer me things Az ¸zleti k¸ldetÈs Do not offer me clothes. Offer me attractive looks.
Do not offer me shoes. Offer me comfort feet of walking. Do not offer me a house. Offer me security, comfort,
and place that is clean and happy. Do not offer me books. Offer me hours of pleasure and benefit of knowledge.
Do not offer me records. Offer me leisure and sound of music. Do not offer me things. Offer me ideas, Do not
offer me things. Offer me ideas, emotions, ambience, feelings and benefits. emotions, ambience, feelings and
benefits. Outline ï Strategy formulation ï Develop vision ï Develop mission ï Why mission statement ï External
assessment ï Internal assessment ï Establish long term objectives © Dr. N·br·di Andr·s DE-AVK Characteristic
of a mission statement Az ¸zleti k¸ldetÈs ïDeclaration of attitude Declaration of attitude ï Not allowed to move
wrong diversification ï ï Not designed to concrete ends, rather to provide motivation, general direction, image
and philiosophy ï Costumer orientation Costumer orientation ï To attract customers who give meaning to an
organization ï Declaration of social policy Declaration of social policy ï Different kind of responsibility Outline
ï Strategy formulation ï Develop vision ï Develop mission ï Why mission statement ï External assessment ï
Internal assessment ï Establish long term objectives © Dr. N·br·di Andr·s DE-AVK Why mission statement?
Az ¸zleti k¸ldetÈs 1. To ensure unanimity of purpose within the organization. 2. To provide a basis or standard
for allocating organizational resources. 3. To establish a general tone or organizational climate. 4. To serve a
focal point for individuals to identify with the organizationís purpose and direction. 5. To facilitate the
translation of objectives into a work structure involving the assignment of tasks to responsible elements within
the organization. 6. To specify organizational purposes or motion and then to translate these purposes into
objectives. Outline ï Strategy formulation ï Develop vision ï Develop mission ï Why mission statement ï
External assessment ï Internal assessment ï Establish long term objectives © Dr. N·br·di Andr·s DE-AVK Why
mission statement? Az ¸zleti k¸ldetÈs Outline ï Strategy formulation ï Develop vision ï Develop mission ï Why
mission statement ï External assessment ï Internal assessment ï Establish long term objectives © Dr. N·br·di
Andr·s DE-AVK Strategy formulation Business mission Internal analysis External analysis External analysis
Establishing long term objectives Outline ï Strategy formulation ï Develop vision ï Develop mission ï Why
mission statement ï External assessment ï Internal assessment ï Establish long term objectives © Dr. N·br·di
Andr·s DE-AVK External assessment Az ¸zleti k¸ldetÈs Outline ï Strategy formulation ï Develop vision ï
Develop mission ï Why mission statement ï External assessment ï Internal assessment ï Establish long term
objectives ÑORGANIZATIONî Suppliers Consumers Competitors Regulatory agencies. Unions, chambers
International Legal system Economic policy Socio/cultural Technological Natural environment Financial
corporations © Dr. N·br·di Andr·s DE-AVK The nature of an external audit Az ¸zleti k¸ldetÈs The purpose is to
develop a finite list of The purpose is to develop a finite list of opportunities opportunities that could benefit a
firm and that could benefit a firm and threats threats that should be avoided. that should be avoided. Methods
for external assessment; Methods for external assessment; 1. Key external forces; (STEP analysis) Key external
forces; (STEP analysis) 2. Competitive Analysis (Porter Competitive Analysis (Porterís Five Forces s Five
Forces Model) 3. The External Factor Evaluation Matrix (EFE) The External Factor Evaluation Matrix (EFE) 4.
The Competitive Profile Matrix (CPM) The Competitive Profile Matrix (CPM) Outline ï Strategy formulation ï
Develop vision ï Develop mission ï Why mission statement ï External assessment ï Internal assessment ï
Establish long term objectives © Dr. N·br·di Andr·s DE-AVK Key external forces Az ¸zleti k¸ldetÈs Key
external forces; (STEP analysis) Key external forces; (STEP analysis) ï Social, cultural, demographic, and
environment ï Technological ï Economic ï Political, governmental, and legal + ï Competitive Competitive
Outline ï Strategy formulation ï Develop vision ï Develop mission ï Why mission statement ï External
assessment ï Internal assessment ï Establish long term objectives © Dr. N·br·di Andr·s DE-AVK Az ¸zleti
k¸ldetÈs Social, Cultural, Demographic, and Environmental Forces Outline ï Strategy formulation ï Develop
vision ï Develop mission ï Why mission statement ï External assessment ï Internal assessment ï Establish long
term objectives 1. What is the dominant religion? 2. What are attitudes to foreign products and services? 3.
Does language impact upon the diffusion of products onto markets? 4. How much time do consumers have for
leisure? 5. What are the roles of men and women within society? 6. How long are the population living? Are the
older generations wealthy? 7. Do the population have a strong/weak opinion on green issues? © Dr. N·br·di
Andr·s DE-AVK Az ¸zleti k¸ldetÈs Social, Cultural, Demographic, and Environmental Variables Outline ï
Strategy formulation ï Develop vision ï Develop mission ï Why mission statement ï External assessment ï
Internal assessment ï Establish long term objectives Number of marriages Number of divorces Number of births
Number of death Immigration rates Social security programs Life expectancy rates Trust in government Ethical
concerns Average level of education Sex roles Average disposable income Retirement age Attitudes tow.
leisure time Pollution control Social programs Number of churches Attitudes tow. product qal. Attitudes tow.
authority Waste management Number of school, college Recycling Water pollution Ozone depletion Air
pollution Social responsibility © Dr. N·br·di Andr·s DE-AVK Technological Forces Az ¸zleti k¸ldetÈs Outline ï
Strategy formulation ï Develop vision ï Develop mission ï Why mission statement ï External assessment ï
Internal assessment ï Establish long term objectives 1. Does technology allow for products and services to be
made more cheaply and to a better standard of quality? 2 .Do the technologies offer consumers and businesses
more innovative products and services such as Internet banking, new generation mobile telephones, etc? 3. How
is distribution changed by new technologies e.g. books via the Internet, flight tickets, auctions, etc? 4. Does
technology offer companies a new way to communicate with consumers e.g. banners, Customer Relationship
Management (CRM), etc? © Dr. N·br·di Andr·s DE-AVK Az ¸zleti k¸ldetÈs Economic Forces Outline ï
Strategy formulation ï Develop vision ï Develop mission ï Why mission statement ï External assessment ï
Internal assessment ï Establish long term objectives Strategists Strategists need to consider consider the state of
a trading trading economy in the economy in the short and long-terms. This is especially especially true when
planning planning for international marketing. international marketing. You need to look at: 1. Interest rates 2.
The level of inflation Employment level per capita 3. Long-term prospects for the economy Gross Domestic
Product (GDP) per capita, and so on © Dr. N·br·di Andr·s DE-AVK Key Economic Variables to be Monitored
Az ¸zleti k¸ldetÈs Outline ï Strategy formulation ï Develop vision ï Develop mission ï Why mission statement ï
External assessment ï Internal assessment ï Establish long term objectives Availability of credit Level of
disposable income Interest rates Inflation rates Government budget deficit Consumption patterns
Unemployment rates Import/export factors Price fluctuations Monetary policies Fiscal policies Gross domestic
product trend Worker productivity levels Value of the local currency Stock market trends Export of labor and
capital Income differences by region and consumer groups Tax rates Change of European Economic Policy ©
Dr. N·br·di Andr·s DE-AVK Political, governmental, and legal forces Az ¸zleti k¸ldetÈs Outline ï Strategy
formulation ï Develop vision ï Develop mission ï Why mission statement ï External assessment ï Internal
assessment ï Establish long term objectives The political political arena has a huge influence influence upon the
regulation regulation of businesses, and the of businesses, and the spending spending power of power of
consumers consumers and other businesses. businesses. You must consider consider issues such as: 1.How
stable is the political environment? 2.Will government policy influence laws that regulate or tax your business?
3.What is the government's position on marketing ethics? 4. What is the government's policy on the economy?
5. Does the government have a view on culture and religion? 6. Is the government involved in trading
agreements such as EU, NAFTA, ASEAN, or others? © Dr. N·br·di Andr·s DE-AVK Az ¸zleti k¸ldetÈs Some
Political, Governmental, and Legal Variables to be Monitored Outline ï Strategy formulation ï Develop vision ï
Develop mission ï Why mission statement ï External assessment ï Internal assessment ï Establish long term
objectives Government regulations Changes in tax laws Special tariffs Number of patterns Political action
committees Environmental protection laws Level of governmental subsidies Import/export regulation
Government fiscal and monetary policy changes Political conditions in foreign countries Special local laws,
taxes Lobbying activities Size of governmental budget National/local elections, regulations Location and
severity of terrorist activities Relationships between neighbor countries Antitrust legislation © Dr. N·br·di
Andr·s DE-AVK Competitive forces Az ¸zleti k¸ldetÈs Outline ï Strategy formulation ï Develop vision ï
Develop mission ï Why mission statement ï External assessment ï Internal assessment ï Establish long term
objectives Collecting and evaluating information on competitors is Collecting and evaluating information on
competitors is essential for successful strategy formulation. essential for successful strategy formulation. 1.
What are the major competitorís strengths? 2. What are the major competitorís weaknesses? 3. What are the
major competitorís objectives and strategies? 4. How will the major competitors most likely respond to STEP
affecting our industry? 5. How vulnerable are the major competitors to our alternative company strategies? 6.
How are our products or services positioned relative to major competitors? © Dr. N·br·di Andr·s DE-AVK
Competitive forces Az ¸zleti k¸ldetÈs Outline ï Strategy formulation ï Develop vision ï Develop mission ï Why
mission statement ï External assessment ï Internal assessment ï Establish long term objectives To what extent
are new firms entering and old firms leaving this industry? 7. What key factors have resulted in our present
competitive position in this industry? 8. How have sales and profit rankings of major competitors in the industry
changed over recent years? Why have these rankings changed that way? 9. What is the nature of supplier and
distributor relationships in this industry? 10. To what extent could substitute products or services be a threat to
competitors in this industry? © Dr. N·br·di Andr·s DE-AVK The nature of an external audit Az ¸zleti k¸ldetÈs
The purpose is to develop a finite list of The purpose is to develop a finite list of opportunities opportunities that
could benefit a firm and that could benefit a firm and threats threats that should be avoided. that should be
avoided. Methods for external assessment; Methods for external assessment; 1. Key external forces; (STEP
analysis) Key external forces; (STEP analysis) 2. Competitive Analysis (Porter Competitive Analysis (Porterís
Five Forces s Five Forces Model) 3. The External Factor Evaluation Matrix (EFE) The External Factor
Evaluation Matrix (EFE) 4. The Competitive Profile Matrix (CPM) The Competitive Profile Matrix (CPM)
Outline ï Strategy formulation ï Develop vision ï Develop mission ï Why mission statement ï External
assessment ï Internal assessment ï Establish long term objectives © Dr. N·br·di Andr·s DE-AVK Az ¸zleti
k¸ldetÈs Competitive Analysis Porterís Five-Forces Model Outline ï Strategy formulation ï Develop vision ï
Develop mission ï Why mission statement ï External assessment ï Internal assessment ï Establish long term
objectives Potential development of substitute products Potential entry of new competitors Bargaining power of
suppliers Bargaining power of consumers Rivalry among competing firms © Dr. N·br·di Andr·s DE-AVK
Rivalry among competing firms Az ¸zleti k¸ldetÈs The most powerful Tools 1. Lowering prices 2. Enhancing
quality 3. Adding features 4. Providing services 5. Extending warranties 6. Increasing advertising Outline ï
Strategy formulation ï Develop vision ï Develop mission ï Why mission statement ï External assessment ï
Internal assessment ï Establish long term objectives © Dr. N·br·di Andr·s DE-AVK The intensity of Rivalry
increases Az ¸zleti k¸ldetÈs 1. Number of competitor increases 2. Competitors become more equal 3. Demand
for the products declines 4. Price cutting become common 5. Consumers can switch brands easily 6. Fixed costs
are high 7. Consumer demand decline or stagnates 8. Mergers and acquisitions are common Outline ï Strategy
formulation ï Develop vision ï Develop mission ï Why mission statement ï External assessment ï Internal
assessment ï Establish long term objectives © Dr. N·br·di Andr·s DE-AVK Az ¸zleti k¸ldetÈs Competitive
Analysis Porterís Five-Forces Model Outline ï Strategy formulation ïDevelop vision ïDevelop mission ïWhy
mission statement ïExternal assessment ïInternal assessment ïEstablish long term objectives Potential
development of substitute products Potential entry of new competitors Potential entry of new competitors
Bargaining power of suppliers Bargaining power of consumers Rivalry among competing firms © Dr. N·br·di
Andr·s DE-AVK Potential entry of new competitors Az ¸zleti k¸ldetÈs BARRIERS BARRIERS 1. The lack of
experience 2. Strong consumer royalty 3. Strong brand preferences 4. Government regulatory policies 5. Tariffs
6. Lack of process to raw materials 7. Possession of patterns 8. Undesirable location 9. Market saturation
Outline ï Strategy formulation ï Develop vision ï Develop mission ï Why mission statement ï External
assessment ï Internal assessment ï Establish long term objectives OPPORTUNITIES OPPORTUNITIES 1.
Higher quality products 2. Lower prices 3. Substantial marketing resources 4. All the opposite listed in barriers
© Dr. N·br·di Andr·s DE-AVK Az ¸zleti k¸ldetÈs Competitive Analysis Porterís Five-Forces Model Outline ï
Strategy formulation ï Develop vision ï Develop mission ï Why mission statement ï External assessment ï
Internal assessment ï Establish long term objectives Potential development of substitute products Potential entry
of new competitors Bargaining power of suppliers Bargaining power of consumers Rivalry among competing
firms © Dr. N·br·di Andr·s DE-AVK Az ¸zleti k¸ldetÈs Potential development of substitute products
Competitive pressures arising from substitute products increase as the relative price of substitute products
declines and consumerís switching costs decrease. Substitutes Substitutes Outline ï Strategy formulation ï
Develop vision ï Develop mission ï Why mission statement ï External assessment ï Internal assessment ï
Establish long term objectives Eyeglasses, contact lens >>>>>>> Laser surgery Sugar >>>>>>>> Artificial
sweeteners Newspapers >>>>>>>> Internet © Dr. N·br·di Andr·s DE-AVK Bargaining power of suppliers Az
¸zleti k¸ldetÈs WHEN bigger? WHEN bigger? 1. Large number of suppliers 2. Few good substitute raw
materials 3. Cost of switching raw materials is especially costly Tools against the bargaining power of suppliers
Backward integration Self manufacture Outline ï Strategy formulation ï Develop vision ï Develop mission ï
Why mission statement ï External assessment ï Internal assessment ï Establish long term objectives © Dr.
N·br·di Andr·s DE-AVK Az ¸zleti k¸ldetÈs Competitive Analysis Porterís Five-Forces Model Outline ï Strategy
formulation ï Develop vision ï Develop mission ï Why mission statement ï External assessment ï Internal
assessment ï Establish long term objectives Potential development of substitute products Potential entry of new
competitors Bargaining power of suppliers Bargaining power of consumers Rivalry among competing firms ©
Dr. N·br·di Andr·s DE-AVK Bargaining power of consumers Az ¸zleti k¸ldetÈs WHEN bigger? WHEN
bigger? 1. When costumers are concentrated 2. Products are standard or undifferentiated 3. If they can
inexpensively switch to competing brands or substitutes 4. If they are particularly important to the seller 5.
When sellers extremely need consumer demand 6. If they are informed about sellerís product prices and costs
Outline ï Strategy formulation ï Develop vision ï Develop mission ï Why mission statement ï External
assessment ï Internal assessment ï Establish long term objectives © Dr. N·br·di Andr·s DE-AVK The nature of
an external audit Az ¸zleti k¸ldetÈs The purpose is to develop a finite list of The purpose is to develop a finite
list of opportunities opportunities that could benefit a firm and that could benefit a firm and threats threats that
should be avoided. that should be avoided. Methods for external assessment; Methods for external assessment;
1. Key external forces; (STEP analysis) Key external forces; (STEP analysis) 2. Competitive Analysis (Porter
Competitive Analysis (Porterís Five Forces s Five Forces Model) 3. The External Factor Evaluation Matrix
(EFE) The External Factor Evaluation Matrix (EFE) 4. The Competitive Profile Matrix (CPM) The Competitive
Profile Matrix (CPM) Outline ï Strategy formulation ï Develop vision ï Develop mission ï Why mission
statement ï External assessment ï Internal assessment ï Establish long term objectives © Dr. N·br·di Andr·s DE-
AVK External Factor Evaluation (EFE) Matrix Az ¸zleti k¸ldetÈs EFE allows strategists to summarize and
evaluate all external factors in one sum. 1. Collect 10 to 20 factors both opportunities and threats that affect the
firm and its industry. 2. Assign to each factor a weight from 0,00 (not important) to 1,00 (extremely important).
The weight indicates the relative importance of that factor to being successful in the firmís industry industry.
The sum of all weights is 1. 3. Assign a rating between 1 and 4 to each external factor to indicate how
effectively the firmís current strategies s current strategies respond to the factor: where 4 is superior, 3 is above
average, 2 is average and 1 is response is poor. 4. Multiply each factorís weight by rating to determine a
weighted score. 5. Sum the weighted score to determine the total weighted score for organization. Outline ï
Strategy formulation ï Develop vision ï Develop mission ï Why mission statement ï External assessment ï
Internal assessment ï Establish long term objectives © Dr. N·br·di Andr·s DE-AVK External Factor Evaluation
(EFE) Matrix Az ¸zleti k¸ldetÈs Outline ï Strategy formulation ï Develop vision ï Develop mission ï Why
mission statement ï External assessment ï Internal assessment ï Establish long term objectives 3. >>>>9 or 10
key items 2. Leading rival firms are more fully 0,07 1 0,07 integrated Total 1,00 Σ (1 to 4) 1. Increasing
governmental 0,04 2 0,08 regulation in the industry Threats 3 . >>>>Ö..9 or 10 items 2. Packaging technology
offers 15 0,03 2 0,06 % annual cost savings 1. Demand for prepared food 0,07 4 0,28 increasing 10 % annually
Opportunities Weighted score Key external factors Weight Rating 1 2 3 4 Importance to the 5 firmís industry
Importance to the firmís current strategy © Dr. N·br·di Andr·s DE-AVK External Factor Evaluation (EFE)
Matrix Az ¸zleti k¸ldetÈs Outline ï Strategy formulation ï Develop vision ï Develop mission ï Why mission
statement ï External assessment ï Internal assessment ï Establish long term objectives The highest weighted
score is 4 the lowest is 1 the average is 2,5. 4 means: the firmís strategies effectively take advantage of existing
opportunities and minimize the potential adverse of external threats. 1 means: The firmís strategies are not
capitalizing on opportunities or avoiding external threats. © Dr. N·br·di Andr·s DE-AVK The nature of an
external audit Az ¸zleti k¸ldetÈs The purpose is to develop a finite list of The purpose is to develop a finite list
of opportunities opportunities that could benefit a firm and that could benefit a firm and threats threats that
should be avoided. that should be avoided. Methods for external assessment; Methods for external assessment;
1. Key external forces; (STEP analysis) Key external forces; (STEP analysis) 2. Competitive Analysis (Porter
Competitive Analysis (Porterís Five Forces s Five Forces Model) 3. The External Factor Evaluation Matrix
(EFE) The External Factor Evaluation Matrix (EFE) 4. The Competitive Profile Matrix (CPM) The Competitive
Profile Matrix (CPM) Outline ï Strategy formulation ï Develop vision ï Develop mission ï Why mission
statement ï External assessment ï Internal assessment ï Establish long term objectives © Dr. N·br·di Andr·s DE-
AVK The Competitive Profile Matrix (CPM) Az ¸zleti k¸ldetÈs Identifies a firmís major competitors and its
particular strengths and weaknesses in relation to a sample firmís strategic position 1. Collect 10 to 20 critical
success factors (CSF) that affect the firm and its industry. The SCF include both internal and external issues. 2.
Assign to each factor a weight from 0,00 (not important) to 1,00 (extremely important). The weight indicates
the relative importance of that factor to being successful in the industry industry. The sum of all weights is 1. 3.
Assign a rating between 1 and 4 to each external factor to refer to strengths and weaknesses: where 4 is major
strength, 3 is minor strength, 2 is minor weakness, and 1 is major weakness. 4. Multiply each factorís weight by
rating to determine a weighted score. 5. Sum the weighted score to determine the total weighted score for
organization. Outline ï Strategy formulation ï Develop vision ï Develop mission ï Why mission statement ï
External assessment ï Internal assessment ï Establish long term objectives © Dr. N·br·di Andr·s DE-AVK The
Competitive Profile Matrix (CPM) Az ¸zleti k¸ldetÈs Outline ï Strategy formulation ï Develop vision ï Develop
mission ï Why mission statement ï External assessment ï Internal assessment ï Establish long term objectives
TOTAL 1,00 3,15 2,80 Market share 0,05 1 0,05 3 0,15 Global expansion 0,20 4 0,8 2 0,40 Customer loyalty
0,10 4 0,4 2 0,20 Financial position 0,15 4 0,6 3 0,45 Management 0,10 4 0,4 3 0,30 Price competitiveness 0,10
3 0,3 4 0,40 Product quality 0,10 4 0,4 3 0,30 Advertising 0,20 1 0,2 3 0,60 Ratin Score g Critical Success
Factors Weight Rating Score Procter&Gambl e AN EXAMPLE AVON © Dr. N·br·di Andr·s DE-AVK The
Competitive Profile Matrix (CPM) Az ¸zleti k¸ldetÈs Outline ï Strategy formulation ï Develop vision ï Develop
mission ï Why mission statement ï External assessment ï Internal assessment ï Establish long term objectives
Important differences between EFE and CPM CPM ï are boarder, they do not include specific or factual data
and even may focus on internal issues. ï Not grouped into opportunities and threats. ï CPM ratings and total
weighted scores for rival firms can be compared to the sample firm. © Dr. N·br·di Andr·s DE-AVK Strategy
formulation Business mission Internal analysis External analysis Establishing long term objectives Outline ï
Strategy formulation ï Develop vision ï Develop mission ï Why mission statement ï External assessment ï
Internal assessment ï Establish long term objectives © Dr. N·br·di Andr·s DE-AVK Internal assessment Internal
assessment Outline ï Strategy formulation ï Develop vision ï Develop mission ï Why mission statement ï
External assessment ï Internal assessment ï Establish long term objectives Internal strengths/weaknesses
strengths/weaknesses, coupled with external opportunities/threats and clear statement of mission provide the
basis for establishing objectives and strategies. Methods for internal assessment: Methods for internal
assessment: 1. Resource Based View (RBV) Approach Resource Based View (RBV) Approach 2. Analyzing
Key Internal Forces Analyzing Key Internal Forces 3. Value Chain Analysis (VCA), (ABC) Value Chain
Analysis (VCA), (ABC) 4. Internal Factor Evaluation (IFE) Matrix Internal Factor Evaluation (IFE) Matrix ©
Dr. N·br·di Andr·s DE-AVK Internal assessment Methods Outline ï Strategy formulation ï Develop vision ï
Develop mission ï Why mission statement ï External assessment ï Internal assessment ï Establish long term
objectives 1. Resource Based View approach Resource Based View approach ï Physical resources Plant,
equipment, location, technology, raw materials, machines ï Human resources Employees, training, experience,
intelligence, knowledge, skills, abilities ï Organizational resources Firm structure, planning processes,
information systems, patents, trademarks, copyrights, databases © Dr. N·br·di Andr·s DE-AVK Internal
assessment Methods Outline ï Strategy formulation ï Develop vision ï Develop mission ï Why mission
statement ï External assessment ï Internal assessment ï Establish long term objectives Key internal forces: Key
internal forces: 1. Management 2. Marketing 3. Finance/accounting 4. Production/operation 5. Research and
development 6. Management Information System © Dr. N·br·di Andr·s DE-AVK Internal assessment Methods
Outline ï Strategy formulation ï Develop vision ï Develop mission ï Why mission statement ï External
assessment ï Internal assessment ï Establish long term objectives 2. Analyzing key internal forces 2. Analyzing
key internal forces 1. Management Planning, organizing, motivating, staffing, and controlling. 2. Marketing
Customer analysis, selling products and services, product and service planning, pricing, distribution, marketing
research, opportunity analysis 3. Finance/ accounting Firmís liquidity, leverage, working capital, profitability,
asset utilization, cash flow, and equity © Dr. N·br·di Andr·s DE-AVK Internal assessment Methods Outline ï
Strategy formulation ï Develop vision ï Develop mission ï Why mission statement ï External assessment ï
Internal assessment ï Establish long term objectives 2. Analyzing key internal forces 2. Analyzing key internal
forces 4. Production/operation Decision on process, capacity, inventory, workforce and quality. 5. Research and
development 6. Management information system Data become information only when they are evaluated,
filtered, condensed, analyzed, and organized for a specific purpose, problem, individual, or time. 3. Value Chain
Analysis 3. Value Chain Analysis Refers to the process whereby a firm determines the costs associated with
organizational activities. 4. Internal Factor Evaluation (IFE) Matrix 4. Internal Factor Evaluation (IFE) Matrix
© Dr. N·br·di Andr·s DE-AVK Key Internal Forces Management Management 1. planning: planning: consists
of all those managerial activities related to preparing for future. Specific tasks: forecasting, establishing
objectives, devising strategies, developing policies, and setting goals. 2. Organizing: Organizing: includes all
those managerial activities that result in a structure of task and authority relationships. Specific areas:
organizational design, job specialization, job description, coordination, job analysis. Outline ï Strategy
formulation ï Develop vision ï Develop mission ï Why mission statement ï External assessment ï Internal
assessment ï Establish long term objectives © Dr. N·br·di Andr·s DE-AVK Key Internal Forces Management
Management 3. Motivating: Motivating: involves efforts directed towards shaping human behavior. Specific
topics: leadership, communication, work groups, delegation of authority, job satisfaction, employee morale. 4.
Staffing: Staffing: are centered on personnel or HRM. Wage and salary administration, interviewing, hiring,
firing, training, employee safety, union relation, career development, personnel research, public relations.
Outline ï Strategy formulation ï Develop vision ï Develop mission ï Why mission statement ï External
assessment ï Internal assessment ï Establish long term objectives © Dr. N·br·di Andr·s DE-AVK Key Internal
Forces Management Management 5. Controlling: Controlling: ensuring that actual results are consistent with
planned results. Key areas: quality control, financial control, sales control, inventory control, expense control,
analysis of variances, rewards, and sanctions. Outline ï Strategy formulation ï Develop vision ï Develop mission
ï Why mission statement ï External assessment ï Internal assessment ï Establish long term objectives Strategy
Strategy evaluation evaluation Controlling Controlling Staffing Staffing Motivating Motivating Strategy
Strategy Implementation Implementation Organizing Organizing Strategy Strategy Formulation Formulation
Planning Planning © Dr. N·br·di Andr·s DE-AVK Internal assessment Methods Outline ï Strategy formulation ï
Develop vision ï Develop mission ï Why mission statement ï External assessment ï Internal assessment ï
Establish long term objectives Key internal forces: Key internal forces: 1. Management 2. Marketing 3.
Finance/accounting 4. Production/operation 5. Research and development 6. Management Information System
© Dr. N·br·di Andr·s DE-AVK Key Internal Forces Finance/accounting Finance/accounting 1. Investment
decision: Investment decision: (capital budgeting) is the allocation and reallocation of capital and resources to
projects, products, assets, and divisions of an organization. 2. Financing decision: Financing decision:
determines the best capital structure, how the firm can raise capital. Issuing stock, increasing dept, selling assets
or using a combination of these. 3. Dividend decision: percentage of earnings paid to stockholders. Outline ï
Strategy formulation ï Develop vision ï Develop mission ï Why mission statement ï External assessment ï
Internal assessment ï Establish long term objectives © Dr. N·br·di Andr·s DE-AVK Key Internal Forces
Finance/accounting Finance/accounting Key financial ratios: Key financial ratios: Like a blood test: reflect a
situation at just one point in time. 1. Liquidity 2. Leverage 3. Activity 4. Profitability 5. Growth Outline ï
Strategy formulation ï Develop vision ï Develop mission ï Why mission statement ï External assessment ï
Internal assessment ï Establish long term objectives © Dr. N·br·di Andr·s DE-AVK Key Internal Forces
Finance/accounting Finance/accounting Outline 1. Liquidity Liquidity ï Strategy formulation ï Develop vision ï
Develop mission ï Why mission statement ï External assessment ï Internal assessment ï Establish long term
objectives A firm can (not) meet its short term obligations Without relying upon the sale of its inventories
Current assets ñ inventory Current liabilities Quick ratio A firm can (not) meet its short term obligations
Current assets Current liabilities Current RATIO How calculated How calculated What it measures What it
measures © Dr. N·br·di Andr·s DE-AVK Key Internal Forces Finance/accounting Finance/accounting Outline
2. Leverage ratios 2. Leverage ratios ï Strategy formulation ï Develop vision ï Develop mission ï Why mission
statement ï External assessment ï Internal assessment ï Establish long term objectives A balance between dept
and equity in a firmís long term capital structure Long term dept__ Total stockholderís equity Long term dept to
equity The extent to which earnings can decline without the firm becoming unable to meet its annual interest
costs Profit before interest and taxes Total interest charges Times interest earned ratio The % of total funds
provided by creditors versus by owners Total dept____ Total stockholderís equity Dept to equity The % of total
funds that are provided by creditors Total dept Total assets Dept to total assets RATIO How calculated How
calculated What it measures What it measures © Dr. N·br·di Andr·s DE-AVK Key Internal Forces
Finance/accounting Finance/accounting Outline 3. Activity ratios 3. Activity ratios ï Strategy formulation ï
Develop vision ï Develop mission ï Why mission statement ï External assessment ï Internal assessment ï
Establish long term objectives The average length of time it takes a firm to collect credit sales (%) Annual
credit sales Account receivable Account receivable turnover The average length of time it takes a firm to collect
credit sales (days) Account receivable Total credit sales/365 days Average collection period Sales productivity
on total assets Sales______ Total assets Total assets turnover Sales productivity and plant and equipment
utilization Sales______ Fixed assets Fixed assets turnover Whether a firm holds excessive stocks of inventories
Sales______ Inventory of finished goods Inventory turnover RATIO How calculated How calculated What it
measures What it measures © Dr. N·br·di Andr·s DE-AVK Key Internal Forces Finance/accounting
Finance/accounting Outline 4. Profitability ratios 4. Profitability ratios ï Strategy formulation ï Develop vision ï
Develop mission ï Why mission statement ï External assessment ï Internal assessment ï Establish long term
objectives Net income______ After tax profits of sales Sales Net profit margin Earnings before interest and
taxes Profitability exclude I&T Sales Operating profit margin A total margin available to cover operating
expenses and yield a profit Sales minus cost of good sold Sales Gross profit margin RATIO How calculated
How calculated What it measures What it measures © Dr. N·br·di Andr·s DE-AVK Key Internal Forces
Finance/accounting Finance/accounting Outline 4. Profitability ratios (continued) 4. Profitability ratios
(continued) ï Strategy formulation ï Develop vision ï Develop mission ï Why mission statement ï External
assessment ï Internal assessment ï Establish long term objectives Attractiveness of firm on equity market
Market price per share Earnings per share Price earning ratio Earnings available to the owners of common stock
Net income______ Number of shares of common stock Earnings per share (EPS) After tax profits of
stockholderís investment Net income Total stockholdersí equity Return on stockholder sí equity After tax
profits of assets (Return on investment) Net income Total assets Return on total assets (ROA) RATIO How
calculated How calculated What it measures What it measures © Dr. N·br·di Andr·s DE-AVK Key Internal
Forces Finance/accounting Finance/accounting Outline 5. Growth ratios 5. Growth ratios ï Strategy formulation
ï Develop vision ï Develop mission ï Why mission statement ï External assessment ï Internal assessment ï
Establish long term objectives Firms growth rate in EPS Earnings Annual % growth in EPS per share Firms
growth rate in dividends per share Annual % growth in dividends per share Dividends per share Firms growth
rate in profits Net income Annual % growth in profits Firms growth rate in sales Annual % growth in total sales
Sales RATIO How calculated How calculated What it measures What it measures © Dr. N·br·di Andr·s DE-
AVK Internal assessment Outline ï Strategy formulation ï Develop vision ï Develop mission ï Why mission
statement ï External assessment ï Internal assessment ï Establish long term objectives Key internal forces: Key
internal forces: 1. Management 2. Marketing 3. Finance/accounting 4. Production/operation 5. Research and
development 6. Management Information System © Dr. N·br·di Andr·s DE-AVK Key Internal Forces
Production/operation Production/operation This function of a business consists of all those activities that
transform inputs into good and services. 5 functions or decision areas 5 functions or decision areas: ï Process ï
Capacity ï Inventory ï Workforce ï Quality Outline ï Strategy formulation ï Develop vision ï Develop mission ï
Why mission statement ï External assessment ï Internal assessment ï Establish long term objectives © Dr.
N·br·di Andr·s DE-AVK Key Internal Forces Production/operation Production/operation Outline ï Strategy
formulation ï Develop vision ï Develop mission ï Why mission statement ï External assessment ï Internal
assessment ï Establish long term objectives Design of physical production system. Specific: choice of
technology, facility layout, process flow analysis, process control, transportation analysis 1. Process Ensuring
the certain quality goods and services are produced. Specific: quality control, sampling, quality assurance and
cost control 5. Quality Managing the skilled, unskilled, clerical, and managerial employees. Specific: job
design, work measurement, job enrichment, work standards and motivation techniques. 4. Workforce Managing
the level of raw materials, work-in process, and finished goods. Specific: what to order, how much to order,
materials handling. 3. Inventory Determination of optimal output level for the firm. Specific: forecasting,
facilities planning, aggregate planning, scheduling, capacity planning. 2. Capacity FUNCTION FUNCTION
DESCRIPTION DESCRIPTION © Dr. N·br·di Andr·s DE-AVK Internal assessment Internal assessment
Outline ï Strategy formulation ï Develop vision ï Develop mission ï Why mission statement ï External
assessment ï Internal assessment ï Establish long term objectives Internal strengths/weaknesses
strengths/weaknesses, coupled with external opportunities/threats and clear statement of mission provide the
basis for establishing objectives and strategies. Methods for internal assessment: Methods for internal
assessment: 1. Resource Based View (RBV) Approach Resource Based View (RBV) Approach 2. Analyzing
Key Internal Forces Analyzing Key Internal Forces 3. Value Chain Analysis (VCA) Value Chain Analysis
(VCA) Activity Based Activity Based Costing (ABC) Costing (ABC) 4. Internal Factor Evaluation (IFE)
Matrix Internal Factor Evaluation (IFE) Matrix © Dr. N·br·di Andr·s DE-AVK Value chain Analysis Outline ï
Strategy formulation ï Develop vision ï Develop mission ï Why mission statement ï External assessment ï
Internal assessment ï Establish long term objectives Value chain analysis refers to the process whereby a firm
determines the costs associated with organizational activities from purchasing raw materials to manufacturing
products to marketing those products. Aims to identify where low cost Aims to identify where low cost
advantages or disadvantages exist advantages or disadvantages exist anywhere along the value chain. anywhere
along the value chain. © Dr. N·br·di Andr·s DE-AVK Value Chain Analysis Outline ï Strategy formulation ï
Develop vision ï Develop mission ï Why mission statement ï External assessment ï Internal assessment ï
Establish long term objectives Supplier Production Distribution Sales + marketing Customer service © Dr.
N·br·di Andr·s DE-AVK Value Chain Analysis Outline ï Strategy formulation ïDevelop vision ïDevelop
mission ïWhy mission statement ïExternal assessment ïInternal assessment ïEstablish long term objectives
Supplier Production Distribution Sales + marketing Customer service Warehouse Maintenance Food and
lodging Cost Fuel accounting Storing Transportatio n Inspection R and D Railroads Component Computer
Trucking Advertising parts Truck drivers Plant location Internet Promotion Transportatio Maintenance
Personnel Publicity Warranty n Energy Plant layout Budgeting Internet Internet Fuel Receiving Shipping Web
site Phone Inventory Loading Salespersons Postage system Raw mat. © Dr. N·br·di Andr·s DE-AVK Value
Chain Analysis Outline ï Strategy formulation ïDevelop vision ïDevelop mission ïWhy mission statement
ïExternal assessment ïInternal assessment ïEstablish long term objectives Supplier Production Distribution
Sales + marketing Customer service © Dr. N·br·di Andr·s DE-AVK Value Chain Analysis Outline ï Strategy
formulation ïDevelop vision ïDevelop mission ïWhy mission statement ïExternal assessment ïInternal
assessment ïEstablish long term objectives Supplier Production Distribution Sales + marketing Customer
service © Dr. N·br·di Andr·s DE-AVK Internal assessment Internal assessment Internal strengths/weaknesses
strengths/weaknesses, coupled with external opportunities/threats and clear statement of mission provide the
basis for establishing objectives and strategies. Methods for internal assessment: Methods for internal
assessment: 1. Resource Based View (RBV) Approach Resource Based View (RBV) Approach 2. Analyzing
Key Internal Forces Analyzing Key Internal Forces 3. Value Chain Analysis (VCA), (ABC) Value Chain
Analysis (VCA), (ABC) 4. Internal Factor Evaluation (IFE) Matrix Internal Factor Evaluation (IFE) Matrix
Outline ï Strategy formulation ïDevelop vision ïDevelop mission ïWhy mission statement ïExternal assessment
ïInternal assessment ïEstablish long term objectives © Dr. N·br·di Andr·s DE-AVK The Internal Factor
Evaluation Matrix Az ¸zleti k¸ldetÈs Identifies a firmís major strengths and weaknesses allows strategists to
summarize and evaluate all internal factors in one sum. 1. Collect 10 to 20 internal factors including both
strengths and weaknesses. Use percentage, ratios and comparative numbers. 2. Assign to each factor a weight
from 0,00 (not important) to 1,00 (extremely important). The weight indicates the relative importance of that
factor to being successful in the industry industry. The sum of all weights is 1. 3. Assign a rating between 1 and
4 to each external factor to refer to strengths and weaknesses: where 4 is major strength, 3 is minor strength, 2 is
minor weakness, and 1 is major weakness. 4. Multiply each factorís weight by rating to determine a weighted
score. 5. Sum the weighted score to determine the total weighted score for organization. Outline ï Strategy
formulation ïDevelop vision ïDevelop mission ïWhy mission statement ïExternal assessment ïInternal
assessment ïEstablish long term objectives © Dr. N·br·di Andr·s DE-AVK Internal Factor Evaluation (IFE)
Matrix Az ¸zleti k¸ldetÈs 3. >>>>9 or 10 key items 2. 86 % of the trade revenues come 0,07 1 0,07 from Europe
Total 1,00 Σ (1 to 4) 1. Our company total dept to equity 0,03 2 0,06 ratio is 0,36 compared to the industry
average of 0,9 Weaknesses 3 . >>>>Ö..9 or 10 items 2. Our company has 50 subsidiary 0,06 4 0,24 in Europe
and Asia 1. Our company provide 24-hour, 7 0,08 3 0,24 day services Strengths Weighted score Key internal
factors Weight Rating Outline ï Strategy formulation ïDevelop vision ïDevelop mission ïWhy mission statement
ïExternal assessment ïInternal assessment ïEstablish long term objectives © Dr. N·br·di Andr·s DE-AVK
Internal Factor Evaluation (IFE) Matrix The highest weighted score is 4 the lowest is 1 the average is 2,5. Total
weighted scores well below 2,5 below 2,5 characterize organizations that are weak internally, whereas scores
significantly above 2,5 above 2,5 indicate a strong internal position position. Outline ï Strategy formulation
ïDevelop vision ïDevelop mission ïWhy mission statement ïExternal assessment ïInternal assessment ïEstablish
long term objectives © Dr. N·br·di Andr·s DE-AVK Internal Factor Evaluation (IFE) Matrix Outline ï Strategy
formulation ïDevelop vision ïDevelop mission ïWhy mission statement ïExternal assessment ïInternal
assessment ïEstablish long term objectives Strategy formulation Business mission Internal analysis External
analysis Establishing long term objectives Establishing long term objectives Generating alternative strategies
Choosing particular strategies to pursue Deciding what new business to enter
Formulation of strategy is a creative and analytical process. It is a process because particular functions are
performed in a sequence over the period of time. The process involves a number of activities and their analysis
to arrive at a decision. Though there may not be unanimity over these activities particularly in the context of
organizational variability, a complete process of strategy formulation and implementation can be understood.

The process set out above includes strategy formulation and its implementation, what has been referred to
as strategic management process. The same process can be applied to both strategy and policy. The figure
suggests the various elements of strategy formulation and process and the way they interact among themselves.
Accordingly .the various elements are organizational mission and objectives, environmental analysis, corporate
analysis, identification of alternatives, and choice of alternative. Up to this stage the formulation is complete.
However, implementation is closely related with formulation because it will provide feedback for adjusting
strategy. A brief discussion of each element will be helpful to understand the problems involved in each.
Page Contents
Organizational mission and objectives –
are the starting point of strategy formulation. As discussed earlier, mission is the fundamental unique purpose of
an organization that sets it apart from other organizations and objective is the end result, which an organization
strives to achieve. These together provide the direction for other aspects of the process.
1) Environmental Analysis –
The second aspect of the process is the environmental analysis. Since the basic objective of strategies is to
integrate the organization with its environment, it must know the kind of environment in which it has to work.
This can be known by environmental analysis. The process of environmental analysis includes collection of
relevant information from the environment, interpreting its impact on the future organizational working, and
determining what opportunities and threats-positive and negative aspects-are offered by the environment. The
environmental information can be collected from various sources like various publi-cations, verbal information
from various people, spying, and forecasting. The process of environmental analysis works better if it is
undertaken on continuous basis and is made an intrinsic part of the strategy formulation.
2) Corporate Analysis –
While environmental analysis is the analysis of external factors, corporate analysis takes into account the
internal factors. These together are known as SWOT (strengths, weaknesses, opportunities and threats) analysis.
It is not merely enough to locate what opportunities and threats are offered by the environment but equally
important is the analysis of how the organization can take the advantages of these opportunities and overcome
threats. Corporate analysis dis-closes strengths and weaknesses of the organization and points out the areas in
which business can be undertaken. Corporate analysis is performed by identifying the factors, which are critical
for the success of the present or future business of the organization, and then evaluating these factors whether
they are contributing in positive way or in negative way. A positive contribution is strength and a negative
contribution is a weakness.

Related: Strategy Implementation

3) Identification of Alternatives –
Environmental analysis and corporate analysis taken together will specify the various alternatives for strategy.
Usually this process will bring large number of alternatives. For example, if an organization is strong in
financial resources, these can be used in many ways, taking several projects. However, all the ways or projects
cannot be selected. Therefore, some criteria should be set up to evaluate each alternative. Normally the criteria
are set in the light of organizational mission and objectives.
4) Choice of Strategy –
The identification and evaluation of various alternatives will narrow down the range of strategies that can
seriously be considered for choice. Choice is deciding the acceptable alternative among the several which fits
with the organizational objectives. Normally at this stage, personal values and expectations of decision-maker
play an important role in strategy because he will decide the course of action depending on his own likings and
disliking. This happens because in one way the organizational objectives reflect the personal philosophy of
individuals particularly at the top management level.
5) Implementation –
After the strategy has been chosen, it is put to implementation, that is, it is put into action. Choice of strategy is
mostly analytical and conceptual while implementation is operational or putting into action. Various factors
which are necessary for implementation are design of suitable organization structure, develop-ing and
motivating people to take up work, designing effective control and information system, allocation of resources,
etc.
When these are undertaken, these may produce results, which can be compared in the light of objectives set, and
control process comes into operation. If the results and objectives differ, a further analysis is required to find out
the reasons for the gap and taking suitable actions to overcome the problems because of which the gap exists.
This may also- require a change in strategy if there is a problem because of the formulation inadequacy. This
puts back the managers at the starting point of the strategy formulation.
Strategic Management - Meaning and Important Concepts
Strategic Management - An Introduction
Strategic Management is all about identification and description of the strategies that managers can carry so as
to achieve better performance and a competitive advantage for their organization. An organization is said to
have competitive advantage if its profitability is higher than the average profitability for all companies in its
industry.
Strategic management can also be defined as a bundle of decisions and acts which a manager undertakes and
which decides the result of the firm’s performance. The manager must have a thorough knowledge and analysis
of the general and competitive organizational environment so as to take right decisions. They should conduct
a SWOT Analysis (Strengths, Weaknesses, Opportunities, and Threats), i.e., they should make best possible
utilization of strengths, minimize the organizational weaknesses, make use of arising opportunities from the
business environment and shouldn’t ignore the threats.
Strategic management is nothing but planning for both predictable as well as unfeasible contingencies. It is
applicable to both small as well as large organizations as even the smallest organization face competition and,
by formulating and implementing appropriate strategies, they can attain sustainable competitive advantage.
It is a way in which strategists set the objectives and proceed about attaining them. It deals with making and
implementing decisions about future direction of an organization. It helps us to identify the direction in which
an organization is moving.
Strategic management is a continuous process that evaluates and controls the business and the industries in
which an organization is involved; evaluates its competitors and sets goals and strategies to meet all existing
and potential competitors; and then reevaluates strategies on a regular basis to determine how it has been
implemented and whether it was successful or does it needs replacement.
Strategic Management gives a broader perspective to the employees of an organization and they can
better understand how their job fits into the entire organizational plan and how it is co-related to other
organizational members. It is nothing but the art of managing employees in a manner which maximizes the
ability of achieving business objectives. The employees become more trustworthy, more committed and more
satisfied as they can co-relate themselves very well with each organizational task. They can understand the
reaction of environmental changes on the organization and the probable response of the organization with the
help of strategic management. Thus the employees can judge the impact of such changes on their own job and
can effectively face the changes. The managers and employees must do appropriate things in appropriate
manner. They need to be both effective as well as efficient.
One of the major role of strategic management is to incorporate various functional areas of the organization
completely, as well as, to ensure these functional areas harmonize and get together well. Another role of
strategic management is to keep a continuous eye on the goals and objectives of the organization.
Following are the important concepts of Strategic Management:

Strategy - Definition and Features

Components of a Strategy Statement

Strategic Management Process

Environmental Scanning

Strategy Formulation

Strategy Implementation

Strategy Formulation vs Implementation

Strategy Evaluation

Strategic Decisions

Business Policy

BCG Matrix

SWOT Analysis

Competitor Analysis

Porter’s Five Forces Model

Strategic Leadership

Corporate Governance

Business Ethics

Core Competencies

Strategy - Definition and Features

The word “strategy” is derived from the Greek word “stratçgos”; stratus (meaning army) and “ago” (meaning
leading/moving).
Strategy is an action that managers take to attain one or more of the organization’s goals. Strategy can also be
defined as “A general direction set for the company and its various components to achieve a desired state in the
future. Strategy results from the detailed strategic planning process”.
A strategy is all about integrating organizational activities and utilizing and allocating the scarce resources
within the organizational environment so as to meet the present objectives. While planning a strategy it is
essential to consider that decisions are not taken in a vaccum and that any act taken by a firm is likely to be met
by a reaction from those affected, competitors, customers, employees or suppliers.
Strategy can also be defined as knowledge of the goals, the uncertainty of events and the need to take into
consideration the likely or actual behavior of others. Strategy is the blueprint of decisions in an organization that
shows its objectives and goals, reduces the key policies, and plans for achieving these goals, and defines the
business the company is to carry on, the type of economic and human organization it wants to be, and the
contribution it plans to make to its shareholders, customers and society at large.
Features of Strategy
1. Strategy is Significant because it is not possible to foresee the future. Without a perfect foresight, the
firms must be ready to deal with the uncertain events which constitute the business environment.
2. Strategy deals with long term developments rather than routine operations, i.e. it deals with probability
of innovations or new products, new methods of productions, or new markets to be developed in future.
3. Strategy is created to take into account the probable behavior of customers and competitors. Strategies
dealing with employees will predict the employee behavior.
Strategy is a well defined roadmap of an organization. It defines the overall mission, vision and direction of
an organization. The objective of a strategy is to maximize an organization’s strengths and to minimize the
strengths of the competitors.
Strategy, in short, bridges the gap between “where we are” and “where we want to be”.

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Similar Articles Under - Strategic Management

 Strategic Management - Introduction
 Components of a Strategy Statement
 Vision & Mission Statements
 Strategic Management Process
 Environmental Scanning
Components of a Strategy Statement
The strategy statement of a firm sets the firm’s long-term strategic direction and broad policy directions. It gives
the firm a clear sense of direction and a blueprint for the firm’s activities for the upcoming years. The main
constituents of a strategic statement are as follows:
1. Strategic Intent
An organization’s strategic intent is the purpose that it exists and why it will continue to exist, providing it
maintains a competitive advantage. Strategic intent gives a picture about what an organization must get into
immediately in order to achieve the company’s vision. It motivates the people. It clarifies the vision of the
vision of the company.
Strategic intent helps management to emphasize and concentrate on the priorities. Strategic intent is, nothing
but, the influencing of an organization’s resource potential and core competencies to achieve what at first may
seem to be unachievable goals in the competitive environment. A well expressed strategic intent should
guide/steer the development of strategic intent or the setting of goals and objectives that require that all of
organization’s competencies be controlled to maximum value.
Strategic intent includes directing organization’s attention on the need of winning; inspiring people by telling
them that the targets are valuable; encouraging individual and team participation as well as contribution; and
utilizing intent to direct allocation of resources.
Strategic intent differs from strategic fit in a way that while strategic fit deals with harmonizing available
resources and potentials to the external environment, strategic intent emphasizes on building new resources and
potentials so as to create and exploit future opportunities.
2. Mission Statement
Mission statement is the statement of the role by which an organization intends to serve it’s stakeholders. It
describes why an organization is operating and thus provides a framework within which strategies are
formulated. It describes what the organization does (i.e., present capabilities), who all it serves (i.e.,
stakeholders) and what makes an organization unique (i.e., reason for existence).
A mission statement differentiates an organization from others by explaining its broad scope of activities, its
products, and technologies it uses to achieve its goals and objectives. It talks about an organization’s present
(i.e., “about where we are”). For instance, Microsoft’s mission is to help people and businesses throughout the
world to realize their full potential. Wal-Mart’s mission is “To give ordinary folk the chance to buy the same
thing as rich people.” Mission statements always exist at top level of an organization, but may also be made for
various organizational levels. Chief executive plays a significant role in formulation of mission statement. Once
the mission statement is formulated, it serves the organization in long run, but it may become ambiguous with
organizational growth and innovations.
In today’s dynamic and competitive environment, mission may need to be redefined. However, care must be
taken that the redefined mission statement should have original fundamentals/components. Mission statement
has three main components-a statement of mission or vision of the company, a statement of the core values that
shape the acts and behaviour of the employees, and a statement of the goals and objectives.
Features of a Mission
a. Mission must be feasible and attainable. It should be possible to achieve it.
b. Mission should be clear enough so that any action can be taken.
c. It should be inspiring for the management, staff and society at large.
 d. It should be precise enough, i.e., it should be neither too broad nor too narrow.
e. It should be unique and distinctive to leave an impact in everyone’s mind.
f. It should be analytical,i.e., it should analyze the key components of the strategy.
g. It should be credible, i.e., all stakeholders should be able to believe it.
3. Vision
A vision statement identifies where the organization wants or intends to be in future or where it should be to
best meet the needs of the stakeholders. It describes dreams and aspirations for future. For instance, Microsoft’s
vision is “to empower people through great software, any time, any place, or any device.” Wal-Mart’s vision is
to become worldwide leader in retailing.
A vision is the potential to view things ahead of themselves. It answers the question “where we want to be”. It
gives us a reminder about what we attempt to develop. A vision statement is for the organization and it’s
members, unlike the mission statement which is for the customers/clients. It contributes in effective decision
making as well as effective business planning. It incorporates a shared understanding about the nature and aim
of the organization and utilizes this understanding to direct and guide the organization towards a better purpose.
It describes that on achieving the mission, how the organizational future would appear to be.
An effective vision statement must have following features-
a. It must be unambiguous.
b. It must be clear.
c. It must harmonize with organization’s culture and values.
d. The dreams and aspirations must be rational/realistic.
e. Vision statements should be shorter so that they are easier to memorize.

In order to realize the vision, it must be deeply instilled in the organization, being owned and shared by
everyone involved in the organization.
4. Goals and Objectives
A goal is a desired future state or objective that an organization tries to achieve. Goals specify in particular what
must be done if an organization is to attain mission or vision. Goals make mission more prominent and
concrete. They co-ordinate and integrate various functional and departmental areas in an organization. Well
made goals have following features-
a. These are precise and measurable.
b. These look after critical and significant issues.
c. These are realistic and challenging.
d. These must be achieved within a specific time frame.
e. These include both financial as well as non-financial components.
Objectives are defined as goals that organization wants to achieve over a period of time. These are the
foundation of planning. Policies are developed in an organization so as to achieve these objectives. Formulation
of objectives is the task of top level management. Effective objectives have following features-
f. These are not single for an organization, but multiple.
g. Objectives should be both short-term as well as long-term.
h. Objectives must respond and react to changes in environment, i.e., they must be flexible.
i. These must be feasible, realistic and operational.

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 Strategy - Definition and Features
 Vision & Mission Statements
 Strategic Management Process
 Environmental Scanning
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Strategic Management
 Strategic Management - Introduction
 Strategy - Definition and Features
 Components of a Strategy Statement
 Vision & Mission Statements
 Strategic Management Process
 Environmental Scanning
 Strategy Formulation
 Strategy Implementation
 Strategy Formulation vs Implementation
 Strategy Evaluation
 Strategic Decisions
 Benefits of Strategic Management
 Business Policy
 BCG Matrix
 SWOT Analysis
 SWOT Analysis of Google
 SWOT Analysis of Starbucks
 SWOT Analysis of Blackberry
 Personal SWOT Analysis
 SWOT Analysis of Amazon
 SWOT Analysis of IKEA
 SWOT Analysis of Nike
 SWOT Analysis of Microsoft
 SWOT Analysis of China Mobile
 Competitor Analysis
 What is Competitive Advantage ?
 Human, Social, and Intellectual Capital as a Means of Competitive Advantage
 Porter’s Five Forces Model
 Blue Ocean Strategy and its Implications for Businesses
 Overfished Ocean Strategy: How to Drive Growth and Attain Profitability
 Porters Five Forces Analysis of the Airlines Industry in the United States
 Porters Five Forces Analysis of Samsung
 Porters Five Forces Analysis of Virgin Atlantic
 Porters Five Forces Analysis of China Mobile
 Strategic Leadership
 Some Pitfalls to be Avoided
 Corporate Governance
 Business Ethics
 Social Responsibilities of Managers
 Core Competencies
 Core Competency Theory of Strategy
 Ansoff Matrix
 Routes to Strategic Growth
 Diversification as a Viable Corporate Strategy
 5 Configurations of Strategic Management
 Role of Planning, Plans and Planners
 Reasons for Avoiding Strategic Planning
 Strategic Management for the Millennials
 Strategizing for the Future
  PESTLE Analysis of the Global Aviation Industry
 PESTLE Analysis of Starbucks
 PESTLE Analysis of Samsung
 SWOT Analysis of Unilever
 Business Strategies to Beat the Downturn
 Analysis of Amazon’s Corporate Strategy
 How Amazon Can Improve its Corporate Strategy
 Cutting Costs Strategically
 Actualizing Business as Usual Strategies for Mission Critical Organizations and Functions
 Why Indian Firms Must Strive for Strategic Autonomy in Their Geoeconomic Strategies

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5. Importance of Vision and Mission Statements

Importance of Vision and Mission Statements
One of the first things that any observer of management thought and practice asks is whether a particular
organization has a vision and mission statement. In addition, one of the first things that one learns in a business
school is the importance of vision and mission statements.
This article is intended to elucidate on the reasons why vision and mission statements are important and
the benefits that such statements provide to the organizations. It has been found in studies that organizations
that have lucid, coherent, and meaningful vision and mission statements return more than double the numbers in
shareholder benefits when compared to the organizations that do not have vision and mission statements.
Indeed, the importance of vision and mission statements is such that it is the first thing that is discussed in
management textbooks on strategy.
Some of the benefits of having a vision and mission statement are discussed below:
 Above everything else, vision and mission statements provide unanimity of purpose to organizations and
imbue the employees with a sense of belonging and identity. Indeed, vision and mission statements are
 embodiments of organizational identity and carry the organizations creed and motto. For this purpose,
they are also called as statements of creed.
 Vision and mission statements spell out the context in which the organization operates and provides the
employees with a tone that is to be followed in the organizational climate. Since they define the reason
for existence of the organization, they are indicators of the direction in which the organization must
move to actualize the goals in the vision and mission statements.
 The vision and mission statements serve as focal points for individuals to identify themselves with the
organizational processes and to give them a sense of direction while at the same time deterring those
who do not wish to follow them from participating in the organization’s activities.
 The vision and mission statements help to translate the objectives of the organization into work
structures and to assign tasks to the elements in the organization that are responsible for actualizing them
in practice.
 To specify the core structure on which the organizational edifice stands and to help in the translation of
objectives into actionable cost, performance, and time related measures.
 Finally, vision and mission statements provide a philosophy of existence to the employees, which is very
crucial because as humans, we need meaning from the work to do and the vision and mission statements
provide the necessary meaning for working in a particular organization.
As can be seen from the above, articulate, coherent, and meaningful vision and mission statements go a long
way in setting the base performance and actionable parameters and embody the spirit of the organization. In
other words, vision and mission statements are as important as the various identities that individuals have in
their everyday lives.
It is for this reason that organizations spend a lot of time in defining their vision and mission statements and
ensure that they come up with the statements that provide meaning instead of being mere sentences that are
devoid of any meaning.
Importance of Vision and Mission Statements
One of the first things that any observer of management thought and practice asks is whether a particular
organization has a vision and mission statement. In addition, one of the first things that one learns in a business
school is the importance of vision and mission statements.
This article is intended to elucidate on the reasons why vision and mission statements are important and
the benefits that such statements provide to the organizations. It has been found in studies that organizations
that have lucid, coherent, and meaningful vision and mission statements return more than double the numbers in
shareholder benefits when compared to the organizations that do not have vision and mission statements.
Indeed, the importance of vision and mission statements is such that it is the first thing that is discussed in
management textbooks on strategy.
Some of the benefits of having a vision and mission statement are discussed below:
 Above everything else, vision and mission statements provide unanimity of purpose to organizations and
imbue the employees with a sense of belonging and identity. Indeed, vision and mission statements are
embodiments of organizational identity and carry the organizations creed and motto. For this purpose,
they are also called as statements of creed.
 Vision and mission statements spell out the context in which the organization operates and provides the
employees with a tone that is to be followed in the organizational climate. Since they define the reason
 for existence of the organization, they are indicators of the direction in which the organization must
move to actualize the goals in the vision and mission statements.
 The vision and mission statements serve as focal points for individuals to identify themselves with the
organizational processes and to give them a sense of direction while at the same time deterring those
who do not wish to follow them from participating in the organization’s activities.
 The vision and mission statements help to translate the objectives of the organization into work
structures and to assign tasks to the elements in the organization that are responsible for actualizing them
in practice.
 To specify the core structure on which the organizational edifice stands and to help in the translation of
objectives into actionable cost, performance, and time related measures.
 Finally, vision and mission statements provide a philosophy of existence to the employees, which is very
crucial because as humans, we need meaning from the work to do and the vision and mission statements
provide the necessary meaning for working in a particular organization.
As can be seen from the above, articulate, coherent, and meaningful vision and mission statements go a long
way in setting the base performance and actionable parameters and embody the spirit of the organization. In
other words, vision and mission statements are as important as the various identities that individuals have in
their everyday lives.
It is for this reason that organizations spend a lot of time in defining their vision and mission statements and
ensure that they come up with the statements that provide meaning instead of being mere sentences that are
devoid of any meaning.
The strategic management process means defining the organization’s strategy. It is also defined as the process
by which managers make a choice of a set of strategies for the organization that will enable it to achieve better
performance.
Strategic management is a continuous process that appraises the business and industries in which the
organization is involved; appraises it’s competitors; and fixes goals to meet all the present and future
competitor’s and then reassesses each strategy.
Strategic management process has following four steps:
1. Environmental Scanning- Environmental scanning refers to a process of collecting, scrutinizing and
providing information for strategic purposes. It helps in analyzing the internal and external factors
influencing an organization. After executing the environmental analysis process, management should
evaluate it on a continuous basis and strive to improve it.
2. Strategy Formulation- Strategy formulation is the process of deciding best course of action for
accomplishing organizational objectives and hence achieving organizational purpose. After conducting
environment scanning, managers formulate corporate, business and functional strategies.
3. Strategy Implementation- Strategy implementation implies making the strategy work as intended or
putting the organization’s chosen strategy into action. Strategy implementation includes designing the
organization’s structure, distributing resources, developing decision making process, and managing
human resources.
4. Strategy Evaluation- Strategy evaluation is the final step of strategy management process. The key
strategy evaluation activities are: appraising internal and external factors that are the root of present
 strategies, measuring performance, and taking remedial / corrective actions. Evaluation makes sure that
the organizational strategy as well as it’s implementation meets the organizational objectives.
These components are steps that are carried, in chronological order, when creating a new strategic management
plan. Present businesses that have already created a strategic management plan will revert to these steps as per
the situation’s requirement, so as to make essential changes.

Components of Strategic Management Process

Strategic management is an ongoing process. Therefore, it must be realized that each component interacts with
the other components and that this interaction often happens in chorus.
Organizational environment consists of both external and internal factors. Environment must be scanned so as
to determine development and forecasts of factors that will influence organizational success. Environmental
scanning refers to possession and utilization of information about occasions, patterns, trends, and
relationships within an organization’s internal and external environment. It helps the managers to decide
the future path of the organization. Scanning must identify the threats and opportunities existing in the
environment. While strategy formulation, an organization must take advantage of the opportunities and
minimize the threats. A threat for one organization may be an opportunity for another.
Internal analysis of the environment is the first step of environment scanning. Organizations should observe
the internal organizational environment. This includes employee interaction with other employees, employee
interaction with management, manager interaction with other managers, and management interaction with
shareholders, access to natural resources, brand awareness, organizational structure, main staff, operational
potential, etc. Also, discussions, interviews, and surveys can be used to assess the internal environment.
Analysis of internal environment helps in identifying strengths and weaknesses of an organization.
As business becomes more competitive, and there are rapid changes in the external environment, information
from external environment adds crucial elements to the effectiveness of long-term plans. As environment is
dynamic, it becomes essential to identify competitors’ moves and actions. Organizations have also to update the
core competencies and internal environment as per external environment. Environmental factors are infinite,
hence, organization should be agile and vigile to accept and adjust to the environmental changes. For instance -
Monitoring might indicate that an original forecast of the prices of the raw materials that are involved in the
product are no more credible, which could imply the requirement for more focused scanning, forecasting and
analysis to create a more trustworthy prediction about the input costs. In a similar manner, there can be changes
in factors such as competitor’s activities, technology, market tastes and preferences.
While in external analysis, three correlated environment should be studied and analyzed —
 immediate / industry environment
 national environment
 broader socio-economic environment / macro-environment
Examining the industry environment needs an appraisal of the competitive structure of the organization’s
industry, including the competitive position of a particular organization and it’s main rivals. Also, an
assessment of the nature, stage, dynamics and history of the industry is essential. It also implies evaluating the
effect of globalization on competition within the industry. Analyzing the national environment needs an
appraisal of whether the national framework helps in achieving competitive advantage in the globalized
environment. Analysis of macro-environment includes exploring macro-economic, social, government, legal,
technological and international factors that may influence the environment. The analysis of organization’s
external environment reveals opportunities and threats for an organization.
Strategic managers must not only recognize the present state of the environment and their industry but also be
able to predict its future positions.
Steps in Strategy Formulation Process
Strategy formulation refers to the process of choosing the most appropriate course of action for the realization
of organizational goals and objectives and thereby achieving the organizational vision. The process of strategy
formulation basically involves six main steps. Though these steps do not follow a rigid chronological order,
however they are very rational and can be easily followed in this order.
1. Setting Organizations’ objectives - The key component of any strategy statement is to set the long-
term objectives of the organization. It is known that strategy is generally a medium for realization of
organizational objectives. Objectives stress the state of being there whereas Strategy stresses upon the
process of reaching there. Strategy includes both the fixation of objectives as well the medium to be
used to realize those objectives. Thus, strategy is a wider term which believes in the manner of
deployment of resources so as to achieve the objectives.
While fixing the organizational objectives, it is essential that the factors which influence the selection of
objectives must be analyzed before the selection of objectives. Once the objectives and the factors influencing
strategic decisions have been determined, it is easy to take strategic decisions.
2. Evaluating the Organizational Environment - The next step is to evaluate the general economic and
industrial environment in which the organization operates. This includes a review of the organizations
competitive position. It is essential to conduct a qualitative and quantitative review of an organizations
existing product line. The purpose of such a review is to make sure that the factors important for
competitive success in the market can be discovered so that the management can identify their own
strengths and weaknesses as well as their competitors’ strengths and weaknesses.
After identifying its strengths and weaknesses, an organization must keep a track of competitors’ moves and
actions so as to discover probable opportunities of threats to its market or supply sources.
3. Setting Quantitative Targets - In this step, an organization must practically fix the quantitative target
values for some of the organizational objectives. The idea behind this is to compare with long term
customers, so as to evaluate the contribution that might be made by various product zones or operating
departments.
4. Aiming in context with the divisional plans - In this step, the contributions made by each department
or division or product category within the organization is identified and accordingly strategic planning is
done for each sub-unit. This requires a careful analysis of macroeconomic trends.
5. Performance Analysis - Performance analysis includes discovering and analyzing the gap between the
planned or desired performance. A critical evaluation of the organizations past performance, present
condition and the desired future conditions must be done by the organization. This critical evaluation
identifies the degree of gap that persists between the actual reality and the long-term aspirations of the
organization. An attempt is made by the organization to estimate its probable future condition if the
current trends persist.
 6. Choice of Strategy - This is the ultimate step in Strategy Formulation. The best course of action is
actually chosen after considering organizational goals, organizational strengths, potential and limitations
as well as the external opportunities.
Strategy Implementation - Meaning and Steps in Implementing a Strategy

Strategy implementation is the translation of chosen strategy into organizational action so as to achieve strategic
goals and objectives. Strategy implementation is also defined as the manner in which an organization should
develop, utilize, and amalgamate organizational structure, control systems, and culture to follow strategies that
lead to competitive advantage and a better performance. Organizational structure allocates special value
developing tasks and roles to the employees and states how these tasks and roles can be correlated so as
maximize efficiency, quality, and customer satisfaction-the pillars of competitive advantage. But, organizational
structure is not sufficient in itself to motivate the employees.

An organizational control system is also required. This control system equips managers with motivational
incentives for employees as well as feedback on employees and organizational performance. Organizational
culture refers to the specialized collection of values, attitudes, norms and beliefs shared by organizational
members and groups.

Following are the main steps in implementing a strategy:

Developing an organization having potential of carrying out strategy successfully.

Disbursement of abundant resources to strategy-essential activities.
Creating strategy-encouraging policies.
Employing best policies and programs for constant improvement.
Linking reward structure to accomplishment of results.
Making use of strategic leadership.
Excellently formulated strategies will fail if they are not properly implemented. Also, it is essential to note that
strategy implementation is not possible unless there is stability between strategy and each organizational
dimension such as organizational structure, reward structure, resource-allocation process, etc.

Strategy implementation poses a threat to many managers and employees in an organization. New power
relationships are predicted and achieved. New groups (formal as well as informal) are formed whose values,
attitudes, beliefs and concerns may not be known. With the change in power and status roles, the managers and
employees may employ confrontation behaviour.
Strategy Formulation vs Strategy Implementation
Following are the main differences between Strategy Formulation and Strategy Implementation-
Strategy Formulation Strategy Implementation

Strategy Formulation includes planning and decision- Strategy Implementation involves all those means
making involved in developing organization’s related to executing the strategic plans.
strategic goals and plans.

In short, Strategy Formulation is placing the Forces In short, Strategy Implementation is managing forces
before the action. during the action.

Strategy Formulation is an Entrepreneurial Strategic Implementation is mainly

Activity based on strategic decision-making. an Administrative Task based on strategic and
operational decisions.

Strategy Formulation emphasizes on effectiveness. Strategy Implementation emphasizes on efficiency.

Strategy Formulation is a rational process. Strategy Implementation is basically an operational

process.

Strategy Formulation requires co-ordination among Strategy Implementation requires co-ordination

few individuals. among many individuals.

Strategy Formulation requires a great deal of initiative Strategy Implementation requires

and logical skills. specific motivational and leadership traits.

Strategic Formulation precedes Strategy STrategy Implementation follows Strategy

Implementation. Formulation.

Strategy Evaluation Process and its Significance

Strategy Evaluation is as significant as strategy formulation because it throws light on the efficiency and
effectiveness of the comprehensive plans in achieving the desired results. The managers can also assess the
appropriateness of the current strategy in todays dynamic world with socio-economic, political and
technological innovations. Strategic Evaluation is the final phase of strategic management.
The significance of strategy evaluation lies in its capacity to co-ordinate the task performed by managers,
groups, departments etc, through control of performance. Strategic Evaluation is significant because of
various factors such as - developing inputs for new strategic planning, the urge for feedback, appraisal and
reward, development of the strategic management process, judging the validity of strategic choice etc.
The process of Strategy Evaluation consists of following steps-
1. Fixing benchmark of performance - While fixing the benchmark, strategists encounter questions such
as - what benchmarks to set, how to set them and how to express them. In order to determine the
benchmark performance to be set, it is essential to discover the special requirements for performing the
main task. The performance indicator that best identify and express the special requirements might then
be determined to be used for evaluation. The organization can use both quantitative and qualitative
criteria for comprehensive assessment of performance. Quantitative criteria includes determination of
net profit, ROI, earning per share, cost of production, rate of employee turnover etc. Among the
 Qualitative factors are subjective evaluation of factors such as - skills and competencies, risk taking
potential, flexibility etc.
2. Measurement of performance - The standard performance is a bench mark with which the actual
performance is to be compared. The reporting and communication system help in measuring the
performance. If appropriate means are available for measuring the performance and if the standards are
set in the right manner, strategy evaluation becomes easier. But various factors such as managers
contribution are difficult to measure. Similarly divisional performance is sometimes difficult to measure
as compared to individual performance. Thus, variable objectives must be created against which
measurement of performance can be done. The measurement must be done at right time else evaluation
will not meet its purpose. For measuring the performance, financial statements like - balance sheet,
profit and loss account must be prepared on an annual basis.
3. Analyzing Variance - While measuring the actual performance and comparing it with standard
performance there may be variances which must be analyzed. The strategists must mention the degree of
tolerance limits between which the variance between actual and standard performance may be accepted.
The positive deviation indicates a better performance but it is quite unusual exceeding the target always.
The negative deviation is an issue of concern because it indicates a shortfall in performance. Thus in this
case the strategists must discover the causes of deviation and must take corrective action to overcome it.
4. Taking Corrective Action - Once the deviation in performance is identified, it is essential to plan for a
corrective action. If the performance is consistently less than the desired performance, the strategists
must carry a detailed analysis of the factors responsible for such performance. If the strategists discover
that the organizational potential does not match with the performance requirements, then the standards
must be lowered. Another rare and drastic corrective action is reformulating the strategy which requires
going back to the process of strategic management, reframing of plans according to new resource
allocation trend and consequent means going to the beginning point of strategic management process.
Benefits of Strategic Management

There are many benefits of strategic management and they include identification, prioritization, and exploration
of opportunities. For instance, newer products, newer markets, and newer forays into business lines are only
possible if firms indulge in strategic planning. Next, strategic management allows firms to take an objective
view of the activities being done by it and do a cost benefit analysis as to whether the firm is profitable.

Just to differentiate, by this, we do not mean the financial benefits alone (which would be discussed below) but
also the assessment of profitability that has to do with evaluating whether the business is strategically aligned to
its goals and priorities.

The key point to be noted here is that strategic management allows a firm to orient itself to its market and
consumers and ensure that it is actualizing the right strategy.

Financial Benefits
It has been shown in many studies that firms that engage in strategic management are more profitable and
successful than those that do not have the benefit of strategic planning and strategic management.

When firms engage in forward looking planning and careful evaluation of their priorities, they have control over
the future, which is necessary in the fast changing business landscape of the 21st century.

It has been estimated that more than 100,000 businesses fail in the US every year and most of these failures are
to do with a lack of strategic focus and strategic direction. Further, high performing firms tend to make more
informed decisions because they have considered both the short term and long-term consequences and hence,
have oriented their strategies accordingly. In contrast, firms that do not engage themselves in meaningful
strategic planning are often bogged down by internal problems and lack of focus that leads to failure.

Non-Financial Benefits
The section above discussed some of the tangible benefits of strategic management. Apart from these benefits,
firms that engage in strategic management are more aware of the external threats, an improved understanding of
competitor strengths and weaknesses and increased employee productivity. They also have lesser resistance to
change and a clear understanding of the link between performance and rewards.

The key aspect of strategic management is that the problem solving and problem preventing capabilities of the
firms are enhanced through strategic management. Strategic management is essential as it helps firms to
rationalize change and actualize change and communicate the need to change better to its employees. Finally,
strategic management helps in bringing order and discipline to the activities of the firm in its both internal
processes and external activities.

Closing Thoughts
In recent years, virtually all firms have realized the importance of strategic management. However, the key
difference between those who succeed and those who fail is that the way in which strategic management is done
and strategic planning is carried out makes the difference between success and failure. Of course, there are still
firms that do not engage in strategic planning or where the planners do not receive the support from
management. These firms ought to realize the benefits of strategic management and ensure their longer-term
viability and success in the marketplace.
Difference Between Strategy Formulation and Strategy Implementation
Last updated on July 26, 2018 by Surbhi S
 Strategy
Formulation and Strategy Implementation are the two most important phases of strategic management
process. Strategy Formulation means crafting a combination of strategies and picking out the best one to
achieve the organizational goals and objectives and thereby reaching the vision of the organization. It involves a
number of steps which are performed in chronological order.
On the other hand, Strategy Implementation refers to the execution of the opted strategy, i.e. it converts the
chosen strategy into action, for the realization of organizational goals and objectives. There are many
management students, who often juxtapose the two terms. But there exist a fine line of differences between
strategy formulation and strategy implementation, which has been explained in the article below.
Content: Strategy Formulation Vs Strategy Implementation
1. Comparison Chart
2. Definition
3. Key Differences
4. Conclusion
Comparison Chart

BASIS FOR STRATEGY

STRATEGY FORMULATION
COMPARISON IMPLEMENTATION

Meaning Strategy Formulation refers to the Strategy Implementation means

preparation of a well thought strategy, to bring the formulated strategy
that helps in the achievement of into action.
organizational goals.

Concept Placement of forces before action Managing forces at the time of

takes place. strategy execution.

Process type Logical Operational

Emphasis on Effectiveness Efficiency

 BASIS FOR STRATEGY
STRATEGY FORMULATION
COMPARISON IMPLEMENTATION

Responsibility Top Management Functional Management

Orientation Planning Execution

Activity type Entrepreneurial Administrative

Requirement of Analytical skills Leadership skills

Definition of Strategy Formulation

Strategy Formulation is concerned with the crafting and designing of strategies, and picking the best strategy for
execution, to achieve the desired organizational goals and objectives. It is the second stage of the Strategic
Management Process. The following are the three major aspects of Strategy Formulation:
 Corporate Level Strategy
 Business Level or Competitive Level Strategy
 Functional Level Strategy
Strategy Formulation involves evaluating the current business strategy and determining measures to improve
them. Ascertaining the major areas where business needs any help from the external environment of business. In
this phase, the present issues and problems of the organization are resolved first. Alternative courses of action
are prepared, taking all the items into account. After that, the strategy is formulated accordingly for
implementation, after all, considerations.
Definition of Strategy Implementation
This is the third and final phase of Stage of Strategic Management Process, where the formulated strategy is put
into action to meet out the organizational goals and objectives. Strategy Implementation is a process of
converting planned decisions into action.
Strategy Implementation Model
It includes directing the ongoing strategy so that it can work in an efficient manner and taking corrective
measures to improve its performance time to time, to reach the targeted results. The following activities are
involved in it:
 Allocation of resources like the man, material, money, machinery, etc.
 Designing the organizational structure for handling new strategy.
 Training manpower.
 Ascertaining functional process.
 A devising system in the organization.
Key Differences Between Strategy Formulation and Strategy Implementation
The following are the major differences between strategy formulation and strategy implementation:
1. Strategy Formulation refers to designing the strategy. Strategy Implementation means, execution of the
opted strategy.
2. Strategy Formulation putting all forces into its place before an action takes place while Strategy
Implementation focuses on managing those forces during execution.
3. Strategy Formulation is a logical process, whereas Strategy Implementation is an operational process.
4. Strategy Formulation puts emphasis on effectiveness, but Strategy Implementation gives stress on
efficiency.
5. Strategy Formulation is the responsibility of top management. Conversely, middle management is
responsible for Strategy Implementation.
6. Strategy Formulation requires intuitive skills. In contrast to, Strategy Implementation, which needs
motivational skills.
7. Strategy Formulation is an entrepreneurial activity. On the other hand, Strategy Implementation is an
administrative activity.
8. Strategy Formulation is related to planning, but Strategy Implementation is concerned with action.
Conclusion
Strategic Management Process is a combination of three processes, i.e. Strategy Analysis, Strategy Formulation,
Strategy Implementation. First of all, in depth diagnosis (analysis) on the business environment, organizational
goals, resources, and competencies is performed, which is followed by strategy choice (formulation) where
alternative strategies are prepared and after taking into consideration various matters the best action plan is
chosen to reach the desired goals. Then finally comes the strategy execution (implementation), where the
decision is brought into action. Without implementation, the strategy would be of no use to the organization.

Topic: strategies for sustainable advantage

 Global strategy: exporting, when businesses are successful and competitive, they can grow
and this means that they outgrow their original ‘home market’.
 Multidomestic strategy: means that competition in each country is handled independently of
industry competition in other countries.
 Transnational strategy: seeks to achieve both global and national responsiveness. “Think
global, act loca
Strategic Management: Formulation and Implementation
RYSZARD BARNAT, LLM., DBA, PHD (STRAT. MGMT)
Strategic Management
Introduction to Management
discusses the concepts of management and manager. Management is discussed in terms of the basic functions
that a manager performs - planning, organizing, leading, and controlling - the roles that a manager must assume,
and the skills required of a manager. The chapter ends with a discussion of foundations of management,
including the essence of management, and the development of management thought and theory.
Strategy Formulation
Formulating strategies involves determining appropriate courses of action for achieving objectives. This part
deals primarily with the strategy formulation process. The process of strategy formulation begins with analysis
with the principal factors in a firm's internal and external environment and ends with functional strategies
designed. It also includes such activities as analysis, planning and selecting mission, objectives, and corporate
and business strategies. As discussed in the following six chapters, strategy formulation combines a future-
oriented perspective with concern for a firm's internal and external environment indeveloping its competitive
plan of action.
Strategy Implementation
Implementation and control of organization are the two last phases in the strategic management process. I shall
begin by discussing the essential aspect of organization strategy implementation. Control of organization
strategy will be discussed later in Part II.
Strategy formulation and strategy implementation - which is how strategy is put into action - are two side of the
coin called strategic management. No matter how creative the formulated strategy, the organization will not
benefit if it is incorrectly implemented. Moreover, organizations that formulate and implement strategies better
than competitors can expect a competitive advantages.
Strategy Control
Execution must be controlled and evaluated if the strategy is to be successfully implemented. Thus, the third
organizational element in the process of implementation strategy is the control systems. Strategic control
focuses on two questions: Is the strategy being implemented as planned? and Is it producing the intended
results? Therefore, strategic control: monitoring strategic progress, evaluating deviations and taking corrective
action is also very important the key tasks in strategy implementation.
Strategic Management And Marketplace
The modern business world is a complicated place. Before managers can learn how to practice strategic
management successfully in the international context, they must have a thorough understanding of the basic
principles of international management. Therefore, the subject of this Part is strategic management for business
that engage in international operations.
Tools And Techniques For Strategic Management
Tools and Techniques for Strategic Management deals with tools and techniques that have been used
successfully in a wide range of business settings.

 Developing Organizational Structure and Design

How to Develop an Organization Structure
by Tara Duggan; Reviewed by Michelle Seidel, B.Sc., LL.B., MBA; Updated February 06, 2019

Related Articles
 1Explanation of Organizational Structure
 2The Advantages of Divisional Organization Structure on Accountability
 3Successful Organizational Structure
 4: Better Efficiency as a Manager
Developing an organizational structure involves defining the framework around which your business
operates. By defining how the organization works, you more effectively choose leaders and make effective
decisions. A clearly established structure helps employees resolve disputes and work together to achieve
strategic goals.
Outline Your Governance Plan
Determine what type of governance you need to make decisions. Identify the roles in your organization.
Typically, an initial steering committee writes the business plan, obtains funding and develops the first
proposals. Identify a leader to coordinate, inspire and support the work.
Identify a board of directors to coordinate activities, make contacts, network with other industry leaders
and clear the way for the organization to meet its objectives. Small groups tend to require a less formal
structure. As the organization grows, the need to explicitly show the hierarchy in an organizational chart
helps everyone understand who makes decisions. Formal structures tend to help an organization’s
members act more quickly.
Establish Rules for Operation
Establish rules by stating how formal and informal groups operate within the organization. For example,
committees typically use Robert’s Rules of Order to conduct meetings. Rules make up an organization’s
culture.
By documenting operating procedures, you can minimize misunderstandings and confusion, especially if
you work in a culturally diverse environment. Groups formed to resolve a single issue may not need a
formal structure but large complex organizations typically need clear rules and authority.
Distribute the Work
Establish task forces and action committees to carry out activities. These people make specific changes to
policies and practices in order to achieve their goals. Define conditions when a temporary support
committee, or collection of volunteers, respond to organization's needs. Locate other organizations trying
to solve the same problems and learn from their experiences. As you learn more, share your expertise as
well.
Allow for Changes Over Time
Evolve your organizational structure over time. As your organization grows, differentiate your functions
into divisions that allow its members to produce products and services. Add divisional leadership to
manage the functions necessary to streamline the specific needs of that particular division. For example,
as your organization grows, establishing a training function for each division ensures that members of
each division receive organizational training and role-specific guidance.
Make Communication Easy Among Divisions
Other divisions typically specialize in product marketing development, marketing and geographic sales.
Avoid communication issues by maintaining a matrix management strategy in which members become
accountable for divisional and functional success. Reduce communication problems by decentralizing
authority. By distributing decision-making throughout the organization, managers at lower levels make
decisions faster and tend to be more motivated and responsible.
WHAT IS ORGANIZATIONAL STRUCTURE?
By structure, we mean the framework around which the group is organized, the underpinnings which keep the
coalition functioning. It's the operating manual that tells members how the organization is put together and how
it works. More specifically, structure describes how members are accepted, how leadership is chosen, and how
decisions are made.
WHY SHOULD YOU DEVELOP A STRUCTURE FOR YOUR ORGANIZATION?
 Structure gives members clear guidelines for how to proceed. A clearly-established structure gives
the group a means to maintain order and resolve disagreements.
 Structure binds members together. It gives meaning and identity to the people who join the group, as
well as to the group itself.
 Structure in any organization is inevitable -- an organization, by definition, implies a structure. Your
group is going to have some structure whether it chooses to or not. It might as well be the structure
 which best matches up with what kind of organization you have, what kind of people are in it, and what
you see yourself doing.
WHEN SHOULD YOU DEVELOP A STRUCTURE FOR YOUR ORGANIZATION?
It is important to deal with structure early in the organization's development. Structural development can
occur in proportion to other work the organization is doing, so that it does not crowd out that work. And it can
occur in parallel with, at the same time as, your organization's growing accomplishments, so they take place in
tandem, side by side. This means that you should think about structure from the beginning of your
organization's life. As your group grows and changes, so should your thinking on the group's structure.
ELEMENTS OF STRUCTURE
While the need for structure is clear, the best structure for a particular coalition is harder to determine. The best
structure for any organization will depend upon who its members are, what the setting is, and how far the
organization has come in its development.
Regardless of what type of structure your organization decides upon, three elements will always be there. They
are inherent in the very idea of an organizational structure.
They are:
 Some kind of governance
 Rules by which the organization operates
 A distribution of work
Governance
The first element of structure is governance - some person or group has to make the decisions within the
organization.
Rules by which the organization operates
Another important part of structure is having rules by which the organization operates. Many of these rules may
be explicitly stated, while others may be implicit and unstated, though not necessarily any less powerful.
Distribution of work
Inherent in any organizational structure also is a distribution of work. The distribution can be formal or
informal, temporary or enduring, but every organization will have some type of division of labor.
There are four tasks that are key to any group:
 Envisioning desired changes. The group needs someone who looks at the world in a slightly different
way and believes he or she can make others look at things from the same point of view.
 Transforming the community. The group needs people who will go out and do the work that has been
envisioned.
 Planning for integration. Someone needs to take the vision and figure out how to accomplish it by
breaking it up into strategies and goals.
 Supporting the efforts of those working to promote change. The group needs support from the
community to raise money for the organization, champion the initiative in the state legislature, and
ensure that they continue working towards their vision.
COMMON ROLES
Every group is different, and so each will have slightly different terms for the roles individuals play in their
organization, but below are some common terms, along with definitions and their typical functions.
 An initial steering committee is the group of people who get things started. Often, this group will create
plans for funding, and organizational and board development. It may also generate by-laws, and then
dissolve. If they continue to meet after approximately the first six months, we might say they have
metamorphosed into a coordinating council.
 A coordinating council (also referred to as a coordinating committee, executive committee,
and executive council), modifies broad, organization-wide objectives and strategies in response to input
from individuals or committees.
 Often, one person will take the place of the coordinating council, or may serve as its head. Such a person
may be known as the Executive Director, Project Coordinator, Program Director, or President. He or
she sometimes has a paid position, and may coordinate, manage, inspire, supervise, and support the
work of other members of the organization.
 Task forces are made up of members who work together around broad objectives. Task forces integrate
the ideas set forward with the community work being done.
For example, from the director of a coalition to reduce violence in a medium-sized city: "Currently, we have
three operational task forces. Members of each have an ongoing dialogue with members of the coordinating
council, and also with their action committees. The oldest was formed with the goal of eliminating domestic
violence about fifteen years ago, when a local woman was killed by her husband. Then, after several outbreaks
of violence in the schools a few years back, our group offered to help, and a second task force sprung up around
reducing youth violence. We've just started a third, with the goal of increasing gun safety.
"All of it is interrelated, and all of it applies to our mission of increasing the safety of residents of South Haven,
as well as that of our visitors. But each task force is contributing to that mission in vastly different ways, with
different objectives, and using different strategies. 'Cause, you know, the strategies you use to stop a ninth
grader from bringing a gun to school just aren't the same as the ones you use to stop a 40-year-old man on
unemployment from beating his wife."
 Action committees bring about specific changes in programs, policies, and practices in the sectors in
which they work.
For example, the task force on domestic violence mentioned above has the following action committees:
 A government and law enforcement committee. Members include police officers, lawyers, a judge, and a
state representative. Currently, they are trying to pass laws with stronger penalties for those convicted of
domestic violence, especially repeat offenders. They are also training officers to be better able to spot an
abusive relationship, and better able to inform a victim of his or her options.
 A social services committee. Members (who include representatives from most of the service agencies in
town) work to assure that staff members know where to send someone for the resources he or she needs.
They are also trying to increase the number of trained volunteer counselors who work at the battered
women's shelter.
 A media committee. Members include local journalists, writers, and graphic designers. They keep the
project and the issue in the public's minds as much as possible with editorials, articles and news clips of
events, as well as advertisements and public service announcements.
  Support committees are groups that help ensure that action committees or other individuals will have the
resources and opportunities necessary to realize their vision. Financial and media committees are
examples of committees formed to help support or facilitate your work.
 Community trustees, also known as the board of trustees or as the board of directors, provide overall
support, advice, and resources to members of the action groups. They are often either people who are
directly affected by the issue or have stature in the community. That way, they are able to make
contacts, network with other community leaders, and generally remove or weaken barriers to meeting
organizational objectives.
 Grantmakers are another part of the picture. Grantmakers exist on an international, national, state, and
local level and may be private companies and foundations, or local, county, state, or federal government
organizations (for example, block grants given by the city would fall into this category).
 Support organizations (not to be confused with the support committees listed above) are groups that can
give your organization the technical assistance it needs.
 Partner organizations are other groups working on some of the same issues as your organization.
Although this list is pretty extensive, your organization may only use two or three of the above mentioned roles,
especially at the beginning. It's not uncommon for a group to start with a steering committee, ask others to serve
as board members, and then recruit volunteers who will serve as members of action committees. In this broad
spectrum of possibilities, consider: Where does your organization fit in? Where do you want to be?
EXAMPLES OF STRUCTURE
So how can all of these pieces be put together? Again, the form a community group takes should be based on
what it does, and not the other way around. The structures given are simply meant to serve as examples that
have been found to be effective for some community-based organizations; they can and should be adapted and
modified for your own group's purposes.
A RELATIVELY COMPLEX STRUCTURE
Example - The Ste. Genevieve's Children's Coalition
The Ste. Genevieve's Children's Coalition is a relatively large community-based group. They have a
coordinating council, a media committee, and three task forces, dealing with adolescent pregnancy,
immunization, and child hunger. Each of the task forces has action committees as well. For example, the
adolescent pregnancy reduction task force has a schools committee that focuses on keeping teen parents in
school and modifying the human sexuality curriculum. A health organizations committee focuses on increasing
access and use of the youth clinic. The media committee works to keep children's issues in the news, and
includes professionals from the local television stations, radio stations, newspaper, and a marketing
professional. The coordinating council is composed of the executive director, her assistant, the media committee
chair, and the chairs of each of the three task forces. A board of directors has been invaluable in helping keep
the coalition financially viable.
In diagram form, a complex organization might look like this:
And in diagram form:
As smaller size means fewer people, these groups are usually less complex, as they have less need for a formal
hierarchy and instead have governance that is consensus-based. A diagram of such a small group might look
something like this, with each of the circles representing an individual member:

WHAT TYPE OF STRUCTURE SHOULD YOU CHOOSE?

First, decide upon the formality your organization will have. The following table, adapted from The Spirit of
Coalition Building can help you make this first decision.

Conditions favoring more or less formality in organizational structures

A looser, less formal, less A tighter, more formal, more

Condition rule bound structure would rule-bound structure would be
be favored when... favored when...

Stage of organization The organization is just The organization is in later

development starting stages of development

Prior relationships among Many such relationships Few such relationships already
members already exist exist

Prior member experience Many such experiences have Few such experiences have
in working together occurred occurred

Member motivation to be
Motivation is high Motivation is low
part of the organization

Number of organization
tasks or issues (broadness There is a single task or issue There are multiple tasks or issues
of purpose)

Organization size The organization is small The organization is large

Organization leadership The leadership is experienced The leadership is inexperienced

There is no particular urgency There is strong urgency to take

Urgency for action
to take action now action now

Organizational structure is something that is best decided upon internally, through a process of critical thinking
and discussion by members of the group.
In your discussions, your answers to the following list of questions may guide your decisions.
 What is your common purpose? How broad is it? Groups with broader purposes often have more
complicated structures, complete with many layers and parts, than do groups with more narrow
purposes.
 Is your group advocacy oriented or service oriented? Service organizations use "top down," one-person-
in-charge structure much more often than do advocacy based groups.
 Is your organization more centralized (e.g., through the work of a specific agency ) or decentralized
(e.g., different neighborhoods working independently on the same problem)? A decentralized group
might find a "top-down" structure inappropriate, as such a group often has several peers working
together on an issue.
 How large is your organization? How large do you envision it becoming? A very small organization
may wish to remain relatively informal, while a community-wide group might require a more formal
structure. A related question, with similar consequences, is:
 How large is the community in which you work?
 How old is your organization? How long do you envision it lasting? A group formed to resolve a single
issue might not need a formal structure at all, while an organization with long-term goals may want
something more concrete, with clearer divisional responsibilities and authority.
 Is the organization entirely volunteer, or are there (or will there be) paid staff? How many? An
organization with many paid staff members may find it more necessary to have people "in charge," as
there are generally more rules and responsibilities for paid staff members, and thus, there must be more
supervision in carrying out these roles.
 Should yours be a new organization, or part of an existing structure? Do you really need to form a new
structure, or would it be better to work within existing structures? Sometimes, your goals may be better
met if you are part of (or linked with) another organization.
IN SUMMARY
Structure is what ensures that your organization will function smoothly and as you intended. You should think
about structure early in the development of your organization, but be aware that the type that fits best may
change as your organization grows.
Contributor
Jenette Nagy
Online Resources
Designing and Developing the Organization, published on August 2008 by Business Excellence. This article
focuses on four key areas of the organizational design process, and also describes the procedures as well as
practices necessary to successfully design and develop a new organizational structure. The emphasis here is on
the corporate sector.
Designing an Effective Organization Structure, by the Bridgespan Group, January 2009. This is a useful,
concise resource that covers topics starting from five interrelated components of effective organization design to
guidelines for developing effective linkages. The primary focus of this manual is again on for-profit businesses.
How to Develop an Organization Structure, by Tara Duggan, Demand Media, is an informational article on
how to develop organization structure with a short step-by-step analysis.
It's All About the Base: A Guide to Building a Grassroots Organizing Program from Community Catalyst.
Module 2: Organizational Structure, by Pathfinder International, is a concise manual describing pros and
cons, together with suggestions for how one might change the organizational structure one has.
Print Resources
Berkowitz, W., & Wolff, T. (1999). The spirit of coalition building. Washington, DC: American Public Health
Association.
Unterman, I. & Davis, R. (1984). Strategic management of not-for-profit organizations: From survival to
success. New York, NY: Praeger.
Organizational Structure and Design C H A P T E R 5 Y ou might not have heard of Empire Company Limited,
but you’ve probably shopped at one of their Sobeys, Safeway, or IGA grocery stores. Empire is a Canadian
food-retailing and real estate company based in Stellarton, Nova Scotia, with more than $17 billion in annual
sales and more than 124 000 employees. Sobeys has been serving Canadians for over 100 years, and one of the
secrets to its competitive success is the synergy that comes from owning its own retail real estate. With a lofty
goal of being recognized as the best food retailer and workplace environment in Canada, Empire has moved
away from a regional management structure in order to reduce complexity and eliminate duplication. The
company streamlined its organizational structure to reflect its transition to an operationally focused grocery
retailer with related real estate interests on the heels of an October 2013 announcement appointing Marc Poulin
as CEO of both Empire Company Ltd. and Sobeys Inc.1 For Empire to be successful, the management structure
requires simplicity and clarity. What kind of organizational structure can support the operations of retail stores
and real estate assets? The CEO has a great deal of flexibility in determining some parts of the structure and less
flexibility in determining others. As a business with significant family ownership, Empire has been able to
pursue a longterm growth strategy rather than focusing on short-term financial results. Empire continues to
expand, adding gas stations from Shell Canada in 2014. In this chapter, we present information about designing
appropriate organizational structures. We look at the various elements of organizational structure and the factors
that influence their design. We also look at some traditional and contemporary organizational designs, as well as
organizational design challenges that today’s managers face. Felix Choo/Alamy PART 3 Organizing Think
About It How do you run retail stores and invest in real estate ventures? Put yourself in CEO Marc Poulin’s
shoes. How can you continue to make Empire successful? What organizational structure will best ensure
Empire’s goals? LEARNING OUTCOMES 5.1 Tell What are the major elements of organizational structure?
106 5.2 Define What factors affect organizational structure? 113 5.3 Describe Beyond traditional organizational
designs, how else can organizations be structured? 116 M05_ROBB6743_08_SE_C05.indd Page 105 9/24/15
4:52 PM user
/206/PHC00193/9780133856743_ROBBINS/ROBBINS_FUNDAMENTALS_OF_MANAGEMENT8_SE_97
8013 ... 106 PART 3 | Organizing Defining Organizational Structure No other topic in management has
undergone as much change in the past few years as that of organizing and organizational structure. Managers
are questioning and re-evaluating traditional approaches to organizing work in their search for organizational
structures that can achieve efficiency but also have the flexibility necessary for success in today’s dynamic
environment. Recall from Chapter 1 that organizing is defined as the process of creating an organization’s
structure. That process is important and serves many purposes (see Exhibit 5-1). The challenge for managers is
to design an organizational structure that allows employees to work effectively and efficiently. Just what is
organizational structure? It is how job tasks are formally divided, grouped, and coordinated within an
organization. When managers develop or change the structure, they are engaged in organizational design, a
process that involves decisions about six key elements: work specialization, departmentalization, chain of
command, span of control, centralization and decentralization, and formalization.2 Work Specialization Adam
Smith first identified division of labour and concluded that it contributed to increased employee productivity.
Early in the twentieth century, Henry Ford applied this concept in an assembly line, where every Ford employee
was assigned a specific, repetitive task. Today we use the term work specialization to describe the degree to
which tasks in an organization are subdivided into separate jobs. The essence of work specialization is that an
entire job is not done by one individual but instead is broken down into steps, and each step is completed by a
different person. Individual employees specialize in doing part of an activity rather than the entire activity.
When work specialization was implemented in the early twentieth century, employee productivity rose initially,
but when used to extreme, human diseconomies from work specialization—boredom, fatigue, stress, poor
quality, increased absenteeism, and higher turnover—more than offset the economic advantages. Most
managers today see work specialization as an important organizing mechanism but not as a source of ever-
increasing productivity. McDonald’s uses high work specialization to efficiently make and sell its products, and
employees have precisely defined roles and standardized work processes. However, other organizations, such as
Bolton, Ontario– based Husky Injection Molding Systems and Ford Australia, have successfully increased job
breadth and reduced work specialization. Still, specialization has its place in some organizations. No hockey
team has anyone play both goalie and centre positions. Rather, players tend to specialize in their positions.
organizing A management function that involves determining what tasks are to be done, who is to do them, how
the tasks are to be grouped, who reports to whom, and where decisions are to be made. organizational structure
How job tasks are formally divided, grouped, and coordinated within an organization. organizational design The
process of developing or changing an organization’s structure. work specialization The degree to which tasks in
an organization are subdivided into separate jobs; also known as division of labour. Tell What are the major
elements of organizational structure? 5.1 • Divides work to be done into specific jobs and departments • Assigns
tasks and responsibilities associated with individual jobs • Coordinates diverse organizational tasks • Clusters
jobs into units • Establishes relationships among individuals, groups, and departments • Establishes formal lines
of authority • Allocates and deploys organizational resources EXHIBIT 5-1 Purposes of Organizing
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8013 ... CHAPTER 5 | Organizational Structure and Design 107 Departmentalization Does your college or
university have an office of student affairs? A financial aid or student housing department? Once jobs have been
divided up through work specialization, they have to be grouped back together so that common tasks can be
coordinated. The basis on which jobs are grouped together is called departmentalization. Every organization
will have its own specific way of classifying and grouping work activities. Exhibit 5-2 shows the five common
forms of departmentalization. Functional departmentalization groups jobs by functions performed. This
approach can be used in all types of organizations, although the functions change to reflect the organization’s
purpose and work. Product departmentalization groups jobs by product line. In this approach, each major
product area is placed under the authority of a manager who is responsible for everything having to do with that
product line. For example, Estée Lauder sells lipstick, eyeshadow, blush, and a variety of other cosmetics
represented by different product lines. The company’s lines include Clinique and Origins, in addition to
Canadiancreated MAC Cosmetics and its own original line of Estée Lauder products, each of which operates as
a distinct company. Geographical departmentalization groups jobs on the basis of territory or geography, such
as the East Coast, Western Canada, or Central Ontario, or maybe by US, European, Latin American, and Asia–
Pacific regions. Process departmentalization groups jobs on the basis of product or customer flow. In this
approach, work activities follow a natural processing flow of products or even of customers. For example, many
beauty salons have separate employees for shampooing, colouring, and cutting hair, all different processes for
having one’s hair styled. Finally, customer departmentalization groups jobs on the basis of customers who have
common needs or problems that can best be met by having specialists for each. There are advantages to
matching departmentalization to customer needs. Large organizations often combine forms of
departmentalization. For example, a major Canadian photonics firm organizes each of its divisions along
functional lines: its manufacturing units around processes, its sales units around seven geographic regions, and
its sales regions into four customer groupings. Two popular trends in departmentalization are the use of
customer departmentalization and the use of cross-functional teams. Toronto-based Dell Canada is organized
around four customer-oriented business units: home and home office; small business; medium and large
business; and government, education, and health care. Customer-oriented structures enable companies to better
understand their customers and to respond faster to their needs. Managers use cross-functional teams—teams
made up of groups of individuals who are experts in various specialties and who work together—to increase
knowledge and understanding for some organizational tasks. Scarborough, Ontario–based Aviva Canada, a
leading property and casualty insurance group, puts together cross-functional catastrophe teams, with trained
representatives from all relevant departments, to more quickly help policyholders when a crisis occurs. During
the BC wildfires of summer 2003, the catastrophe team worked on both local and corporate issues, including
managing information technology, internal and external communication, tracking, resourcing, and vendors. This
type of organization made it easier to meet the needs of policyholders as quickly as possible.3 We discuss the
use of cross-functional teams more fully in Chapter 10. departmentalization The basis on which jobs are
grouped together. functional departmentalization Grouping jobs by functions performed. product
departmentalization Grouping jobs by product line. geographical departmentalization Grouping jobs on the
basis of territory or geography. process departmentalization Grouping jobs on the basis of product or customer
flow. customer departmentalization Grouping jobs on the basis of customers who have common needs or
problems. cross-functional teams Work teams made up of individuals who are experts in various functional
specialties. Burnaby, British Columbia–based TELUS is structured around four customer-oriented business
units to improve customer response times: consumer solutions (focused on services to homes and individuals);
business solutions (focused on services to small and medium-sized businesses and entrepreneurs); TELUS
Québec (a TELUS company focused on services for the Quebec marketplace); and partner solutions (focused on
services to wholesale customers, such as telecommunications carriers and wireless communications companies).
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8013 ... 108 PART 3 | Organizing EXHIBIT 5-2 The Five Common Forms of Departmentalization Manager,
Manufacturing Efficiencies from putting together similar specialties and people with common skills,
knowledge, and orientations Coordination within functional area In-depth specialization Poor communication
across functional areas Limited view of organizational goals + + + – – Manager, Human Resources Manager,
Accounting Manager, Engineering Manager, Purchasing Functional Departmentalization More effective and
efficient handling of specific regional issues that arise Better service of needs of unique geographic markets
Duplication of functions Feelings of isolation from other organizational areas possible + + – – Sales Director,
Central Region Sales Director, Prairies Region Sales Director, Western Region Sales Director, Eastern Region
Geographical Departmentalization Specialization in particular products and services possible Managers able to
become experts in their industry Closer to customers Duplication of functions Limited view of organizational
goals + + + – – Bombardier Transportation Bombardier Aerospace Commercial Aircraft Regional Aircraft
Business Aircraft Amphibious Aircraft Flexjet Skyjet Rail Vehicles Total Transit Systems Propulsion and
Controls Services Retail Control Solutions Bogies Product Departmentalization Source: Bombardier Annual
Report More efficient flow of work activities Use possible only with certain types of products + – Sawing
Department Manager Planing and Milling Department Manager Assembling Department Manager Lacquering
and Sanding Department Manager Finishing Department Manager Inspection and Shipping Department
Manager Process Departmentalization Specialists able to meet customers’ needs and problems Duplication of
functions Limited view of organizational goals + – – Manager, Wholesale Accounts Manager, Retail Accounts
Manager, Government Accounts Customer Departmentalization Plant Manager Vice-President for Sales
Bombardier Plant Superintendent Director of Sales Military Aviation Training
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8013 ... CHAPTER 5 | Organizational Structure and Design 109 Chain of Command The chain of command is
the continuous line of authority that extends from upper organizational levels to the lowest levels and clarifies
who reports to whom. It helps employees answer questions such as “Who do I go to if I have a problem?” or
“To whom am I responsible?” You cannot discuss the chain of command without discussing these other
concepts: authority, responsibility, accountability, unity of command, and delegation. Authority refers to the
rights inherent in a managerial position to tell people what to do and to expect them to do it.4 To facilitate
decision making and coordination, an organization’s managers are part of the chain of command and are
granted a certain degree of authority to meet their responsibilities. As managers coordinate and integrate the
work of employees, those employees assume an obligation to perform any assigned duties. This obligation or
expectation to perform is known as responsibility. Responsibility brings with it accountability, which is the
need to report and justify work to a manager’s superiors. Sobeys maintains an environmental scorecard where it
tracks its performance on environmental pledges such as reducing greenhouse gas emissions by 15 percent,
reducing landfill waste by 30 percent, and selling only sustainable seafood products. The unity of command
principle helps preserve the concept of a continuous line of authority. It states that every employee should
receive orders from only one superior. Without unity of command, conflicting demands and priorities from
multiple managers can create problems. Because managers have limited time and knowledge, they may delegate
some of their responsibilities to other employees. Delegation is the assignment of authority to another person to
carry out specific duties, allowing the employee to make some of the decisions. Delegation is an important part
of a manager’s job, as it can ensure that the right people are part of the decision-making process. Hey, You’re
the Boss Now—Delegating 101 gives more tips on how to do a better job of delegating. These concepts are far
less important today. For example, at the Michelin plant in Tours, France, managers have replaced the top-down
chain of command with “birdhouse” meetings, in which employees meet for five minutes at regular intervals
throughout the day at a column on the shop floor to study simple tables and charts to identify production
bottlenecks. Instead of being bosses, shop managers are enablers.5 In addition, information technology has
provided employees with immediate access to information instead of waiting to hear from someone higher up in
the chain of command. Line and Staff Authority In many organizations, a distinction can be made between line
and staff authority. Line managers are responsible for the essential activities of the organization, including
production and sales. Line managers have the authority to issue orders to those in the chain of command. The
president, the production manager, and the sales manager are examples of line managers. Staff managers work
in the supporting activities of the organizations, such as human resources or accounting. Staff managers have
advisory authority and cannot issue orders to those in the chain of command (except those in their own
department). The vice-president of chain of command The continuous line of authority that extends from the top
of the organization to the lowest level and clarifies who reports to whom. authority The rights inherent in a
managerial position to tell people what to do and to expect them to do it. responsibility The obligation or
expectation to perform any assigned duties. accountability The need to report and justify work to a manager’s
superiors. unity of command The management principle that states every employee should receive orders from
only one superior. delegation The assignment of authority to another person to carry out specific duties,
allowing the employee to make some of the decisions. line managers Managers responsible for the essential
activities of the organization, including production and sales. staff managers Managers who work in the
supporting activities of the organizations (such as human resources or accounting).
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8013 ... 110 PART 3 | Organizing accounting, the human resources manager, and the marketing research
manager are examples of staff managers. Matthew Malek, Manager of Talent Management and Organizational
Development at Empire Company Limited, may have recommendations about potential real estate
opportunities, but CEO Marc Poulin is likely more interested in Malek’s advice about managing employees.
Span of Control How many employees can a manager efficiently and effectively manage? This question of span
of control is important because, to a large degree, it determines the number of levels and managers an
organization needs. All things being equal, the wider or larger the span, the more efficient the organization. An
example can show why. Assume that we have two organizations, both of which have 64 employees. As Exhibit
5-3 shows, if one organization has a uniform span of four and the other a span of eight, the wider span will have
one fewer level and approximately 12 fewer managers. If the average manager made $50 000 a year, the
organization with the wider span would save more than $600 000 a year in management salaries alone.
Obviously, wider spans are more efficient in terms of cost. However, at some point, wider spans reduce
effectiveness. When the span becomes too large, employee performance can suffer because managers may no
longer have the time to provide the necessary leadership and support. The top performing manufacturing plants
have up to 40 production workers per supervisor.6 In a large call centre, that number can be as high as 50
customer service representatives per supervisor. Today’s View The contemporary view of span of control
recognizes that many factors influence the appropriate number of employees a manager can efficiently and
effectively manage. These factors include the skills and abilities of the manager and the employees, and the
characteristics of the work being done. For example, the more training and experience employees have, the less
direct supervision they need. Therefore, managers with well-trained and experienced employees can function
quite well with a wider span. Other contingency variables that determine the appropriate span include similarity
of employee tasks, the complexity of those tasks, the physical proximity of subordinates, the degree to which
standardized procedures are in place, the sophistication of the organization’s information system, EXHIBIT 5-3
Contrasting Spans of Control Assuming Span of 4 Span of 4: Employees: Managers (levels 1–3) = 64 = 21 Span
of 8: Employees: Managers (levels 1–2) = 64 = 9 (Highest) Assuming Span of 8 Organizational Level (Lowest)
Members at Each Level 1 4 16 64 1 8 64 1 2 3 4 span of control The number of employees a manager can
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8013 ... CHAPTER 5 | Organizational Structure and Design 111 the strength of the organization’s culture, and
the preferred style of the manager.7 Wider spans of control are also possible due to technology—it is easier for
managers and their subordinates to communicate with each other, and there is often more information readily
available to help employees perform their jobs. The trend in recent years has been toward larger spans of
control, which are consistent with managers’ efforts to reduce costs, speed up decision making, increase
flexibility, get closer to customers, and empower employees. However, to ensure that performance does not
suffer because of these wider spans, organizations are investing heavily in employee training. Managers
recognize that they can handle a wider span when employees know their jobs well or can turn to coworkers if
they have questions. Centralization and Decentralization In some organizations, top managers make all the
decisions and lower-level managers and employees simply carry out their orders. At the other extreme are
organizations in which decision making is pushed down to the managers who are closest to the action. The
former organizations are centralized, and the latter are decentralized. Centralization describes the degree to
which decision making is concentrated at a single point in the organization. If top managers make the
organization’s key decisions with little or no input from below, then the organization is centralized. In contrast,
the more that lower-level employees provide input or actually make decisions, the more decentralization there
is. Keep in mind that the concept of centralization/decentralization is relative, not absolute—an organization is
never completely centralized or decentralized. Few organizations could function effectively if all decisions were
made by only a select group of top managers; nor could they function if all decisions were delegated to
employees at the lowest levels. Nestlé uses decentralized marketing with centralized production, logistics, and
supply chain management.8 Today’s View Most organizations start with a centralized model, where a founder
makes all the decisions. As the businesses grow and diversify their environments become complex. These
businesses need to become more flexible and responsive, resulting in decentralized decision making. In large
companies especially, lower-level managers are “closer to the action” and typically have more detailed
knowledge about problems and how best to solve them than do top managers. For example, the Bank of
Montreal’s some 1000 branches are organized into “communities”—a group of branches within a limited
geographical area. Each community is led by a community area manager, who typically works within a 20-
minute drive of the other branches. This area manager can respond faster and more intelligently to problems in
his or her community than could a senior executive in Toronto. Another term for increased decentralization is
employee empowerment, which means giving more decision-making authority to employees. centralization The
degree to which decision making is concentrated at a single point in the organization. decentralization The
degree to which lower-level employees provide input or actually make decisions. employee empowerment
Giving more authority to employees to make decisions. Kingsey Falls, Quebec–based Cascades, a leading
manufacturer of packaging products and tissue paper, uses decentralization effectively with more than 100
operating units located in Canada, the United States, and Europe.9 Companies are treated as separate entities,
based on product, and operate like a federation of small and medium-sized businesses. Each mill is accountable
for its own bottom line, and employees are motivated through profit sharing in the profits generated by their
own mill. The emphasis on decentralized, entrepreneurial management has been copied by other Canadian
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8013 ... 112 PART 3 | Organizing What determines whether an organization will move toward more
centralization or decentralization? Companies facing dynamic environments are more likely to need to adapt
quickly to change, and thus decentralize decision making. Stable environments allow for more rules and
procedures, so decision making can be centralized more easily. A community college with one location is more
likely to be centralized, while a college in a major metropolitan area with five campuses might treat each of the
campuses as a separate unit and decentralize decision making to support a more complex environment.
Formalization Formalization refers to the degree to which jobs within the organization are standardized and the
extent to which employee behaviour is guided by rules and procedures. If a job is highly formalized, the person
doing that job has little freedom to choose what is to be done, when it is to be done, and how he or she does it.
Employees can be expected to handle the same input in exactly the same way, resulting in consistent and
uniform output. Organizations with high formalization have explicit job descriptions, numerous organizational
rules, and clearly defined procedures covering work processes. On the other hand, where formalization is low,
job behaviours are relatively unstructured, and employees have a great deal of freedom in how they do their
work. The degree of formalization varies widely among organizations and even within organizations. For
example, at a newspaper, news reporters often have a great deal of discretion in their jobs. They may pick their
news topics, find their own stories, research them the way they want to, and write them up, usually within
minimal guidelines. In contrast, employees who lay out the newspaper pages do not have that type of freedom.
They have constraints—both time and space—that standardize how they do their work. Today’s View Although
some formalization is important and necessary for consistency and control, many of today’s organizations seem
to be less reliant on strict rules and standardization to guide and regulate employee behaviour. Consider the
following situation: It is 2:37 p.m. and a customer at a watch repair store is trying to drop off a watch for same-
day repair. Store policy states that items must be dropped off by 2:00 p.m. for this service. The clerk knows that
rules like this are supposed to be followed. At the same time, he wants to accommodate the customer, and he
knows that the watch could, in fact, be repaired that day. He decides to accept the watch and, by so doing, to
violate the policy. He just hopes that his manager does not find out.10 Has this employee done something
wrong? He did “break” the rule. But by breaking the rule, he actually brought in revenue and provided the
customer good service— so good, in fact, that the customer may be satisfied enough to come back in the future.
Because such situations where rules may be too restrictive frequently arise, many organizations allow
employees some freedom to make decisions they feel are best under the circumstances. However, this freedom
does not mean that all organizational rules are thrown out the window. There will be rules that are important for
employees to follow, and these rules should be explained so employees understand the importance of adhering
to them. But for other rules, employees may be given some leeway in application.11 formalization The degree
to which jobs within the organization are standardized and the extent to which employee behaviour is guided by
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8013 ... EXHIBIT 5-4 Mechanistic Versus Organic Organizations ORGANIC Collaboration (both vertical and
horizontal) Adaptable duties Few rules Informal communication Decentralized decision authority Flatter
structures Rigid hierarchical relationships Fixed duties Many rules Formalized communication channels
Centralized decision authority Taller structures MECHANISTIC If these are the contingency factors, then this
is the most appropriate structure. What Contingency Variables Affect Structural Choice? Define What factors
affect organizational structure? 5.2 Identify the contingency factors that favour either the mechanistic model or
the organic model of organizational design. 113 John Cogill/AP Images M05_ROBB6743_08_SE_C05.indd
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8013 ... Organic organization • Highly adaptive and flexible structure ▪ Collaboration (both vertical and
horizontal) ▪ Adaptable duties ▪ Few rules ▪ Informal communication ▪ Decentralized decision authority ▪ Wider
spans of control leading to flatter structures 1 The “If”: Contingency Variables MECHANISTIC ORGANIC
Mechanistic or Organic12 Mechanistic organization (or bureaucracy) • Rigid and tightly controlled structure •
Combines traditional aspects of all six elements or organizational structure: ▪ High specialization ▪ Rigid
departmentalization ▪ Clear chain of command ▪ Narrow spans of control leading to taller structure ▪
Centralization ▪ High formalization • Loose structure allows for rapid adjustment to change13 Strategy—
Structure • Based on work of Alfred Chandler14 • Goals are important part of organization’s strategies;
structure should facilitate goal achievement • Simple strategy ➛ simple structure • Elaborate strategy ➛ more
complex structure • Certain structural designs work best with different organizational strategies15 ▪ Passionate
pursuit of innovation ➛ organic ▪ Passionate pursuit of cost control ➛ mechanistic Photo-K/fotolia mechanistic
organization An organization that is rigid and tightly controlled. organic organization An organization that is
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8013 ... 3 4 Technology—Structure • Technology is used—by every organization—to convert inputs into
outputs (see Exhibit 5-5) Environment—Structure • Environment is a constraint on managerial discretion •
Environment also has a major effect on an organization’s structure ▪ Stable environment: mechanistic structure ▪
Dynamic/uncertain environment: organic structure ▪ Helps explain why so many managers today have
restructured their organizations to be lean, fast, and flexible17 UNIT PRODUCTION MASS PRODUCTION
PROCESS PRODUCTION Structural characteristics: Low vertical differentiation Moderate vertical
differentiation High vertical differentiation Low horizontal differentiation High horizontal differentiation Low
horizontal differentiation Low formalization High formalization Low formalization Most effective structure:
Organic Mechanistic Organic EXHIBIT 5-5 Woodward’s Findings on Technology and Structure 2 Size—
Structure • Considerable evidence that size (number of employees) affects structure16 • Magic number seems to
be 2000 employees • Large organizations (>2000 employees)—mechanistic • When an organization reaches this
number, size is less influential; adding more employees has little impact as structure is already fairly
mechanistic MECHANISTIC ORGANIC Adding a significant number of new employees to a smaller
organization that has a more organic structure will force it to become more mechanistic 115 TAlex/fotolia
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8013 ... 116 PART 3 | Organizing Common Organizational Designs What types of organizational designs exist
in small businesses or in big companies such as Ford Canada, Corel, McCain Foods, Procter & Gamble, and
eBay? When making organizational design decisions, managers can choose from traditional organizational
designs and contemporary organizational designs. Traditional Organizational Designs In designing a structure
to support the efficient and effective accomplishment of organizational goals, managers may choose to follow
more traditional organizational designs. These designs—the simple structure, functional structure, and
divisional structure—tend to be more mechanistic. Exhibit 5-6 summarizes the strengths and weaknesses of
each design. Simple Structure Most organizations start as entrepreneurial ventures with a simple structure
consisting of owners and employees. A simple structure is an organizational structure with low
departmentalization, wide spans of control, authority centralized in a single person, and little formalization.18
This structure is most commonly used by small businesses in which the owner and manager are one and the
same. Most organizations do not remain simple structures. As an organization grows, it generally reaches a
point where it has to add employees. As the number of employees rises, the structure tends to become more
specialized and formalized. Rules and regulations are introduced, work becomes specialized, departments are
created, levels of management are added, and the organization becomes increasingly bureaucratic. At this point,
a manager might choose to organize around a functional structure or a divisional structure. Functional Structure
A functional structure is an organizational structure that groups similar or related occupational specialties
together. It is the functional approach to departmentalization applied to the entire organization. Revlon, for
example, is organized around the functions of operations, finance, human resources, and product research and
development. Divisional Structure The divisional structure is an organizational structure that consists of
separate business units or divisions.19 In this structure, each unit or division has EXHIBIT 5-6 Strengths and
Weaknesses of Common Traditional Organizational Designs Structure Strengths Weaknesses Simple Structure
Fast; flexible; inexpensive to maintain; clear accountability Not appropriate as organization grows; reliance on
one person is risky Functional Structure Cost-saving advantages from specialization (economies of scale,
minimal duplication of people and equipment), and employees are grouped with others who have similar tasks
Pursuit of functional goals can cause managers to lose sight of what is best for the overall organization;
functional specialists become insulated and have little understanding of what other units are doing Divisional
Structure Focuses on results—division managers are responsible for what happens to their products and services
Duplication of activities and resources increases costs and reduces efficiency simple structure An organizational
structure with low departmentalization, wide spans of control, authority centralized in a single person, and little
formalization. functional structure An organizational structure that groups similar or related occupational
specialties together. divisional structure An organizational structure that consists of separate business units or
divisions. Describe Beyond traditional organizational designs, how else can organizations be structured? 5.3
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8013 ... CHAPTER 5 | Organizational Structure and Design 117 relatively limited autonomy, with a division
manager responsible for performance who has strategic and operational authority over his or her unit. In
divisional structures, however, the parent corporation typically acts as an external overseer to coordinate and
control the various divisions, and often provides support services such as financial and legal. For example,
Maple Leaf Sports & Entertainment has three divisions, including two sports teams, the Raptors and the Maple
Leafs. Contemporary Organizational Designs Managers in contemporary organizations often find that
traditional hierarchical designs are not appropriate for the increasingly dynamic and complex environments they
face. In response to marketplace demands to be lean, flexible, and innovative, managers are developing creative
ways to structure and organize work and to make their organizations more responsive to the needs of customers,
employees, and other organizational constituents.20 At the Canada Revenue Agency, the workforce is spread
out, and employees rely on shared workspaces, mobile computing, and virtual private networks to get work
done. Nevertheless, work gets done effectively and efficiently.21 Exhibit 5-7 summarizes some of the newest
concepts in organizational designs. Team Structure Larry Page and Sergey Brin, cofounders of Google, have
created a corporate structure that “tackles most big projects in small, tightly focused teams.”22 In a team
structure, the entire organization is made up of work groups or teams that perform the organization’s work.23
Employee empowerment is crucial in a team structure, because there is no line of managerial authority from top
to bottom. Rather, employee teams are free to design work in the way they think is best. However, the teams are
also held responsible for all work and performance results in their respective areas. Let us look at some
examples of organizations that are organized around teams. EXHIBIT 5-7 Contemporary Organizational
Designs Structure Description Advantages Disadvantages Team A structure in which the entire organization is
made up of work groups or teams. Employees are more involved and empowered. Reduced barriers among
functional areas. No clear chain of command. Pressure on teams to perform. Matrix–Project Matrix is a
structure that assigns specialists from different functional areas to work on projects but who return to their areas
when the project is completed. Project is a structure in which employees continuously work on projects. As one
project is completed, employees move on to the next project. Fluid and flexible design that can respond to
environmental changes. Faster decision making. Complexity of assigning people to projects. Task and
personality conflicts. Boundaryless A structure that is not defined by or limited to artificial horizontal, vertical,
or external boundaries; includes virtual and networked types of organizations. Highly flexible and responsive.
Draws on talent wherever it is found. Lack of control. Communication difficulties. team structure An
organizational structure in which the entire organization is made up of work groups or teams.
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8013 ... 118 PART 3 | Organizing Whole Foods Market, the largest natural-foods grocer in the United States,
now has nine stores in Ontario and British Columbia. Each Whole Foods store is an autonomous profit centre
composed of an average of 10 self-managed teams, each with a designated team leader. The team leaders in
each store are a team; store leaders in each region are a team; and the company’s six regional presidents are a
team.24 At the Sun Life Assurance Company of Canada (US) office in Wellesley Hills, Massachusetts,
customer representatives work in eight-person teams trained to expedite all customer requests. When customers
call in, they are not switched from one specialist to another, but to one of the teams, who takes care of every
aspect of the customer’s request. Together, team members work to make resolving insurance difficulties go
much smoother. In large organizations, the team structure complements what is typically a functional or
divisional structure. This structural addition enables the organization to have the efficiency of a bureaucracy
while providing the flexibility that teams provide. To improve productivity at the operating level, for example,
Toyota’s CAPTIN plant (based in Delta, British Columbia), Motorola, and Xerox use self-managed teams
extensively.25 Matrix and Project Structures Other popular contemporary designs are the matrix and project
structures. The matrix structure is an organizational structure that assigns specialists from different functional
departments to work on one or more projects led by project managers. Once a project is completed, the
specialists return to their functional departments. Exhibit 5-8 shows an example of the matrix structure used
in an aerospace firm. Along the top are the familiar organizational functions. The specific projects the firm is
currently working on are listed along the left-hand side: aircraft, mission systems and avionics, engines and
parts, and space technologies. Each project is managed by an individual who staffs his or her project with
people from each of the functional departments. Adding this vertical dimension to the traditional horizontal
functional departments in effect “weaves together” elements of functional and product departmentalization,
creating a matrix arrangement. Another unique aspect of this design is that it creates a dual chain of command,
which explicitly violates the classical organizing principle of unity of command. How does a matrix structure
work in reality? Employees in a matrix organization have two managers: their functional department manager
and their product or project EXHIBIT 5-8 A Matrix of Organization in an Aerospace Firm Design Engineering
Manufacturing Contract Administration Purchasing Accounting Human Resources (HR) Design Group
Manufacturing Group Contract Group Purchasing Group Accounting Group HR Group Design Group Aircraft
Mission Systems and Avionics Engines and Parts Space Technologies Manufacturing Group Contract Group
Purchasing Group Accounting Group HR Group Design Group Manufacturing Group Contract Group
Purchasing Group Accounting Group HR Group Design Group Manufacturing Group Contract Group
Purchasing Group Accounting Group HR Group matrix structure An organizational structure that assigns
specialists from different functional departments to work on one or more projects.
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8013 ... CHAPTER 5 | Organizational Structure and Design 119 manager, who share authority. The project
managers have authority over the functional members who are part of their project team in areas relative to the
project’s goals. However, decisions such as promotions, salary recommendations, and annual reviews remain
the functional manager’s responsibility. To work effectively, project and functional managers have to
communicate regularly, coordinate work demands on employees, and resolve conflicts together. Although the
matrix structure continues to be an effective organizational structure choice for some organizations, many are
using a project structure, in which employees continuously work on projects. Unlike the matrix structure, a
project structure has no formal departments that employees return to at the completion of a project. Instead,
employees take their specific skills, abilities, and experiences to other projects. All work in project-structured
organizations is performed by teams of employees who become part of a project team because they have the
appropriate work skills and abilities. Project structures tend to be fluid and flexible organizational designs. This
type of structure has no departmentalization or rigid organizational hierarchy to slow down decision making or
taking action. Managers act as facilitators, mentors, and coaches. They “serve” the project teams by eliminating
or minimizing organizational obstacles and by ensuring that the teams have the resources they need to
effectively and efficiently complete their work. Boundaryless Organizations Another approach to
contemporary organizational design is the boundaryless organization, an organization whose design is not
determined by a predefined structure. Instead the organization seeks to eliminate the chain of command, places
no limits on spans of control, and replaces departments with empowered teams.27 The term boundaryless
organization was coined by Jack Welch, former chair of General Electric (GE), who wanted to eliminate
vertical and horizontal boundaries within GE and break down external barriers between the company and its
customers and suppliers. This idea may sound odd, but many successful organizations are finding they can
operate more effectively in today’s environment by remaining flexible and unstructured: The ideal structure for
them is not having a rigid, predefined structure. Instead, the boundaryless organization seeks to eliminate the
chain of command, to have limitless spans of control, and to replace departments with empowered teams.28
What do we mean by “boundaries”? A typical organization has internal boundaries— horizontal boundaries
imposed by work specialization and departmentalization, and vertical boundaries created by separating
employees into organizational levels and hierarchies. The organization also has external boundaries, which
separate the organization from its customers, suppliers, and other stakeholders. To minimize or eliminate these
boundaries, managers might use virtual or network organizational structures. How does a boundaryless
organization operate in practice? General Electric is made up of a number of companies, including GE Money,
which provides financial services to consumers and retailers; GE Water & Process Technologies, which
produces water treatment, wastewater treatment, and process systems products; GE Energy, which supplies
technology to the energy industry; and NBC Universal Studios, a leading media and entertainment company.
Anyone working in any division of GE can learn about opportunities available in the other business units and
how to move into those units, if so desired. Mobility is one way a boundaryless organization functions for its
employees. Outside the company, the boundaryless structure allows GE customers to ask factories to increase
inventory when the customer needs more product. Thus, the customer makes a decision about inventory that
was once made inside the organization. GE also encourages customers and suppliers to evaluate its service
levels, giving direct and immediate feedback to employees. project structure An organizational structure in
which employees continuously work on projects. boundaryless organization An organization that is not defined
by a chain of command, places no limits on spans of control, and replaces departments with empowered teams.
Sergey Nivens/Fotolia Oticon A/S, a Danish hearing-aid manufacturer, has no departments or employee job
titles. All work is project based, and project teams form, disband, and form again as the work requires.
Employees “join” project teams because they bring needed skills and abilities to that project. Once the project is
completed, they move on to the next one.26 Echo/Getty Images M05_ROBB6743_08_SE_C05.indd Page 119
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8013 ... 120 PART 3 | Organizing Virtual Organizations A virtual organization has elements of a traditional
organization, but also relies on recent developments in information technology to get work done.29 Thus, the
organization could consist of a small core of full-time employees plus outside specialists hired on a temporary
basis to work on opportunities that arise.30 The virtual organization could also be composed of employees who
work from their own home offices—connected by technology but perhaps occasionally getting together face to
face. An example of a virtual organization is Strawberry Frog, an international advertising agency based in
Amsterdam. The small administrative staff accesses a network of more than 100 people around the globe to
complete advertising projects. By relying on this global web of freelancers, the company enjoys a network of
talent without the overhead and structural complexity of a more traditional organization. The inspiration for
virtual organizations comes from the film industry. If you look at the film industry, people are essentially “free
agents” who move from project to project applying their skills—directing, talent search, costuming, makeup, set
design—as needed. Some organizations are now testing out a new form of virtuality, using the virtual online
world Second Life to create a different type of organization. Vancouver-based Davis LLP is the first Canadian
law firm to have a presence in Second Life. 31 Lawyer Dani Lemon, whose online avatar (the digital version of
a real person) is Lemon Darcy, said that “the online world gives [Davis LLP] an opportunity to interact with
clients and meet new ones who are comfortable in that setting.” Lemon believes that being part of Second Life
will bring new clients to Davis and give the company an opportunity to communicate in new ways. Several of
her colleagues have joined her in this virtual office, including Sarah Dale-Harris (BarristerSolicitor
Underwood), Pablo Guzman (PabloGuzman Little), Chris Bennett (IPand Teichmann), David Spratley (DaveS
Blackadder), and Chris Metcalfe (IP Maximus). Davis LLP’s Second City office has a boardroom off the lobby
that can be used for online conferences, a room containing recruiting information from Davis, and a library that
will house online legal information. “I think it will be an evolving process,” Lemon said of the online office.
“We will use it as a networking tool and as a way to meet clients.”32 The law firm plans to hold online events
in Second Life, conduct seminars, and give talks that might be of value to potential clients. Network
Organizations Another structural option for managers wanting to minimize or eliminate organizational
boundaries is the network organization, which is a small core organization that outsources major business
functions.33 This approach allows organizations to concentrate on what they do best and to contract out other
activities to companies that specialize in those activities. Many large organizations use the network structure to
outsource manufacturing. While many companies use outsourcing, not all are successful at it. Managers should
be aware of some of the problems involved in outsourcing, such as the following: • choosing the wrong
activities to outsource • choosing the wrong vendor • writing a poor contract • failing to consider personnel
issues • losing control over the activity New Westminster, British Columbia–based iGEN Knowledge Solutions
uses its virtual form to bring technical solutions to its business clients. iGEN associates work from home offices
connected by wireless technologies to solve client problems collaboratively. This structure allows faster idea
implementation, product development, and service delivery. The company finds it easy to set up operations in
different regions of the country without large overhead costs because of its virtual structure. virtual organization
An organization that has elements of a traditional organization, but also relies on recent developments in
information technology to get work done. network organization A small core organization that outsources major
business functions. Companies such as Cisco Systems, Nike, Ericsson, Reebok, and Mitel have found that they
can do business worth hundreds of millions of dollars without owning manufacturing facilities. San Jose,
California–based Cisco Systems is essentially a research and development company that uses outside suppliers
and independent manufacturers to assemble the Internet routers its engineers design. Similarly, Beaverton,
Oregon–based Nike is a product development and marketing company that contracts with outside organizations
to manufacture its athletic footwear. Ottawa-based Mitel Networks designs computer equipment but outsources
manufacturing and repair to BreconRidge, another Ottawa high tech firm.34 vichie81/Fotolia Syda
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8013 ... CHAPTER 5 | Organizational Structure and Design 121 • ignoring the hidden costs • failing to develop
an exit strategy (for either moving to another vendor or deciding to bring the activity back in-house) A review
of 91 outsourcing activities found that the two most likely reasons for an outsourcing venture failure were
writing a poor contract and losing control of the activity.35 Canadian managers say they are reluctant to
outsource.36 The PricewaterhouseCoopers (PwC) 2011 Business Insights survey37 showed outsourcing as the
lowest priority in terms of improving the competitiveness of Canadian businesses, while innovation and
reducing costs were perceived as more important than outsourcing for dealing with volatility. In some cases,
companies formerly used as outsourcers are now direct competitors due to globalization. Organizational Design
Challenges As managers look for organizational designs that will best support and facilitate employees doing
their work efficiently and effectively in today’s dynamic environment, certain challenges arise with which they
must contend. These challenges include designing office space, keeping employees connected, building a
learning organization, and managing global structural issues. Designing Office Space Office space has always
been a battle between freeing employees to work and maximizing space to minimize costs (see Exhibit 5-9). In
the early 1900s, Frederick Taylor suggested that properly organized offices would boost productivity. In 1964,
Herman Miller designed the Action Office, with clusters of barrier-free offices. Openness and proximity were
meant to break down barriers and encourage “meaningful traffic”. When the furniture was reduced in size and
interlocked a few years later, the Action Office really took off.38 The Cube Farm was the next phase as
furniture firms were imitating Miller’s design and using cheaper materials to make mass cubicles. Today’s
office spaces are collaborative, accommodating virtual workers with group spaces to engineer interaction and
foster creativity. International design firm Gensler conducted a study EXHIBIT 5-9 Comparison of the Major
Office Styles Office Style Space/Cost What They Got Right What They Got Wrong The Action Office (1960s–
70s) Average space per employee 500 sq ft $22/sq ft (Toronto) • Flexibility for employers to choose elements •
Well-designed desk spaces gave better access to tools and resources • High-quality components were very
expensive • Open environment was noisy and distracting The Cube Farm (1980s–90s) Average space per
employee 144 sq ft $40/sq ft (Toronto) • Cubes offered some privacy and the ability to personalize • Businesses
found cubicles flexible and affordable • Quarters became cramped • Bad air and artificial light left workers
unmotivated and anxious to leave • “Prairie-dogging,” or the tendency of workers to pop their heads up to
communicate with others The Collaborative Office (present) Average space per employee 176 sq ft $68/sq ft
(Toronto) • Open designs encourage interaction • Workers can adapt to the environment that is best for them •
Smaller footprint equals lower costs • Open-concept offices distract from the ability to be deep in focus • Less
efficiency in shared spaces Source: Adapted from Steve Brearton, “Circles and Squares,” Canadian Business,
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8013 ... 122 PART 3 | Organizing in 2013 that found workers spent about one-quarter of their workday
collaborating and more than half in deep focus. That means employers need to provide office environments that
facilitate interaction while allowing freedom from interruption.39 Keeping Employees Connected Many
organizational design concepts were developed during the twentieth century, when work tasks were fairly
predictable and constant, most jobs were full-time and continued indefinitely, and work was done at an
employer’s place of business under a manager’s supervision.41 However, many organizations today are not like
that, as you saw in our preceding discussion of virtual and network organizations. A major structural design
challenge for managers is finding a way to keep widely dispersed and mobile employees connected to the
organization. We cover information on motivating these employees in Chapter 9. Building a Learning
Organization Doing business in an intensely competitive global environment, managers at British retailer Tesco
realize how important it is for stores to operate smoothly behind the scenes. At Tesco, they do so through the
use of a proven tool—a set of software applications called Tesco in a Box, which promotes consistency in
operations and acts as a way to share innovations. Tesco is an example of a learning organization, an
organization that has developed the capacity to constantly learn, adapt, and change.42 In a learning
organization, employees continually acquire and share new knowledge and apply that knowledge in making
decisions or doing their work. Some organizational theorists even go so far as to say that an organization’s
ability to learn and to apply that learning may be the only sustainable source of competitive advantage.43 What
structural characteristics does a learning organization need? First, members of a learning organization must be
able to share information and collaborate on work activities throughout the entire organization—across different
functional specialties and even at different organizational levels. This sharing and collaboration requires that
structural and physical barriers be minimal. In such a boundaryless environment, employees can work together
and collaborate in doing the organization’s work the best way they can and learn from each other. Second,
because of the need to collaborate, teams tend to be an important feature of a learning organization’s structural
design. Employees work in teams empowered to make decisions about doing whatever work needs to be done
and to resolve issues. With empowered employees and teams, the organization has little need for “bosses” to
direct and control. Instead, managers serve as facilitators, supporters, and advocates. Managing Global
Structural Issues Are there global differences in organizational structures? Are Australian organizations
structured like those in Canada? Are German organizations structured like those in France or Mexico? Given
the global nature of today’s business environment, managers need to be familiar with the issues surrounding
structural differences. Researchers have concluded that the structures and strategies of organizations worldwide
are similar, “while the behavior within them is maintaining its cultural uniqueness.”44 What does this mean for
designing effective and efficient structures? When designing or changing structure, managers may need to think
about the cultural implications of certain design elements. One study showed that formalization—rules and
bureaucratic mechanisms—may be more important in less economically developed countries and less important
in more economically developed countries, where employees may have higher levels of professional education
and skills.45 Other structural design elements may be affected by cultural differences as well, such as chain of
command and span of control. A Final Thought No matter what structural design managers choose for their
organization, the structure should help employees work in the most efficient and effective way possible to meet
the organization’s goals. After all, structure is simply a means to an end. To understand your reaction to
organizational structure, see at the end of the chapter. And the Survey Says... 40 8%of companies surveyed have
more than 40 percent of their employees working virtually. 44 % of employees say their top gripe about
working from home is not having face-to-face interaction. 29%of employees are called “any time, anywhere.”
20% of employees have “nonstandard” jobs (work fewer than 35 hours a week, independent contractors, day
labourers, etc.). 12%of respondents to a global workforce survey said that telecommuting was extremely
important to them. 81%of employers offer some form of flexible work arrangements. 37%of employees work
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8013 ... CHAPTER 5 | Organizational Structure and Design 123 Summary of Learning Outcomes 5 Review
and Apply 5.1 What are the major elements of organizational structure? Organizational structure is the formal
arrangement of jobs within an organization. Organizational structures are determined by six key elements: work
specialization, departmentalization, chain of command, span of control, centralization and decentralization, and
formalization. Decisions made about these elements define how work is organized; how many employees
managers supervise; where in the organization decisions are made; and whether employees follow standardized
operating procedures or have greater flexibility in how they do their work. For Empire Company Limited,
separating the operation of the grocery retail and related real estate because of the work specialization involved
makes sense. For example, Sobeys executives would not necessarily make good decisions about which Shell
stations to acquire. 5.2 What factors affect organizational structure? No one organizational structure is best. The
appropriate structure depends on the organization’s strategy (innovation, cost minimization, imitation), its size,
the technology it uses (unit production, mass production, or process production), and the degree of
environmental uncertainty the organization faces. For Empire, organizing its grocery businesses by brand makes
sense—Sobeys, Safeway, and IGA are different “brands” with different types of customers. Each brand has a
similar organizational structure, as size, technology, and environmental uncertainty would not differ in any
meaningful way among the brands. 5.3 Beyond traditional organizational designs, how else can organizations
be structured? The traditional structures of organizations are simple, functional, and divisional. Contemporary
organizational designs include team structure, matrix and project structures, and boundaryless organizations.
Empire moved from a regional management structure to one that resembles a traditional divisional structure for
its two businesses. Other structures might be considered to operate its grocery business, such as a project
structure or a boundaryless organization, because retail stores can be managed in a variety of ways. Study,
practise, and explore real management situations with these helpful resources: • Interactive Lesson
Presentations: Work through interactive presentations and assessments to test your knowledge of management
concepts. • PIA (Personal Inventory Assessments): Enhance your ability to connect with key concepts through
these engaging self-reflection assessments. • Study Plan: Check your understanding of chapter concepts with
self-study quizzes. • Simulations: Practise decision making in simulated management environments.
MyManagementLab 123 Snapshot Summary Defining Organizational Structure Work Specialization
Departmentalization Chain of Command Span of Control Centralization and Decentralization Formalization
What Contingency Variables Affect Structural Choice? Common Organizational Designs Traditional
Organizational Designs Contemporary Organizational Designs Organizational Design Challenges A Final
Thought 5.1 5.2 5.3 M05_ROBB6743_08_SE_C05.indd Page 123 9/24/15 4:53 PM user
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8013 ... 124 PART 3 | Organizing Developing Management Skills Dilemma Choose an organization for which
you have worked. How did the structure of your job and the organization affect your job satisfaction? Did the
tasks within your job make sense? In what ways could they be better organized? What structural changes would
you make to this organization? Would you consider making this a taller or flatter organization (that is, would
you increase or decrease the span of control)? How would the changes you have proposed improve response to
customers and your job satisfaction? Becoming a Manager • If you belong to a student organization or are
employed, notice how various activities and events are organized through the use of work specialization, chain
of command, authority, responsibility, and so forth. • As you read current business periodicals, note what types
of organizational structures businesses use and whether or not they are effective. • Talk to managers about how
they organize work and what they have found to be effective. • Look for examples of organizational charts
(visual representations of organizations’ structures) and use them to try to determine what structural design the
organization is using. Diversity Matters Most companies recognize the benefits of employing a diverse
workforce. Along with its many advantages, diversity also presents challenges for managers. Managers must
dedicate focus to creating a cohesive work environment. Organizational leaders can ensure that workplace
diversity is successful by enacting effective policies, communicating the organization’s diversity vision, and
providing employees with diversity training. Many organizations are moving toward a full-time diversity
champion role. Often that role is housed within HR, which can lead to misalignment with the organization’s
structure and operations. Diversity planning should align with an organization’s vision and strategy. To do so,
the diversity role should reside outside a functional area like marketing or HR. The goal of diversity awareness
is to create a workplace where employees appreciate differences in race, gender, religion, cultural values, and
thinking styles. As an example, diversity can help teams in the workplace develop a wider variety of problem-
solving strategies and approaches. Diversity training is often necessary to reduce employee conflict. Companies
can use evaluations to measure the effectiveness of its diversity workforce through employee turnover, and
employee satisfaction with their job and the work environment. Using formal evaluation allows companies to
reward individuals and teams that follow company diversity policies and guidelines. Hey, You’re the Boss
Now! Delegating 101 About the Skill Managers get things done through other people. Because any manager’s
time and knowledge is limited, effective managers need to understand how to delegate. Delegation is the
assignment of authority to another person to carry out specific duties. It allows an employee to make some of
the decisions. Delegation should not be confused with participation. In participative decision making, authority
is shared. In delegation, employees make their own decisions. Steps in Developing the Skill A number of
actions differentiate the effective delegator from the ineffective delegator. You can be more effective at
delegating if you use the following five suggestions:46 1. Clarify the assignment. Determine what is to be
delegated and to whom. You need to identify the person Discussion Questions 1. Describe what is meant by the
term organizational design. 2. What is the difference between a mechanistic and an organic organization? 3.
Describe the characteristics of a learning organization. What are its advantages? 4. Which do you think is more
efficient: a wide or a narrow span of control? What is an example of a company that would benefit from a
narrow span of control? A wide span of control? 5. Do you think the concept of organizational structure, as
described in this chapter, is appropriate for charitable organizations? If yes, which organizational design do you
believe to be most appropriate? If no, why not? Explain your position. 6. Why should structure follow strategy
instead of the reverse? 7. What functions could your college or university outsource? Why?
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8013 ... CHAPTER 5 | Organizational Structure and Design 125 who is most capable of doing the task and then
determine whether he or she has the time and motivation to do the task. If you have a willing and able
employee, your responsibility is to provide clear information on what is being delegated, the results you expect,
and any time or performance expectations you may have. Unless there is an overriding need to adhere to
specific methods, you should specify only the results expected. Get agreement on what is to be done and the
results expected, but let the employee decide the best way to complete the task. 2. Specify the employee’s range
of discretion. Every situation of delegation comes with constraints. Although you are delegating to an employee
the authority to perform some task or tasks, you are not delegating unlimited authority. You are delegating
authority to act on certain issues within certain parameters. You need to specify what those parameters are so
that employees know, without any doubt, the range of their discretion. 3. Allow the employee to participate.
One of the best ways to decide how much authority will be necessary to accomplish a task is to allow the
employee who will be held accountable for the task to participate in that decision. Be aware, however, that
allowing employees to participate can present its own set of potential problems as a result of employees’ self-
interests and biases in evaluating their own abilities. 4. Inform others about the delegation. Delegation should
not take place behind the scenes. Not only do the manager and employee need to know specifically what has
been delegated and how much authority has been given, so does anyone else, both inside and outside the
organization, who is likely to be affected by the employee’s decisions and actions. Essentially, you need to
communicate what has been delegated (the task and amount of authority) and to whom. 5. Establish feedback
channels. To delegate without establishing feedback controls is to invite problems. The establishment of
controls to monitor the employee’s performance increases the likelihood that important problems will be
identified and the task will be completed on time and to the desired specifications. Ideally, these controls should
be determined at the time of the initial assignment. Agree on a specific time for the completion of the task and
then set progress dates on which the employee will report back on how well he or she is doing and on any major
problems that may have arisen. These controls can be supplemented with periodic checks to ensure that
authority guidelines are not being abused, organizational policies are being followed, proper procedures are
being met, and so forth. Practising the Skill Ricky Lee is the manager of the contracts group of a large regional
office-supply distributor. His manager, Anne Zumwalt, has asked him to prepare, by the end of the month, the
department’s new procedures manual, which will outline the steps followed in negotiating contracts with office
products manufacturers who supply the organization’s products. Because Ricky has another major project he is
working on, he went to Anne and asked her if it would be possible to assign the rewriting of the procedures
manual to Bill Harmon, one of his employees, who has worked in the contracts group for about three years.
Anne said she had no problems with Ricky reassigning the project as long as Bill knew the parameters and the
expectations for the completion of the project. Ricky is preparing for his meeting in the morning with Bill
regarding this assignment. Prepare an outline of what Ricky should discuss with Bill to ensure the new
procedures manual meets expectations. Your Essential Management Reading List Learning from key
management experts can help you understand today’s management theory and practice. What follows is a list of
some of the more influential management books: • Change by Design—Tim Brown • Building the Awesome
Organization—Katherine Catlin and Jana Matthews • The Culture Game—Dan Mezick Team Exercises 3BL:
The Triple Bottom Line Integrating Sustainability into the Organizational Structure Sustainability. Social
responsibility. The environment. These concepts are buzzwords for regulators and stakeholders who put
pressure on organizations to deal with 3BL issues, urging companies to determine how best to incorporate 3BL
as part of their organizational structure.47 Organizations are concerned both with structure—where will 3BL
decision-making authority reside?—and with the processes and flow of information across the organization.
What kind of internal structure and support would magnify their 3BL efforts? Organizations typically feature
one of three 3BL structures.48 The first is the traditional model, in which 3BL is an initiative or a few activities.
Minimal resources are allocated to 3BL, and they may be spread across many departments or business units.
The second is the federated model, where the M05_ROBB6743_08_SE_C05.indd Page 125 9/24/15 4:53 PM
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8013 ... 126 PART 3 | Organizing organization has likely created a 3BL business unit and engaged an executive
such as a Chief Sustainability Officer or a Chief Responsibility Officer. This unit is able to liaise with other
business units and starts to align 3BL priorities with business strategy. The last model is an embedded structure,
where 3BL is no longer a separate initiative but integrated into the company’s business model, structure, and
culture. Companies at this point view 3BL as a major source of competitive advantage. Thinking Strategically
About 3BL Some best practices for ensuring 3BL success in an organization include the following: • Tie
responsibility with senior executives. You need more than “support” from the CEO—the CEO needs to drive
the bus and set up a cross-functional 3BL committee with employee participation. • Establish regular target
setting and reporting. The focus on accountability builds traction within an organization. • Use employees,
partners, and collaborators to leverage 3BL capabilities. Achieve greater outcomes by working collaboratively
with everyone in your sphere of influence. • Recruit 3BL change agents. These champions of change will help
embed a culture of concern for people, profit, and the planet. How Is Your School Organized? Every university
or college displays a specific type of organizational structure. For example, if you are a business major, your
classes are often housed in a department, school, or faculty of business. But have you ever asked why? Or is it
something you just take for granted? In Chapter 3 you had an opportunity to assess your college or university’s
strengths, weaknesses, and competitive advantage and see how these fit into its strategy. In this chapter, we
argued that structure follows strategy. Given your assessment in Chapter 3 (if you have not done so, you may
want to refer to page 63 for the strategy part of this exercise), analyze your college or university’s overall
structure in terms of its degree of formalization, centralization/decentralization, and complexity. Look at the
departmentalization that exists. Is your college or university more organic or mechanistic? How well does your
college or university’s structure fit with its strategy? Do the same thing for your college or university’s size,
technology, and environment. Assess its size, degree of technological routineness, and environmental
uncertainty. Based on these assessments, what kind of structure would you predict that your college or
university has? Does it have this structure now? Compare your findings with those of other classmates. Are
there similarities in how each viewed the college or university? Differences? To what do you attribute these
findings? Be the Consultant: The Nova Scotia Association of Social Workers The Nova Scotia Association of
Social Workers (NSASW) contracted your management consulting firm to conduct an operational structure
review.49 The size of social worker governance councils varies across Canada, with larger associations like
NSASW having professional staff to carry out association activities. The NSASW has a governance council of
30, as well as a Board of Examiners to provide oversight for the association. The Council is the governance
body for the association and is responsible to follow the association bylaws and the Social Workers Act of Nova
Scotia. The Board is responsible for registration and renewal of provincial social workers, regulation of the
members’ practice to protect the public, and dealing with discipline and complaints. The Council and the Board
have a difficult relationship, and staff roles, responsibilities, and reporting relationships are not clearly defined.
The executive director complains about being stressed and overworked and is not conducting performance
evaluations. The membership has increased dramatically, putting a burden on the association’s financial
resources, staff, and volunteers. Your analysis leads you to discover that Council meetings regularly run late
and not all of the agenda items are accomplished. Consensus is almost impossible to reach, and decision making
is ineffective at times. The Board plays a valuable role in assuring the public and professional interests are
safeguarded, but no formal communication mechanism between the Board and the Council has been
established. You provided an interim report with many recommendations. Specifically, the Board has brought
you in to discuss three of your recommendations: 1. reduction of the governance council size to 15 members 2.
creation of a liaison committee to work with both the Council and the Board to develop a stronger working
and reporting relationship 3. formal approval of staff position descriptions by Council, with the executive
director responsible for their implementation, to facilitate the association’s performance management system
What information will you provide to the Council to support your recommendations?
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8013 ... CHAPTER 5 | Organizational Structure and Design 127 Business Cases Pfizer: A New Kind of
Structure Admit it.51 Sometimes the projects you are working on (school, work, or both) can get pretty boring
and monotonous. Do you ever dream about having a magic button you could push to get someone else to do the
boring, time-consuming stuff for you? At Pfizer, such a button is a reality for a large number of employees. As
a global pharmaceutical company, Pfizer is continually looking for ways to be more efficient and effective. The
company’s head of pfizerWorks (aka Office of the Future), Jordan Cohen, found that the “Harvard MBA staff
we hired to develop strategies and innovate were instead Googling and making PowerPoints.” Indeed, internal
studies conducted to find out just how much time its valuable talent was spending on menial tasks was startling.
The average Pfizer employee was spending 20 to 40 percent of his or her time on support work (creating
documents, typing notes, doing research, manipulating data, scheduling meetings) and only 60 to 80 percent on
knowledge work (strategy, innovation, networking, collaborating, critical thinking). The problem was not just at
lower levels. Even the highest-level employees were affected. So Cohen began looking for solutions. The
solution he chose turned out to be the numerous knowledge-process outsourcing companies based in India.
Initial tests of outsourcing support tasks did not go well. However, Cohen continued to tweak the process until
everything worked. Now Pfizer employees can click the OOF (Office of the Future) button in Microsoft
Outlook, and they are connected to an outsourcing company where a single worker in India receives the request
and assigns it to a team. The team leader calls the employee to clarify the request. The team leader then emails
back a cost estimate for the requested work. At this point, the Pfizer employee can say yes or no. Cohen says
that the benefits of OOF have been unexpected. Time spent on data analysis has been cut—sometimes in half.
The financial benefits are also impressive. Pfizer employees love it. “It’s kind of amazing,” Cohen says, “I
wonder what they used to do.” Questions 1. Describe and evaluate what Pfizer is doing. 2. What structural
implications—good and bad—does this approach have? (Think in terms of the six organizational design
elements.) 3. Do you think this arrangement would work for other types of organizations? Why or why not? 4.
What role do you think organizational structure plays in an organization’s efficiency and effectiveness?
Explain. Levitt-Safety Limited Levitt-Safety Limited is Canada’s largest specialist supplier of safety equipment
and services.50 Like many Canadian companies, it looked to emerging foreign markets for growth
opportunities. However, globalization and outsourcing are no longer a one-way street. Foreign competitors are
eyeing the Canadian market, because barriers to entry, such as the North American regulatory and approval
bodies, are easier to navigate in Canada. To be successful in the Canadian marketplace, foreign companies need
to spend a lot of time and money to build up their brands. Or they could form an alliance with a company like
Levitt-Safety to piggyback on a brand that is already established and well known after 36 years of business.
Increased competition has led to downward pressure on profit margins. To counter this, CEO Bruce Levitt
created an intermediary company to import product and resell it to Levitt-Safety’s distribution business. The
company sales teams now have a much better understanding of inventory carrying costs, stock-outs, dead stock,
and other often hidden costs. Levitt-Safety also has a separate manufacturing business, NL Technologies, run by
Heidi Levitt, which has become a world leader in the manufacturing and design of mining technology. Levitt-
Safety has created an effective organizational structure, with an intermediary and a separately managed
company. Levitt-Safety is looking at adding another brand that it can sell to others in the industry. Questions 1.
Should Bruce Levitt set up another company or, instead, set up an alliance with a foreign company that would
sell its products under the Levitt-Safety name? 2. How has Levitt-Safety remained a family business for over 75
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8013 ...
The 6 Building Blocks of Organizational Structure [Diagrams]

Written by Erik Devaney

@bardofboston

The following is an excerpt from our free resource, An Illustrated Guide to Organizational Structures. If you'd
like to download the full guide, click here.
Behind every great company, division, or team is a great organizational structure -- a structure tailored to a
company's, division's, or team's goals, and one that helps employees understand how they fit into the bigger
picture.
Without the proper structure in place, an organization may fail to function efficiently, or even collapse. As
Executive Coach Gill Corkindale noted in a , “Poor organizational design and structure results in a bewildering
morass of contradictions: confusion within roles, a lack of coordination among functions, failure to share ideas,
and slow decision-making bring managers unnecessary complexity, stress, and conflict.”
So, how do you decide which type of organizational structure is the best fit for your company, division, or
team?
Download our full guide to organizational structure here to learn how to structure your company for
success.
Before we can answer that, we first need to understand how an organizational structure is built -- what are the
different building blocks we can arrange? What are the different levers we can pull?
Let's explore six key components of organizational structure using some visual examples.
The 6 Building Blocks of Organizational Structure
1) Chain of Command
One of the most basic elements of an organizational structure, chain of command is exactly what it sounds like:
an unbroken line of authority that extends from the top of the organization (e.g. a CEO) all the way down to the
bottom. Chain of command clarifies who reports to whom within the organization.

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2) Span of Control
Span of control refers to the number of subordinates a superior can effectively manage. The higher the ratio of
subordinates to superiors, the wider the span of control.

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3) Centralization
Who makes the decisions in an organization? If decision-making power is concentrated at a single point, the
organizational structure is centralized. If decision-making power is spread out, the structure is decentralized.
While a decentralized structure promotes a more democratic decision-making process, it can also slow down the
decision-making process, making it harder for organizations to operate efficiently.

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4) Specialization
Also known as division of labor, specialization is the degree to which activities or tasks in an organization are
broken down and divided into individual jobs.
High specialization can be beneficial for an organization, as it allows employees to become “masters” in
specific areas, increasing their productivity as a result.
However, low specialization allows for more flexibility, as employees can more easily tackle a broader array of
tasks (as opposed to being specialized for a single task).

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5) Formalization
Similar to specialization, formalization deals with the how jobs are structured within an organization. The key
differentiator here is that formalization also takes into account the degree to which an employee’s tasks and
activities are governed by rules, procedures, and other mechanisms.
A formal organizational structure seeks to separate the individual from the role or position, as the role or
position stays the same regardless of who’s holding it. An informal organization, on the other hand, places more
value on the individual. It allows for the evolution of a role or position based on an individual’s preferences,
skill set, etc., and places less importance on what team or department that individual is part of.
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6) Departmentalization
Departmentalization refers to the process of grouping jobs together in order to coordinate common activities
and tasks.
If an organization has rigid departmentalization, each department or team is highly autonomous, and there is
little (or no) interaction between different teams. In contrast, loose departmentalization entails that teams have
more freedom to interact and collaborate.
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It’s worth noting that the way in which an organization departmentalizes is often used as a proxy for the overall
type of organizational structure that organization has. For example, an organization that departmentalizes by
function (i.e. marketing, sales, services), is said to have a functional organizational structure.
If you want to learn more about functional organizational structures, as well as other types of structures,
download the full resource: An Illustrated Guide to Organizational Structures.
Want to learn more about working in marketing? Check out the 9 Qualities to Look for in a High-Performing
Business Development Professional.

Originally published Dec 11, 2014 8:00:00 AM, updated April 18 2018
Topics:
Marketing Jobs
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Creating an Organizational Structure
Learning Objectives
1. Know and be able to differentiate among the four types of organizational structure.
2. Understand why a change in structure may be needed.
Within most firms, executives rely on vertical and horizontal linkages to create a structure that they hope will
match the needs of their firm’s strategy. Four types of structures are available to executives: (1) simple, (2)
functional, (3) multidivisional, and (4) matrix (Figure 9.6 “Common Organizational Structures”). Like
snowflakes, however, no two organizational structures are exactly alike. When creating a structure for their
firm, executives will take one of these types and adapt it to fit the firm’s unique circumstances. As they do this,
executives must realize that the choice of structure will influence their firm’s strategy and strategic options in
the future. Once a structure is created, it constrains certain future strategic moves, and supports others. If a
firm’s structure is designed to maximize efficiency, for example, the firm may lack the flexibility needed to
react quickly to exploit new opportunities.
Figure 9.6: Common Organizational Structures
Executives rely on vertical and horizontal linkages to create a structure that they hope will match the firm’s
needs. While no two organizational structures are exactly alike, four general types of structures are available to
executives: simple, functional, multidivisional, and matrix.

Simple structures do not rely on formal systems

of division of labor, and organizational charts
are not generally needed. If the firm is a sole
Simple Structure proprietorship, one person performs all of the
tasks that the organization needs to accomplish.
Consequently, this structure is common for
many small businesses.

Within a functional structure, employees are

divided into departments that each handles
activities related to a functional area of the
Functional Structure
business, such as marketing, production, human
resources, information technology, and
customer service.

In this type of structure, employees are divided

into departments based on product areas and/or
geographic regions. Jim Pattison Group, for
example, has nine product divisions; Food and
Multidivisional Structure Beverage, Media, Entertainment, Automotive
and Agriculture, Periodical Distribution and
Marketing, Signs, Packaging, Forest Products
and Port Service, and Investments and
Partnerships.

Firms that engage in projects of limited duration

often use a matrix structure where employees
can be put on different teams to maximize
Matrix Structure
creativity and idea flow. As parodied in the
movie Office Space, this structure is common in
high tech and engineering firms.

Simple Structure
Many organizations start out with a simple structure. In this type of structure, an organizational chart is usually
not needed. Simple structures do not rely on formal systems of division of labor (Figure 9.7 “Simple
Structure”). If the firm is a sole proprietorship, one person performs all the tasks the organization needs to
accomplish. Many professions, such as doctors, lawyers, and architects, find that a simple structure meets the
needs of their business. The same is true for small business owners; for example, on the TV series The
Simpsons, both bar owner Moe Szyslak and Comic Book Guy are shown handling all aspects of their respective
businesses.
 Figure 9.7: Simple Structure [Image description]
If the firm consists of more than one person, tasks tend to be distributed among them in an informal manner
rather than each person developing a narrow area of specialization. In a family-run restaurant or bed and
breakfast, for example, each person will contribute as needed to tasks, such as cleaning restrooms, food
preparation, and serving guests (hopefully not in that order). Meanwhile, strategic decision making in a simple
structure tends to be highly centralized. Indeed, often the owner of the firm makes all the important decisions.
Because there is little emphasis on hierarchy within a simple structure, organizations that use this type of
structure tend to have very few rules and regulations. The process of evaluating and rewarding employees’
performance also tends to be informal.

Figure 9.8: There is a good reason most sole

proprietors do not bother creating formal organizational charts.
The informality of simple structures creates both advantages and disadvantages. On the plus side, the flexibility
offered by simple structures encourages employees’ creativity and individualism. Informality has potential
negative aspects, too. Important tasks may be ignored if no one person is specifically assigned accountability for
them. A lack of clear guidance from the top of the organization can create confusion for employees, undermine
their motivation, and make them dissatisfied with their jobs. Thus when relying on a simple structure, the owner
of a firm must be sure to communicate often and openly with employees.
Functional Structure
As a small organization grows, the person in charge of it often finds that a simple structure is no longer
adequate to meet the organization’s needs. Organizations become more complex as they grow, and this can
require more formal division of labour and a strong emphasis on hierarchy and vertical links. In many cases,
these firms evolve from using a simple structure to relying on a functional structure.

Figure 9.9: Functional Structure [Image

description]
Within a functional structure, employees are divided into departments that each handle activities related to a
functional area of the business, such as marketing, production, human resources, information technology, and
customer service (Figure 9.9 “Functional Structure”). Each of these five areas would be headed up by a
manager who coordinates all activities related to her functional area. Everyone in a company that works on
marketing the company’s products, for example, would report to the manager of the marketing department. The
marketing managers and the managers in charge of the other four areas in turn would report to the chief
executive officer.
 Figure 9.10: An example of a functional
structure.
Using a functional structure creates advantages and disadvantages. An important benefit of adopting a
functional structure is that each person tends to learn a great deal about his or her particular function. By being
placed in a department that consists entirely of marketing professionals, an individual has a great opportunity to
become an expert in marketing. Thus a functional structure tends to create highly skilled specialists. Second,
grouping everyone that serves a particular function into one department tends to keep costs low and create
efficiencies. Also, because all the people in a particular department share the same background training, they
tend to get along with one another. In other words, conflicts within departments are relatively rare.
Using a functional structure also has a significant downside: executing strategic changes can be very slow when
compared with other structures. Suppose, for example, that a textbook publisher decides to introduce a new
form of textbook that includes “scratch and sniff” photos that let students smell various products in addition to
reading about them. If the publisher relies on a simple structure, the leader of the firm can simply assign
someone to shepherd this unique new product through all aspects of the publication process.
If the publisher is organized using a functional structure, however, every department in the organization will
have to be intimately involved in the creation of the new textbooks. Because the new product lies outside each
department’s routines, it may become lost in the proverbial shuffle. And unfortunately for the books’ authors,
the publication process will be halted whenever a functional area does not live up to its responsibilities in a
timely manner. More generally, because functional structures are slow to execute change, they tend to work best
for organizations that offer narrow and stable product lines.
The specific functional departments that appear in an organizational chart vary across organizations that use
functional structures. In the example offered earlier in this section, a firm was divided into five functional areas:
(1) marketing, (2) production, (3) human resources, (4) information technology, and (5) customer service. In the
TV show The Office, a different approach to a functional structure is used at the Scranton, Pennsylvania, branch
of Dunder Mifflin. As of 2009, the branch was divided into six functional areas: (1) sales, (2) warehouse, (3)
quality control, (4) customer service, (5) human resources, and (6) accounting. A functional structure was a
good fit for the branch at the time because its product line was limited to just selling office paper.
Multidivisional Structure
Many organizations offer a wide variety of products and services. Some of these organizations sell their
offerings across an array of geographic regions. These approaches require firms to be responsive to local
customers’ needs. Yet, as noted, functional structures tend to be fairly slow to change. As a result, when they
expand, many firms abandon the use of a functional structure as no longer optimal for their larger size. Often
the new choice is a multidivisional structure. In this type of structure, employees are divided into departments
based on products, services, and/or geographic regions.
In the multidivisional form, the firm is divided into semi-autonomous divisions that have their own support
(corporate) structures with each division being responsible for its own production and maximizing its own
profit. The firm still has a central office that oversees the other divisions but the central office’s main
responsibility is to develop overall strategies for the business, not to be responsible for each division’s
operations.
Jim Pattison Group is an example of a company organized this way. As noted in this chapter’s opening vignette,
most of the company’s employees belong to one of nine product divisions: Food and Beverage, Media,
Entertainment, Automotive and Agriculture, Periodical Distribution and Marketing, Signs, Packaging, Forest
Products and Port Services, and Investments and Partnerships.
A big advantage of a multidivisional structure is that it allows a firm to act quickly. When Jim Pattison
Group made a strategic move such as acquiring Ocean Foods, only the relevant division (in this case, Food and
Beverage) needed to be involved in integrating the new unit into the company’s hierarchy. In contrast, if the
Group was organized using a functional structure, the transition would be much slower because all the divisions
in the company would need to be involved. A multidivisional structure also helps an organization better serve
customers’ needs. In the summer of 2006, for example, Jim Pattison Group’s Investments and Partnerships
division created Great Pacific Bank Limited in Barbados. Because one division of Jim Pattison Group handles
all the firm’s investment business, the wisdom and skill needed to decide when to enter the banking business in
Barbados was more easily accessible.
Of course, empowering divisions to act quickly can backfire if people in those divisions take actions that do not
fit with the company’s overall strategy. McDonald’s experienced this kind of situation in 2002. The France
division of McDonald’s ran a surprising advertisement in a magazine called Femme Actuelle. The ad included a
quote from a nutritionist that asserted children should not eat at a McDonald’s more than once per week.
Executives at McDonald’s headquarters in suburban Chicago were concerned about the message sent to their
customers, of course, and they made it clear that they strongly disagreed with the nutritionist.

Figure 9.11: Problems can be created when

delegating lots of authority to local divisions. McDonald’s top executives were angered when an ad by their
France division suggested that children should only eat at their restaurants once a week.
Another downside of multidivisional structures is that they tend to be more costly to operate than functional
structures. While a functional structure offers the opportunity to gain efficiency by having just one department
handle all activities in an area, such as marketing, a firm using a multidivisional structure needs to have
marketing units within each of its divisions. In the Jim Pattison Group’s case, for example, each of its nine
divisions must develop its own marketing skills, which may reduce a firm’s overall profit margin. The
organization does have a Group Opportunities (GO) program that offers assistance such as group purchasing
and shared services that can create efficiencies and save money.
An additional benefit of such moves is that consistency is created across divisions. Many Canadian universities
and colleges have created an Office of Sustainability to coordinate sustainability initiatives across the entire
organization. McMaster University has beekeeping on campus (McMaster, 2014). The University of
Saskatchewan celebrated International Polar Bear Day by pledging to reduce building energy use by adjusting
the cooling and heating temperatures in its buildings, and encouraging students and staff to take personal action
to save energy now and in the future (University of Saskatchewan, 2014).
Matrix Structure
Within functional and multidivisional structures, vertical linkages between bosses and subordinates are central
for decision making, communications, and accountability. Matrix structures, in contrast, rely heavily on
horizontal relationships (Ketchen & Short, 2011). In particular, these structures create cross-functional teams
that each work on a different project. This offers several benefits: maximizing the organization’s flexibility,
enhancing communication by emphasizing both vertical (top-down) and horizontal communications across
functional lines, and supporting a stronger spirit of teamwork and collaboration. A matrix structure can also
help develop new managers. In particular, a person with limited managerial experience can become a team
leader for a relatively small project in developing their talents for leading others.
Using a matrix structure can create difficulties too. One concern is that using a matrix structure violates the
unity of command principle because each employee is assigned multiple bosses. Specifically, any given
individual reports to a functional area supervisor as well as one or more project supervisors. This has the
potential to create confusion for employees because they are left unsure about who should be giving them
direction, especially in setting priorities for their work. Violating the unity of command principle also creates
opportunities for unsavory employees to avoid responsibility by claiming to be busy on the other supervisor’s
projects.
The potential for conflicts arising between project managers within a matrix structure is another concern.
Chances are that you have had some classes with professors who are excellent speakers, while in other classes,
you have been forced to suffer through a semester of semi-incomprehensible lectures. This mix of experiences
reflects a fundamental reality of management: in any organization, some workers are more talented and
motivated than others. Within a matrix structure, each project manager naturally will want the best people in the
company assigned to his or her project because the boss evaluates these managers based on how well their
projects perform. Because the best people are a scarce resource, infighting and politics can easily flare up
around which people are assigned to each project.
One area where some degree of matrix management appears to be successful is in health. Most larger Canadian
provinces use a regional health model, with regions covering up to half of the province. Local employees, often
physically quite remote from headquarters, receive professional direction and orders from HQ health specialists
such as the regional head nurse or the regional dental director, while receiving day-to-day directions from a
local operations manager.
Organizations such as engineering and consulting firms that are functionally project oriented and require
maximum flexibility for projects of limited duration are candidates for matrix management. Matrix structures
are also used to organize research and development departments within many large corporations. In each of
these settings, the benefits of organizing around semi-autonomous teams are sufficient to outweigh the risks of
doing so. However, overall, given the risks and issues in matrix management, few organizations are good
candidates for a matrix structure.
 Figure 9.12: Within a matrix structure, you will
have multiple bosses, which contradicts the rule of direct chain of command. [Image description]
Strategy at the Movies
Office Space
How much work can a man accomplish with eight bosses breathing down his neck? For Peter Gibbons, an
employee at information technology firm Initech in the 1999 movie Office Space, the answer was zero. Initech’s
use of a matrix structure meant that each employee had multiple bosses, each representing a different aspect of
Initech’s business. High-tech firms often use matrix to gain the flexibility needed to manage multiple projects
simultaneously. Successfully using a matrix structure requires excellent communication among various
managers—however, excellence that Initech could not reach. When Gibbons forgot to put the appropriate cover
sheet on his TPS report, each of his eight bosses—and a parade of his coworkers—admonished him. This fiasco
and others led to Gibbons to become cynical about his job.
Simpler organizational structures can be equally frustrating. Joanna, a waitress at nearby restaurant Chotchkie’s,
had only one manager—a stark contrast to Gibbons’s eight bosses. Unfortunately, Joanna’s manager had an
unhealthy obsession with the “flair” (colorful buttons and pins) used by employees to enliven their uniforms. A
series of mixed messages about the restaurant’s policy on flair led Joanna to emphatically proclaim—both
verbally and nonverbally—her disdain for the manager. She then quit her job and stormed out of the restaurant.
Office Space illustrates the importance of organizational design decisions to an organization’s culture and to
employees’ motivation levels. A matrix structure can facilitate resource sharing and collaboration but may also
create complicated working relationships and impose excessive stress on employees. Chotchkie’s organizational
structure involved simpler working relationships, but these relationships were strained beyond the breaking
point by a manager’s eccentricities. In a more general sense, Office Space shows that all organizational
structures involve a series of trade-offs that must be carefully managed.
 Figure 9.13: Within a poorly organized firm like
Initech, simply keeping possession of a treasured stapler is a challenge.
Boundaryless Organizations
Most organizational charts show clear divisions and boundaries between different units. The value of a much
different approach was highlighted by former GE CEO Jack Welch when he created the term boundaryless
organization. A boundaryless organization is one that removes the usual barriers between parts of the
organization as well as barriers between the organization and others (Askenas et al., 1995). Eliminating all
internal and external barriers is not possible, of course, but making progress toward being boundaryless can help
an organization become more flexible and responsive.
One example is W. L. Gore, a maker of fabrics, medical implants, industrial sealants, filtration systems, and
consumer products. This firm avoids organizational charts, management layers, and supervisors despite having
approximately 9,000 employees across thirty countries. Rather than granting formal titles to certain people,
leaders with W. L. Gore emerge based on performance and they attract followers to their ideas over time. As
one employee noted, “We vote with our feet. If you call a meeting, and people show up, you’re a leader (Hamel,
2007).”
 Figure 9.14: The boundaryless approach to
structure embraced by W.L. Gore drives the kind of creative thinking that led to their most famous product,
GORE-TEX.
An illustration of how removing barriers can be valuable has its roots in a very unfortunate event. During
2005’s Hurricane Katrina, rescue efforts were hampered by a lack of coordination between responders from the
National Guard (who are controlled by state governments) and those from active-duty military units (who are
controlled by federal authorities). According to one National Guard officer, “It was just like a solid wall was
between the two entities (Elliott, 2011).” Efforts were needlessly duplicated in some geographic areas while
attention to other areas was delayed or inadequate. For example, poor coordination caused the evacuation of
thousands of people from the New Orleans Superdome to be delayed by a full day. The results were immense
human suffering and numerous fatalities.
 Figure 9.15: In 2005, boundaries between
organizations hampered rescue efforts following Hurricane Katrina.
As Hurricane Sandy moved toward the U.S. East Coast near the end of 2012, the Secretary of Defense and
affected governors agreed to appoint dual status commanders who could direct federal and National Guard
forces. These commanders are typically National Guard officers who have been trained to preserve the two
separate chains of command of federal and state forces, helping to coordinate troops and reduce redundancies.
Under the direction of these commanders, Guard personnel conducted damage assessments and search-and-
rescue missions, removed debris, delivered supplies and equipment, and supported evacuation shelters. The
Defense Department also named active duty deputies to help supply dual status commanders with active duty
troops if needed to deal with the effects of the hurricane. The coordinated effort worked much more efficiently
in assisting those in need during and after the storm.
Reasons for Changing an Organization’s Structure
Creating an organizational structure is not a one-time activity. Executives must revisit an organization’s
structure over time and make changes to it if certain danger signs arise. For example, a structure might need to
be adjusted if decisions with the organization are being made too slowly or if the organization is performing
poorly.
In 2014, Walmart Canada confirmed that it laid off 750 employees across Canada to re-work its management
structure. According to the company, after testing a new management structure in select stores, 1,300 associates
were promoted to more senior roles and about 200 senior managers were added.
Procter and Gamble, the world’s largest consumer products manufacturer, announced in 2014 that it may sell
off its iconic Ivory soap brand. A range of reports pegged Ivory’s 2013 global revenues at $112 million, and its
share of the U.S. bar soap market at 3.4 percent. Even though Ivory maintains a high profile, it has retreated
significantly from its highs of past decades, and it may be considered an expendable laggard among the high-
performance product mix that P&G’s CEO wants to create. P&G is being trimmed to concentrate on the
seventy to eighty brands that generate more than $100 million in gross annual revenues. Ivory is just above that
cutline, and projections do not call for growth.
Sometimes structures become too complex and need to be simplified. Many observers believe that this
description fit Cisco Systems Inc., which designs, manufactures, and sells networking equipment. The
company’s CEO, John Chambers, has moved Cisco away from a hierarchical emphasis toward a focus on
horizontal linkages. As of late 2009, Cisco had four types of such linkages. For any given project, a small team
of people reported to one of forty-seven boards. The boards averaged fourteen members each. Forty-three of
these boards each reported to one of twelve councils. Each council also averaged fourteen members. The
councils reported to an operating committee consisting of Chambers and fifteen other top executives. Four of
the forty-seven boards bypassed the councils and reported directly to the operating committee. These
arrangements are so complex and time consuming that some top executives spend 30 percent of their work
hours serving on more than ten of the boards, councils, and the operating committee.
Because it competes in fast-changing high-tech markets, Cisco needed to be able to make competitive moves
quickly. The firm’s complex structural arrangements are preventing this. In late 2007, a competitor, Hewlett-
Packard (HP), started promoting a warranty service that provides free support and upgrades within the computer
network switches market. Because Cisco’s response to this initiative had to work its way through multiple
committees, the firm did not take action until April 2009. During the delay, Cisco’s share of the market dropped
as customers embraced HP’s warranty. This problem and others created by Cisco’s overly complex structure
were so severe that one columnist wondered aloud, “Has Cisco’s John Chambers lost his mind?” (Blodget,
2009). In the summer of 2011, Chambers reversed course and decided to return Cisco to a more traditional
structure, while reducing the firm’s workforce by 9 percent. Time will tell whether these structural changes will
boost Cisco’s stock price, which dipped to $18 in mid-2011, but had rallied to the $24 range by 2014.
Key Takeaways
 Executives must select among the four types of structure (simple, functional, multidivisional, and
matrix) available to organize operations. Each structure has unique advantages, and the selection of
structures involves a series of trade-offs.
53 Building Organizational Structures
1. What are the traditional forms of organizational structure?
The key functions that managers perform include planning, organizing, leading, and controlling. This module
focuses specifically on the organizing function. Organizing involves coordinating and allocating a firm’s
resources so that the firm can carry out its plans and achieve its goals. This organizing, or structuring, process is
accomplished by:
 Determining work activities and dividing up tasks (division of labor)
 Grouping jobs and employees (departmentalization)
 Assigning authority and responsibilities (delegation)
The result of the organizing process is a formal structure within an organization. An organization is the order
and design of relationships within a company or firm. It consists of two or more people working together with a
common objective and clarity of purpose. Formal organizations also have well-defined lines of authority,
channels for information flow, and means of control. Human, material, financial, and information resources are
deliberately connected to form the business organization. Some connections are long-lasting, such as the links
among people in the finance or marketing department. Others can be changed at almost any time—for example,
when a committee is formed to study a problem.
Every organization has some kind of underlying structure. Typically, organizations base their frameworks on
traditional, contemporary, or team-based approaches. Traditional structures are more rigid and group employees
by function, products, processes, customers, or regions. Contemporary and team-based structures are more
flexible and assemble employees to respond quickly to dynamic business environments. Regardless of the
structural framework a company chooses to implement, all managers must first consider what kind of work
needs to be done within the firm.
Founded in 1943, Sweden retailer IKEA has grown from a small mail-order operation to a global force in home
furnishings with more than 390 stores throughout Europe, North America, Africa, Australia, and Asia. Best
known for its contemporary furniture designs, highly trafficked store openings, and quirky advertising, the
IKEA Group consists of multiple divisions corresponding to the company’s retail, supply chain, sales, and
design and manufacturing functions. What factors likely influenced the development of IKEA’s organizational
structure as the company expanded over the years? (Credit: JJBers/ flickr/ Attribution 2.0 Generic (CC BY
2.0))

Division of Labor
The process of dividing work into separate jobs and assigning tasks to workers is called division of labor. In a
fast-food restaurant, for example, some employees take or fill orders, others prepare food, a few clean and
maintain equipment, and at least one supervises all the others. In an auto assembly plant, some workers install
rearview mirrors, while others mount bumpers on bumper brackets. The degree to which the tasks are
subdivided into smaller jobs is called specialization. Employees who work at highly specialized jobs, such as
assembly-line workers, perform a limited number and variety of tasks. Employees who become specialists at
one task, or a small number of tasks, develop greater skill in doing that particular job. This can lead to greater
efficiency and consistency in production and other work activities. However, a high degree of specialization can
also result in employees who are disinterested or bored due to the lack of variety and challenge.
Traditional Structures
After a company divides the work it needs to do into specific jobs, managers then group the jobs together so
that similar or associated tasks and activities can be coordinated. This grouping of people, tasks, and resources
into organizational units is called departmentalization. It facilitates the planning, leading, and control
processes.
An organization chart is a visual representation of the structured relationships among tasks and the people
given the authority to do those tasks. In the organization chart in (Figure), each figure represents a job, and
each job includes several tasks. The sales manager, for instance, must hire salespeople, establish sales
territories, motivate and train the salespeople, and control sales operations. The chart also indicates the general
type of work done in each position. As (Figure) shows, five basic types of departmentalization are commonly
used in organizations:
Organization Chart for a Typical Appliance Manufacturer
Attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license

1. Functional departmentalization, which is based on the primary functions performed within an

organizational unit (marketing, finance, production, sales, and so on). Ethan Allen Interiors, a vertically
integrated home furnishings manufacturer, continues its successful departmentalization by function,
including retail, manufacturing and sourcing, product design, logistics, and operations, which includes
tight financial controls.
“2016 Annual Report,” http://www.ethanallen.com, accessed July 18, 2017.

Five Traditional Ways to Organize

(Attribution: Copyright Rice University, OpenStax, under CC BY 4.0 license.)

2. Product departmentalization, which is based on the goods or services produced or sold by the
organizational unit (such as outpatient/emergency services, pediatrics, cardiology, and orthopedics). For
example, ITT is a diversified leading manufacturer of highly engineered components and customized
technology solutions for the transportation, industrial, and oil and gas markets. The company is
organized into four product divisions: Industrial Process (pumps, valves, and wastewater treatment
equipment), Control Technologies (motion control and vibration isolation products), Motion
Technologies (shock absorbers, brake pads, and friction materials), and Interconnect Solutions
(connectors for a variety of markets).
“ITT 2016 Fact Sheet V2,” https://www.itt.com, accessed July 18, 2017.

3. Process departmentalization, which is based on the production process used by the organizational unit
(such as lumber cutting and treatment, furniture finishing, and shipping). For example, the organization
of Gazprom Neft, a Russian oil company, reflects the activities the company needs to perform to extract
oil from the ground and turn it into a final product: exploration and research, production (drilling),
refining, and marketing and distribution.
“Our Business,” http://www.gazprom-neft.com, accessed July 18, 2017.

Pixar, the animated-movie company now part of Disney, is divided into three parallel yet interactive process-
based groups: technology development, which delivers computer-graphics tools; creative development, which
creates stories and characters and animates them; and production, which coordinates the film-making process.

“Pixar Animation Studios,” The Disney Wiki, http://disney.wiki.com, accessed July 18, 2017; Bob Gower,
“Want a Creative Culture? Pixar Says Do These 3 Things,” Inc., https://www.inc.com, August 9, 2016.
 4. Customer departmentalization, which is based on the primary type of customer served by the
organizational unit (such as wholesale or retail purchasers). The PNC Financial Services Group offers
a wide range of services for all of its customers and is structured by the type of consumer it serves: retail
banking for consumers; the asset management group, with specific focus on individuals as well as
corporations, unions, municipalities, and others; and corporate and institutional banking for middle-
market companies nationwide.
“Corporate Overview,” https://www.pnc.com, accessed July 18, 2017.

Ethics in Practice
Panera’s Menu Comes Clean Making a strategic change to a company’s overall philosophy and the way it does
business affects every part of the organizational structure. And when that change pertains to sustainability and
“clean food,” Panera Bread Company took on the challenge more than a decade ago and now has a menu free of
man-made preservatives, sweeteners, colors, and flavors.
In 2015, Ron Shaich, company founder and CEO, announced Panera’s “no-no” list of nearly 100 ingredients,
which he vowed would be eliminated or never used again in menu items. Two years later, the company
announced that its menu was “100 percent clean,” but the process was not an easy one.
Panera used thousands of labor hours to review the 450 ingredients used in menu items, eventually
reformulating more than 120 of them to eliminate artificial ingredients. Once the team identified the ingredients
that were not “clean,” they worked with the company’s 300 vendors—and in some instances, a vendor’s
supplier—to reformulate an ingredient to make it preservative-free. For example, the recipe for the company’s
popular broccoli cheddar soup had to be revised 60 times to remove artificial ingredients without losing the
soup’s taste and texture. According to Shaich, the trial-and-error approach was about finding the right balance
of milk, cream, and emulsifiers, like Dijon mustard, to replace sodium phosphate (a no-no item) while keeping
the soup’s texture creamy. Panera also created a new cheddar cheese to use in the soup and used a Dijon
mustard that contained unpreserved vinegar as a substitute for the banned sodium phosphate.
Sara Burnett, Panera’s director of wellness and food policy, believes that the company’s responsibility goes
beyond just serving its customers. She believes that Panera can make a difference by using its voice and
purchasing power to have a positive impact on the overall food system. In addition, the company’s Herculean
effort to remove artificial ingredients from its menu items also helped it take a close look at its supply chain and
other processes that Panera could simplify by using better ingredients.
Panera is not yet satisfied with its commitment to clean food. The food chain recently announced its goal of
sourcing 100 percent cage-free eggs for all of its U.S. Panera bakery-cafés by 2020.
Critical Thinking Questions
1. How does Panera’s approach to clean eating provide the company with a competitive advantage?
2. What kind of impact does this commitment to preservative-free food have on the company’s
organizational structure?
3. Does “clean food” put additional pressure on Panera and its vendors? Explain your reasoning.
Sources: “Our Food Policy,” https://www.panerabread.com, accessed July 24, 2017; Emily Payne, “Panera
Bread’s Sara Burnett on Shifting Demand for a Better Food System,” Food Tank, http://foodtank.com, accessed
July 18, 2017; Julie Jargon, “What Panera Had to Change to Make Its Menu ‘Clean,’” The Wall Street
Journal, https://www.wsj.com, February 20, 2017; John Kell, “Panera Says Its Food Menu Is Now 100%
‘Clean Eating,’” Fortune, http://fortune.com, January 13, 2017; Lani Furbank, “Seven Questions with Sara
Burnett, Director of Wellness and Food Policy at Panera Bread,” Food Tank, https://foodtank.com, April 12,
2016.
5. Geographic departmentalization, which is based on the geographic segmentation of organizational units
(such as U.S. and Canadian marketing, European marketing, and Latin American marketing).
People are assigned to a particular organizational unit because they perform similar or related tasks, or because
they are jointly responsible for a product, client, or market. Decisions about how to departmentalize affect the
way management assigns authority, distributes resources, rewards performance, and sets up lines of
communication. Many large organizations use several types of departmentalization. For example, Procter &
Gamble (P&G), the multibillion-dollar consumer-products company, integrates four different types of
departmentalization, which the company refers to as “four pillars.” First, the Global Business Units (GBU)
divide the company according to products (baby, feminine, and family care; beauty; fabric and home care; and
health and grooming). Then, P&G uses a geographical approach, creating business units to market its products
around the world. There are Selling and Market Operations (SMO) groups for North America; Latin America;
Europe; Asia Pacific; Greater China; and India, the Middle East, and Africa. P&G’s third pillar is Global
Business Services division (GBS), which also uses geographic departmentalization. GBS provides technology
processes and standard data tools to enable the GBUs and SMOs to better understand the business and to serve
consumers and customers better. It supports P&G business units in areas such as accounting and financial
reporting, information technology, purchases, payroll and benefits administration, and facilities management.
Finally, the divisions of the Corporate Functions pillar provide a safety net to all the other pillars. These
divisions are comprised of functional specialties such as customer business development; external relations;
human resources; legal, marketing, consumer, and market knowledge; research and development; and
workplace services.

“Corporate Structure,” http://us.pg.com, accessed July 18, 2017.

Line-and-Staff Organization
The line organization is designed with direct, clear lines of authority and communication flowing from the top
managers downward. Managers have direct control over all activities, including administrative duties. An
organization chart for this type of structure would show that all positions in the firm are directly connected via
an imaginary line extending from the highest position in the organization to the lowest (where production of
goods and services takes place). This structure, with its simple design and broad managerial control, is often
well-suited to small, entrepreneurial firms.
As an organization grows and becomes more complex, the line organization can be enhanced by adding staff
positions to the design. Staff positions provide specialized advisory and support services to line managers in
the line-and-staff organization, shown in (Figure). In daily operations, individuals in line positions are
directly involved in the processes used to create goods and services. Individuals in staff positions provide the
administrative and support services that line employees need to achieve the firm’s goals. Line positions in
organizations are typically in areas such as production, marketing, and finance. Staff positions are found in
areas such as legal counseling, managerial consulting, public relations, and human resource management.
Line-and-Staff Organization
(Attribution: Copyright Rice University, OpenStax, under CC BY 4.0 license.)

1. How does specialization lead to greater efficiency and consistency in production?

2. What are the five types of departmentalization?
Summary of Learning Outcomes
1. What are the traditional forms of organizational structure?
Firms typically use traditional, contemporary, or team-based approaches when designing their organizational
structure. In the traditional approach, companies first divide the work into separate jobs and tasks. Managers
then group related jobs and tasks together into departments. Five basic types of departmentalization are
commonly used in organizations:
 Functional: Based on the primary functions performed within an organizational unit
 Product: Based on the goods or services produced or sold by the organizational unit
 Process: Based on the production process used by the organizational unit
 Customer: Based on the primary type of customer served by the organizational unit
 Geographic: Based on the geographic segmentation of organizational units
Glossary
customer departmentalization
Departmentalization that is based on the primary type of customer served by the organizational unit.
departmentalization
The process of grouping jobs together so that similar or associated tasks and activities can be coordinated.
division of labor
The process of dividing work into separate jobs and assigning tasks to workers.
functional departmentalization
Departmentalization that is based on the primary functions performed within an organizational unit.
geographic departmentalization
Departmentalization that is based on the geographic segmentation of the organizational units.
line-and-staff organization
An organizational structure that includes both line and staff positions.
line organization
An organizational structure with direct, clear lines of authority and communication flowing from the top
managers downward.
line positions
All positions in the organization directly concerned with producing goods and services and that are directly
connected from top to bottom.
organization
The order and design of relationships within a firm; consists of two or more people working together with a
common objective and clarity of purpose.
organization chart
A visual representation of the structured relationships among tasks and the people given the authority to do
those tasks.
process departmentalization
Departmentalization that is based on the production process used by the organizational unit.
product departmentalization
Departmentalization that is based on the goods or services produced or sold by the organizational unit.
specialization
The degree to which tasks are subdivided into smaller jobs.
staff positions
Positions in an organization held by individuals who provide the administrative and support services that line
employees need to achieve the firm’s goals.
A clear organizational design can maximize your company's efficiency.
Establishing a strong organizational structure can increase a company's efficiency -- whether it consists of two
employees or 200. Organizational structure identifies the positions in an office, determines who manages
departments and defines individual job roles. Organizational charts or "org" charts are often used to display the
org structure.

Very small companies may have a simple organizational structure, with one manager making decisions. Larger
companies may divide the company into groups to distribute responsibility. Putting an effective organizational
structure into place can increase productivity, improve operating costs and employee satisfaction. If your
business has grown beyond its initial structure or your current organizational design just isn't working, it may be
time to rethink the roles your managers, departments and committees play and move toward a better company
structure.

Options to develop a company organizational structure include:

1. Design your own simple organizational charts.

2. Allow a human resources department to outline your company's org structure.
3. Use software to help map out an organizational structure.
4. Hire management consultants to determine your organizational design.

Create your own org structure

If your company is very small (for example, five employees or less), a simple organizational structure --
identifying the owner or president and supporting staff roles -- may work. However, you still need to assess
your current resources and consider future needs. Who will be in charge when the main decision maker is out of
the office? Who will take on new responsibilities as work increases?

Empower your HR department to create a company organizational design

If your company is large enough to have a human resource department, consider giving it a large role in
determining your organizational design. As the entry and exit point for all employees, HR staff members should
be able to assess worker needs and resources.

Consider purchasing software to create your organizational charts

Not only can organizational structure software help create org charts to visually show where current staffing
needs exist, some versions help track staff changes and can provide quick employee totals. A number of
software options exist for creating organizational charts for both small and large companies.

Hire a consultant to produce an organizational structure

Management consultants can help assess your company's needs and establish a new, more cost-effective
organizational structure. Although hiring a consultant is an added expense, many firms will provide a project
estimate before starting to help you budget for the service.

 If your company has recently grown or its organizational structure is outdated, consider developing and
instituting a new organizational design.
 Even extremely small companies can benefit from implementing a simple organizational structure after
assessing resources and needs.
 Organizational charts can help set responsibility and establish a chain of command, improving
communication and staff relationships.
 Share org charts with your company so that everyone knows which employees are responsible for
various functions, who should be contacted for information and how the internal positions relate to each
other.

 Designing Adaptive Organizations

The world today is experiencing a faster rate of change than ever before. Technological advancement is
happening at lightning speed, and this is causing ripple effects throughout organizations, talent, culture,
and nearly all aspects of organizational life. As leaders respond to and anticipate in this level of change,
they often develop a “what if” mindset when it comes to making choices for the organization: “What if
next year we grew? What if we acquire another company? What if we are acquired?”
The very real concern associated with this practice is that any kind of substantial organization choice
based on a prediction of what might come can easily prove to be wrong within in a fairly short amount of
time. What made sense a few months ago might be completely off base going forward. No wonder so
many organizations desire and seek flexibility in their organization designs.
Flexibility as an Organization Design Principle
There are tactics and techniques leaders and organizations can adopt that support the design of adaptive
organizations. When implemented, the following organization design ideas allow a company to have
flexibility and adapt more readily to changes within and outside of the organization.

Evaluating Organization Design Choices for Flexibility

One excellent way to build flexibility into your company is to make it one of the design criteria for your
organization. This encourages leaders to evaluate choices based on whether or not they allow the
organization to flex and adapt.
For example, when considering a new technology, leaders can ask, “Are we installing a technology that
can expand if we were to acquire someone? Can it expand or adapt if we change our products or
services? Can the technology grow with us as our organization evolves?” While these kinds of questions
don’t always give definitive answers, they help ensure that the organization is thinking beyond the
moment or the immediate situation and is considering the consequences of potential organization realities
in the future.
Modular Design Structures
In any given organization, certain organization structure options will prove more flexible than other
available options. These might not be the same from one organization to the next. For instance,
organizing work around a functional grouping can create a lot of flexibility in some situations. A function
can operate across many parts of an organization, allowing all to benefit. If a new company is acquired,
that function can be shared with that new business with only incremental changes. However, being set up
as a function can also be a limiting factor in other situations, such as when different business units have
distinct differences that a single function can’t support effectively.
Another example is a company that organizes itself around customers rather than functions. Doing this
allows the company to add or divest customer business units as needed to meet strategic priorities and
opportunities. As an example, one of our clients recently announced they are going to spin off a business,
and it will be relatively easy for them to do because they are organized in a highly modular way.
Flexible Ways of Working
The way we structure work promotes either flexibility or rigidity. One highly flexible way of doing work
is to use an Agile approach. Agile makes use of ways of working that are quick, flexible, and responsive.
It is also highly compatible with a modular structure, because the quick work sprints that Agile calls for
naturally bring the right people together to do high-value work and then divert them to other business
essential activities when finished.
The great benefit of using Agile ways of working in an environment of change is that by operating in a
more Agile fashion—in bursts, short doses, and concentrated work efforts—if something’s not going to
work it usually becomes quickly apparent. And if it turns out the work is misdirected, it’s not a life
sentence. It just calls for a shift. People can be moved around or the scope of the project changed on short
notice relatively easily, as opposed to working in a more waterfall or linear fashion which requires a
longer-term commitment and may not surface misalignments until well into the work effort.
Flexibility Facilitates Resilience
An adaptable organization is one whose internal and external structures enable it to flex readily in
response to change. This is unlikely to happen by chance. By intentionally making organization design
choices that encourage flexibility in structure and work processes, leaders can build an adaptive
organization that remains resilient and competitive in a changing business environment.
Topic 7: Designing Adaptive Organizations Organizing Organizing is the deployment of resources to achieve
strategic goals. It is reflected in Division of labor into specific departments & jobs, Formal lines of authority,
Mechanisms for coordinating diverse organizational tasks Organization Structure Organization structure is the
framework in which the organization defines how task are divided, resources are deployed, and departments are
coordinated. Organization Structure is defined as i) Set of formal tasks assigned ii) Formal reporting
relationships iii) The design of systems to ensure iv) effective coordination of employees across departments
The set of formal tasks and formal reporting relationships provided a framework for vertical control of the
organization: Work Specialization and Division of labor. Tasks are subdivided into individual jobs Employees
perform only the tasks relevant to their specialized function Jobs tend to be small, but they can be performed
efficiently Chain of Command: Unbroken line of authority that links all persons in an organization Shows who
reports to whom It is associated with two underlying principles – Unity of Command: employees held
accountable to only one supervisor – Scalar Principle: clearly defined line of authority Chain of Command:
Authority, Responsibility, Accountability and Delegation a) Authority: The chain of command illustrates the
authority structure of the organization. Authority is the formal and legitimate right of a manager to make
decisions and issue orders, and allocate resources to achieve organizationally desired outcomes. Authority is
distinguished by three characteristics: (1) Authority is vested in organizational positions, not people. (2)
Authority is accepted by subordinates. (3) Authority flows down the vertical hierarchy. b) Responsibility is the
duty to perform the task or activity as assigned. c) Accountability means that the people with authority and
responsibility are subject to reporting and justifying task outcomes to those above them in the chain of
command. d) Delegation is the process managers use to transfer authority and responsibility to positions below
them in the hierarchy. Line Authority: Line departments perform the tasks that reflect the organization’s
primary goals. They work directly with customers/products. Staff Authority: Staff departments are those
departments that provide specialized skills in support of line departments Span of Management/Span of Control
Number of employees who report to a supervisor Traditional view = seven subordinates per manager Lean
organizations today = 30+ subordinates Reorganization to Increase Span of Management: Tall versus Flat
Structure: Span of Control used in an organization determines whether the structure is tall or flat. Tall structure
has a narrow span and more hierarchical levels. Flat structure has a wide span, is horizontally dispersed and
fewer hierarchical levels. The trend has been toward wider spans of control Factors Associated With Supervisor
Involvement: – Work is stable and routine – Subordinates perform similar work tasks – Subordinates are
concentrated in a single location – Subordinates are highly trained – Rules and procedure defining task activities
are available – Support systems and personnel are available for the manager – Little time is required in
nonsupervisory activities – Managers’ preferences and styles favor a large span Centralization and
Decentralization Change and uncertainty are usually associated with decentralization. The amount of
centralization or decentralization must fit the firm’s strategy. During crisis or risk of company failure, authority
may be centralization. Departmentalization – Basis for grouping positions into departments – Choices regarding
chain of command Five traditional approaches: – Functional – Divisional – Matrix – Teams – Virtual Networks
Vertical Functional Structure: Divisional Structure: – An organisation structure in which departments are
grouped based on similar organisational outputs – An alternative for assigning divisional responsibility is to
group company activities by geographic region or customer group Three types of Divisional Structure: a)
Geographic-based structure b) Product structure c) Customer-based strcture Functional Structure VS Divisional
Structure: The primary difference between divisional and functional structures is that the chain of command
from each function converges lower in the hierarchy In a divisional structure, differences of opinion among
research, marketing, manufacturing and finance would be resolved at the divisional level rather than by the
president Thus, the divisional structure encourages decentralization Decision making is pushed down at least
one level in the hierarchy, freeing the president and other top managers for strategic planning Matrix Approach:
An organisation structure that uses functional and divisional chains of command simultaneously in the same
part of the organisation The matrix structure evolved as a way to improve horizontal coordination and
information sharing Team Approach: The vertical chain of command is a powerful means of control, but
passing all decisions up the hierarchy takes too long and keeps responsibility at the top The team approach gives
managers a way to delegate authority, push responsibility to lower levels, and be more flexible and responsive
in the competitive global environment a) Cross-functional teams The teams which consist of employees from
various functional departments who are responsible to meet as a team and resolve mutual problems Team
members typically still report to their functional departments, but they also report to the team, one member of
whom may be the leader Cross-functional teams are used to provide needed horizontal coordination to
complement an existing divisional or functional structure b) Permanent teams It is a groups of employees who
are organised in a way similar to a formal department Each team brings together employees from all functional
areas focused on a specific task or project Emphasis is on horizontal communication and information sharing
because representatives from all functions are coordinating their work and skills to complete a specific
organisational task Authority is pushed down to lower levels, and front-line employees are often given the
freedom to make decisions and take action on their own Virtual Network Approach: An organizational structure
that disaggregates major functions to separate companies that are brokered by small headquarters organization.
The organisation may be viewed as a central hub surrounded by a network of outside specialist Rather than
being housed under one roof, services such as accounting, design, manufacturing, and distribution are
outsourced to separate organisations that are connected electronically to the central office The idea behind
networks is that a company can concentrate on what it does best and contract out other activities to companies
with distinctive competence in those specific areas, which enables a company to do more with less Approaches
to Structural Design: Struct ural Advantages Disadvantages Appro ach ???? Can draw on expertise worldwide
Highly flexible and responsive Reduced overhead costs Lack of control Weak boundaries Greater demands on
managers Employee loyalty weakened ???? Efficient use of resources Economic of scale In depth skill
specialization and development Top manager direction and control Poor communication across functional
departments Slow response to external changes Lagging innovation Decisions concentrated at top of hierarchy,
creating delay ???? Fast response Flexibility in unstable environment Foster concern for customer needs
Excellent coordination across functional departments Duplication of resources across divisions Less technical
depth and specialization Poor coordination across divisions ???? More efficient use of resources than single
hierarchy Flexibility Adaptable to changing environment Interdisciplinary cooperation Frustration and
confusion from dual chain of command High conflict between two sides of matrix Many meetings, more than
discussion than action Expertise available to all divisions ???? Reduced barriers among departments Increase
compromise Shorter response time Quicker decisions Better morale, enthusiasm from employee involvement
Dual loyalties and conflict Time and resources spent on meetings Unplanned decentralization Organizing for
Horizontal Coordination The Need for Coordination: Coordination refers to the quality of collaboration across
departments. Without coordination, a company’s left hand will not act in concert with the right hand, causing
problems and conflicts Required regardless of whether the organization has a functional, divisional, or team
structure Task Forces, Teams, and Project Management Task Force: A task force is a temporary team or
committee designed to solve a short-term problem involving several departments Team: In addition to creating
task forces, companies also set up cross-functional teams A cross-functional team furthers horizontal
coordination because participations from several departments meet regularly to solve ongoing problems of
common interest Similar to a task force except that it works with continuing rather than temporary problems
and exist for several years. Project Manager: A project manager is a person who is responsible for coordinating
activities of several departments on a full-time basis for the completion of a specific project Examples of
Project Manager Relationships Project manager is not a member of one of the departments being coordinated
Project managers are located outside of the departments and have responsibility for coordinating several
departments to achieve desired project outcomes Reengineering Business process reengineering: Radical
redesign of business processes to achieve dramatic improvements in cost, quality, service, and speed Change the
way manager think about how work is done Focus on process rather than function Process = organized group of
related tasks and activities that work together to transform inputs into outputs and create value Reengineering at
Michigan Casting Center: Structure Follows Strategy: The right structure is designed to fit the organization’s
strategy Recent study demonstrated that business performance is strongly influenced by how well the company
structure is aligned with its strategic.
Presentation on theme: "Chapter 9 Designing Adaptive Organizations"— Presentation transcript:
1 Chapter 9 Designing Adaptive Organizations
MGMTChuck WilliamsDesigned & Prepared by B-books, Ltd.
2 Organizational Structure
The vertical and horizontal configuration of departments, authority, and jobs within a company.Organizational
ProcessThe collection of activities that transform inputs into outputs that customers value.This chapter begins
by reviewing the traditional organizational structure approach to organizational design. Organizational structure
is the vertical and horizontal configuration of departments, authority, and jobs within a company. Exhibit 9.1
shows Sony’s organizational chart.In the second half of the chapter, you will learn how contemporary
organizations are becoming more adaptive by redesigning their internal and external processes. An
organizational process is the collection of activities that transforms inputs into outputs that customers value.
3 Organizational Structure
Process View of Microsoft’s OrganizationExhibit 9.2 shows the basic internal and external processes that
Microsoft uses to write computer software, beginning from customer feedback and ending with software
distribution and sales. The cycle begins again.
4 Designing Organizational Structures
After reading these sections, you should be able to:describe the departmentalization approach to organizational
structure.explain organizational authority.discuss the different methods for job design.
5 Departmentalization Customer Geographic Matrix Functional Product 1
Departmentalization is a method of subdividing work and workers into separate organizational units that take
responsibility for completing particular tasks.Organizational structures have been created by departmentalizing
work according to five methods, described on the slides that follow.1
6 Functional Departmentalization
The most common organizational structure is functional departmentalization. Companies tend to use this
structure when they are small or just starting out. Functional departmentalization organizes work and workers
into separate units responsible for particular business functions or areas of expertise. For example, a common
set of functions would consist of accounting, sales, marketing, production, and human resources
departments.However, not all functionally departmentalized companies have the same functions, as compared
in exhibit 9.3.1.1
7 Functional Departmentalization
AdvantagesDisadvantagesWork done by highly skilled specialistsLowers costs through reduced
duplicationCommunication and coordination problems are lessenedCross-department coordination can be
difficultMay lead to slower decision makingProduces managers with narrow experiencesFunctional
departmentalization has some advantages. First, it allows work to be done by highly qualified specialists. While
the accountants in the accounting department take responsibility for producing accurate revenue and expense
figures, the engineers in research and development can focus their efforts on designing a product that is reliable
and simple to manufacture. Second, it lowers costs by reducing duplication. When the engineers in research and
development come up with that fantastic new product, they don't have to worry about creating an aggressive
advertising campaign to sell it. That task belongs to the advertising experts and sales representatives in
marketing. Third, with everyone in the same department having similar work experience or training,
communication and coordination are less problematic for departmental managers.However, functional
departmentalization has a number of disadvantages, too. To start, cross-department coordination can be
difficult. Managers and employees are often more interested in doing what's right for their function than in
doing what's right for the entire organization. A good example is the traditional conflict between marketing and
manufacturing. Marketing typically pushes for spending more money to make more products with more
accessories and capabilities to meet customer needs. By contrast, manufacturing pushes for fewer products with
simpler designs, so that manufacturing facilities can ship finished products on time and keep costs within
expense budgets. As companies grow, functional departmentalization may also lead to slower decision-making,
and produce managers and workers with narrow experience and expertise.1.1
8 Product Departmentalization
United TechnologiesCarrierHamilton SundstrandUTC Fire andSecurityOtisPratt & WhitneyUTC Power--
Administrative services--Communication & public relations --Customer service & support--E-Business --
Engineering --etc…SikorskyProduct departmentalization organizes work and workers into separate units
responsible for producing particular products or services. For example, United Technologies is organized into
product lines, a portion of them shown in this slide.For a complete structure, refer to Exhibit 9.4.1.2
9 Product Departmentalization
AdvantagesDisadvantagesDuplication of activitiesDifficult to coordinate across departmentsManagers
specialize, but have broader experiencesEasier to assess work-unit performanceDecision-making is fasterOne of
the advantages of product departmentalization is that, like functional departmentalization, it allows managers
and workers to specialize in one area of expertise. However, unlike the narrow expertise and experiences in
functional departmentalization, managers and workers develop a broader set of experiences and expertise
related to an entire product line. Likewise, product departmentalization makes it easier for top managers to
assess work-unit performance. Finally, because managers and workers are responsible for the entire product line
rather than for separate functional departments, decision-making should be faster, because there are fewer
conflicts (compared to functional departmentalization).The primary disadvantage of product
departmentalization is duplication. For example, you can see in Figure 9.4 that the Otis Elevators and Pratt &
Whitney Divisions both have departments such as customer service, engineering, human resource, etc.
Duplication like this often results in higher costs.A second disadvantage is that it can be difficult to achieve
coordination across the different product departments. For example, United Technologies would probably have
difficulty standardizing its policies and procedures in product departments as different as the Carrier and
Sikorsky divisions.1.2
10 Customer Departmentalization
Customer departmentalization organizes work and workers into separate units responsible for particular kinds of
customers.Exhibit 9.5 shows that Sprint is organized into departments that cater to businesses, consumers,
homes, and companies requiring supply chain services.1.3
11 Customer Departmentalization
AdvantagesDisadvantagesFocuses on customer needsProducts and services tailored to customer
needsDuplication of resourcesDifficult to coordinate across departmentsEfforts to please customers may hurt
the companyThe primary advantage to customer departmentalization is that it focuses the organization on
customer needs rather than on products or business functions. Furthermore, creating separate departments to
serve specific kinds of customers allows companies to specialize and adapt their products and services to
customer needs and problems.The primary disadvantage of customer departmentalization is that, like product
departmentalization, it leads to duplication of resources. Furthermore, like product departmentalization, it can
be difficult to achieve coordination across different customer departments. Finally, the emphasis on meeting
customers' needs may lead workers to make decisions that please customers but hurt the business.1.3
12 Geographic Departmentalization
Coca-Cola Enterprises Territories of OperationGeographic departmentalization organizes work and workers
into separate units responsible for doing business in particular geographical areas.Exhibit 9.6 shows the
geographic departmentalization used by Coca-Cola Enterprises.1.4
13 Geographic Departmentalization
AdvantagesDisadvantagesResponsive to the demands of different market areasUnique resources located close
to the customerDuplication of resourcesDifficult to coordinate across departmentsThe primary advantage of
geographic departmentalization is that it helps companies respond to the demands of different markets. This can
be especially important when selling in different countries. For example, CCE’s geographic divisions sell
products suited to the taste preferences in different countries. CCE bottles and distributes the following products
in Europe but not in the U.S.: Aquarius, Bonaqua, Burn, Canada Dry, Coca-Cola light, Cresta flavors, Five
Alive, Kia-Ora, Kinley, Lilt, Malvern, and Oasis. Another advantage is that geographic departmentalization can
reduce costs by locating unique organizational resources closer to customers. For instance, it is much cheaper
for CCE to build bottling plants in Belgium than to bottle Coke in England and then transport it across the
English Channel.The primary disadvantage of geographic departmentalization is that it can lead to duplication
of resources. For example, while it may be necessary to adapt products and marketing to different geographic
locations, it's doubtful that CCE needs significantly different inventory tracking systems from location to
location. Also, even more so than with the other forms of departmentalization, it can be especially difficult to
coordinate departments that are literally thousands of miles from each other and whose managers have very
limited contact with each other.1.4
14 Matrix Departmentalization
Procter & GambleNorth AmericaWesternEuropeAsia, India,AustraliaBeauty Care,Feminine CareFabric &
HomeCareBaby Care,Family CareSnacks &BeveragesCountry Managers in Spain, UAE, Kenya, etc.Country
Managers in India, South Korea, etc.Matrix departmentalization is a hybrid structure in which two or more
forms of departmentalization are used together. The most common matrix combines product and functional
forms of departmentalization.Several things distinguish matrix departmentalization from the other traditional
forms of departmentalization. First, most employees report to two bosses, a functional boss and a project or
product boss. Second, by virtue of the function-by-project design, matrix structures lead to much more cross-
functional interaction than other forms of departmentalization. In fact, while matrix workers are members of
only one functional department (based on their work experience and expertise), it is common for them to be
members of several ongoing project groups. Third, because of the high level of cross-functional interaction,
matrix departmentalization requires significant coordination between functional and project managers. In
particular, these managers have the complex job of tracking and managing the multiple project and functional
demands on employees' time.1.5
15 Matrix Departmentalization
AdvantagesDisadvantagesRequires high levels of coordinationConflict between bossesRequires high levels of
management skillsEfficiently manage large, complex tasksPool of available resourcesThe primary advantage of
matrix departmentalization is that it allows companies to efficiently manage large, complex tasks like
researching, developing, and marketing pharmaceuticals. Efficiency comes from avoiding duplication. For
example, rather than having an entire marketing function for each project, the company simply assigns and
reassigns workers from the marketing department as they are needed at various stages of product completion.
More specifically, an employee from a department may simultaneously be part of five different ongoing
projects but may only be actively completing work on a few projects at a time. Another advantage is the ability
to carry out large, complex tasks. Because of the ability to quickly pull in expert help from all the functional
areas of the company, matrix project managers have a much more diverse set of expertise and experience at
their disposal than do managers in the other forms of departmentalization.The primary disadvantage of matrix
departmentalization is the high level of coordination required to manage the complexity involved with running
large, ongoing projects at various levels of completion. Matrix structures are notorious for confusion and
conflict between project bosses or between project and functional bosses. Disagreements or misunderstanding
about project schedules, budgets, available resources, and the availability of employees with particular
functional expertise are common. Another disadvantage is that matrix structures require much more
management skill than the other forms of departmentalization.Because of these problems, many matrix
structures evolve from the simple matrix, in which project and functional managers negotiate conflicts and
resources, to the complex matrix, in which specialized matrix managers and departments are added to the
organizational structure. In the complex matrix, project and functional managers report to the same matrix
manager, who helps them sort out conflicts and problems.1.5
16 Organizational Authority
Delegation of AuthorityDegree ofCentralizationChain of CommandLine versus Staff AuthorityAuthority is the
right to give commands, take action, and make decisions to achieve organizational objectives.Traditionally,
organizational authority has been characterized by the following dimensions: chain of command, line versus
staff authority, delegation of authority, and degree of centralization.2
17 Chain of Command The vertical line of authority in an organization
Clarifies who reports to whomUnity of commandmatrix organizations violate this principleworkers report to
only one bossThe chain of command is the vertical line of authority that clarifies who reports to whom
throughout the organization. People higher in the chain of command have the right, if they so choose, to give
commands, take action, and make decisions concerning activities occurring anywhere below them in the chain.
In the following discussion about delegation and decentralization, you will learn that managers don’t always
choose to exercise their authority directly.One of the key assumptions underlying the chain of command is unity
of command, which means that workers should report to just one boss. In practical terms, this means that only
one person can be in charge at a time. Matrix organizations, in which employees have two bosses, automatically
violate this principle. This is one of the primary reasons that matrix organizations are difficult to manage. The
purpose of unity of command is to prevent the confusion that might arise when an employee receives
conflicting commands from two different bosses.When Steve Ballmer took over the CEO position at Microsoft
from Bill Gates, the new chain of command was surprisingly unclear. Once they became comfortable with the
change, however, the new structure proved to be a success.2.1
18 Line versus Staff Authority
Line authoritythe right to command immediate subordinates in the chain of commandStaff authoritythe right to
advise but not command othersversusA second dimension of authority is the distinction between line and staff
authority. Line authority is the right to command immediate subordinates in the chain of command.Staff
authority is the right to advise but not command others who are not subordinates in the chain of command.The
terms “line” and “staff” are also used to describe different functions within the organization. A line function is
an activity that contributes directly to creating or selling the company’s products. So, for example, activities that
take place within the manufacturing and marketing departments would be considered line functions. A staff
function is one that does not contribute directly to creating or selling the company’s products, but instead
supports line activities. Typical staff functions within an organization are accounting, human resources, and
legal services. For example, marketing managers might consult with the legal staff to make sure the wording of
a particular advertisement is legal.2.2
19 Delegation of Authority
The assignment of direct authority and responsibility to a subordinate to complete tasks for which the manager
is normally responsible.Managers can exercise their authority directly by completing the tasks themselves, or
they can choose to pass on some of their authority to subordinates. Delegation of authority is the assignment of
direct authority and responsibility to a subordinate to complete tasks for which the manager is normally
responsible.2.3
20 Delegation of Authority
When a manager delegates work, three transfers occur. First, the manager transfers full responsibility for the
assignment to the subordinate. Indeed, most managers have way too much to do. So, from a practical
perspective, they can't assume new responsibilities that come with change and growth until they fully delegate
old ones.Another problem is that managers often fear that the task won't be done as well if they don’t do it
themselves. Second, delegation transfers to the subordinate full authority over the budget, resources, and
personnel needed to do the job. To do the job effectively, subordinates must have the same tools and
information at their disposal that managers had when they were responsible for the same task. The third transfer
that occurs with delegation is the transfer of accountability. The subordinate now has the authority and
responsibility to do the job, and is then accountable for getting the job done. In other words, managers give
subordinates their managerial authority and responsibility in exchange for results.2.3
21 How to be a More Effective Delegator
Trust your staff to do a good job.Avoid seeking perfection.Give effective job instructions.Know your true
interests.Follow up on progress.Praise the efforts of your staff.Don’t wait to the last minute to delegate.Ask
questions, expect answers, assist employees.Provide the resources you would expect if doing the assignment
yourself.Delegate to the lowest possible level.2.3
22 Degree of Centralization
Centralization of authorityprimary authority is held by upper managementDecentralizationsignificant authority
is found in lower levels of the organizationStandardizationsolving problems by applying rules, procedures, and
processesCentralization of authority is the location of most authority at the upper levels of the organization. In a
centralized organization, managers make most decisions, even the relatively small ones.Decentralization is the
location of a significant amount of authority in the lower levels of the organization. An organization is
decentralized if it has a high degree of delegation at all levels. In a decentralized organization, workers closest
to problems are authorized to make the decisions necessary to solve the problems on their own. Decentralization
has a number of advantages. It develops employee capabilities throughout the company, and leads to faster
decision making and more satisfied customers and employees. With results like these, the key question is no
longer whether companies should decentralize, but where they should decentralize. One rule of thumb is to stay
centralized where standardization is important and to decentralize where standardization is
unimportant.Standardization is solving problems by consistently applying the same rules, procedures, and
processes.2.4
23 Decentralization at Whole Foods
Beyond the BookDecentralization at Whole FoodsOperating decisions at Whole Foods—from what to stock,
what to charge for it, and whom to hire—are made not from the top, but by individual work teams.Each team is
in charge of a department, like wine or seafood, or produce.New employees are assigned to a team for a 4-week
trial. At the end of 4 weeks, the new member must be approved by 2/3 vote of the team to remain on it.Whole
Foods believes that decisions should be made by those most impacted by them.Source: “Break Free!,” Fortune,
1 October 2007,
24 Job Rotation, Enlargement, Enrichment Job Characteristics Model
Job DesignJobSpecializationJob Rotation, Enlargement, EnrichmentJob Characteristics ModelJob design is the
number, kind, and variety of tasks that individual workers perform in doing their jobs.3
25 Job SpecializationA job that is a small part of a larger task or processJobs are simple, easy to learn, &
economicalCan lead to low satisfaction, high absenteeism, & employee turnoverJob specialization is a job
composed of a small part of a larger task or process. Specialized jobs are characterized by simple, easy-to-learn
steps, low variety, and high repetition. One of the clear disadvantages of specialized jobs is that, being so easy
to learn, they quickly become boring. This, in turn, can lead to low job satisfaction and high absenteeism and
employee turnover, all of which are very costly to organizations. Why, then, do companies continue to create
and use specialized jobs? The primary reason is that specialized jobs are very economical. Once a job has been
specialized, it takes little time to learn and master. Consequently, when experienced workers quit or are absent,
the company loses little productivity when replacing them with a new employee.The text uses the extended
example of the drive-thru employee at a fast-food restaurant.3.1
26 Job Rotation, Enlargement, and Enrichment
periodically moving workers from one specialized job to anotherJob Enlargementincreasing the number of tasks
performed by a workerJob Enrichmentadding more tasks and authority to an employee’s jobJob rotation
attempts to overcome the disadvantages of job specialization by periodically moving workers from one
specialized job to another to give them more variety and the opportunity to use different skills. Another way to
counter the disadvantages of specialization is to enlarge the job.Job enlargement is increasing the number of
different tasks that a worker performs within one particular job. So, instead of having to perform just one task,
workers with enlarged jobs would be given several tasks to perform.Job enrichment attempts to overcome the
deficiencies in specialized work by increasing the number of tasks and by giving workers the authority and
control to make meaningful decisions about their work.3.2
27 Job Characteristics Model
A job redesign approach that seeks to increase employee motivationEmphasizes internal motivationexperience
work as meaningfulexperience responsibility for work outcomesknowledge of resultsThe central outcome of the
JCM is internal motivation. Internal motivation is motivation that comes from the job itself rather than from
outside rewards such as a raise or praise from the boss. If workers feel that performing the job well is itself
rewarding, then the job has internal motivation.First, workers must experience the work as meaningful, that is,
they must view their job as being important. Second, they must experience responsibility for work outcomes—
they must feel personally responsible for the work being done well. Third, workers must have knowledge of
results, that is, know how well they are performing their jobs. All three critical psychological states must occur
for work to be internally motivating.3.3
28 Motivation by Job Design: The JCM
Job Characteristics Model (JCM)Hackman and Oldham’s concept that any job can be described through five
core job dimensions:Skill variety – Requirements for different tasks in the job.Task identity – Completion of a
whole piece of work.Task significance – The job’s impact on others.Autonomy – Level of discretion in decision
making.Feedback – Amount of direct and clear information on performance.The way elements in a job are
organized (job design) impacts motivation, satisfaction, and performance.
29 The Job Characteristics Model
Employee growth-need strength moderates the relationships.Source: J.R. Hackman and G.R. Oldham, Work
Design (excerpted from pp. 78–80). © 1980 by Addison-Wesley Publishing Co., Inc. Reprinted by permission
of Addison-Wesley Longman, Inc.
30 Guidelines for Enriching a Job
Source: J.R. Hackman and J.L. Suttle, eds., Improving Life at Work (Glenview, IL: Scott Foresman, 1977), p.
138.
31 Designing Organizational Processes
After reading these sections, you should be able to:explain the methods that companies are using to redesign
international organizational processes (i.e., intraorganizational processes).describe the methods that companies
are using to redesign external organizational processes (i.e., interorganizational processes).Nearly 40 years ago,
Tom Burns and G.M. Stalker described how two kinds of organizational designs, mechanistic and organic, are
appropriate for different kinds of organizational environments. Mechanistic organizations are characterized by
specialized jobs and responsibilities, precisely defined, unchanging roles, and a rigid chain of command based
on centralized authority and vertical communication. This type of organization works best in stable, unchanging
business environments. By contrast, organic organizations are characterized by broadly defined jobs and
responsibility, loosely defined, frequently changing roles, and decentralized authority and horizontal
communication based on task knowledge. This type of organization works best in dynamic, changing business
environments.
32 Two Kinds of Organizational Designs
(Burns and Stalker)MechanisticOrganic
33 Intraorganizational Processes
ReengineeringEmpowerment4
34 ReengineeringThe fundamental rethinking and radical redesign of business processesIntended to achieve
dramatic improvements in performanceChange the orientation from vertical to horizontalChange task
interdependenceReengineering is "the fundamental rethinking and radical redesign of business processes to
achieve dramatic improvements in critical, contemporary measures of performance, such as cost,
quality, service and speed." Hammer and Champy further explained the four key words shown in italics in this
definition. The first key word is "fundamental." When reengineering organizational designs, managers must ask
themselves, "Why do we do what we do?" and "Why do we do it the way we do?" The usual answer is
"Because that's the way we've always done it."The second key word is "radical." Reengineering is about
significant change, about starting over by throwing out the old ways of getting work done.The third key word is
"processes." Hammer and Champy noted that "Most business people are not process oriented; they are focused
on tasks, on jobs, on people, on structures, but not on processes."The fourth key word is "dramatic."
Reengineering is about achieving quantum improvements in company performance. Reengineering changes an
organization's orientation from vertical to horizontal. Instead of taking orders from upper management, lower
and middle level managers and workers take orders from a customer who is at the beginning and end of each
process.In essence, reengineering changes work by changing task interdependence, the extent to which
collective action is required to complete an entire piece of work.4.1
35 Reengineering and Task Interdependence
Reengineering changes work by changing task interdependence. Depicted are the three kinds of task
interdependence.In pooled interdependence, each job or department independently contributes to the whole.In
sequential interdependence, work must be performed in succession as one group’s outputs become the inputs for
the next group or job.In reciprocal interdependence, different jobs or groups work together in a back-and-forth
manner to complete the process.4.1
36 Empowerment A feeling of intrinsic motivation
Empowering WorkersPermanently passing decision-making authority and responsibilities from managers to
workers by giving them the information and resources they need to make good decisionsA feeling of intrinsic
motivationWorkers perceive meaning in their workEmployees are capable of self-determinationEmpowering
workers means permanently passing decision-making authority and responsibility from managers to workers.
However, for workers to be fully empowered, companies must give them the information and resources they
need to make and carry out good decisions, and then reward them for taking individual initiative.Empowerment
is a feeling of intrinsic motivation in which workers perceive their work to have meaning and perceive
themselves to be competent, having an impact, and capable of self-determination. Work has meaning when it is
consistent with personal standards and beliefs. Workers feel competent when they believe they can perform an
activity with skill. The belief that they are having an impact comes from a feeling that they can affect work
outcomes. A feeling of self-determination arises from workers’ belief that they have the autonomy to choose
how best to do their work.Empowerment can lead to changes in organizational processes, because meaning,
competence, impact, and self-determination produce empowered employees who take active rather than passive
roles in their work.4.2
37 Interorganizational Processes
ModularOrganizationsVirtual OrganizationsExcept for the core business activities that they can perform better,
faster, and cheaper than others, modular organizations outsource all remaining business activities to outside
companies, suppliers, specialists, or consultants. The term "modular" is used because the business activities
purchased from outside companies can be added and dropped as needed, much like adding pieces to a three-
dimensional puzzle.By contrast to modular organizations in which the interorganizational process revolves
around a central company, a virtual organization is part of a network in which many companies share skills,
costs, capabilities, markets, and customers with each other. However, unlike modular organizations, in which
outside organizations are tightly linked to one central company, virtual organizations work with some
companies in the network alliance, but not with all.5
38 Modular Organizations
Exhibit 9.11 depicts a modular organization in which the company has chosen to keep training, human
resources, sales, etc., as core business activities, but it has outsourced the noncore activities of product
distribution, Web page design, advertising, etc.5.1
39 Modular Organizations
AdvantagesDisadvantagescan cost less to run than traditional organizationslets organizations focus on core
competenciesloss of control from outsourcingmay reduce their competitive advantageModular organizations
have several advantages. Because they pay for outsourced labor, expertise, or manufacturing capabilities only
when needed, they can cost significantly less to run than traditional organizations. It lets a company focus on
their core competencies. To obtain these advantages, it is important that modular organizations work closely
with reliable partners that they trust.Disadvantages include the loss of control that occurs when key activities
are outsourced to other companies. Also it reduces a company’s competitive advantage if they mistakenly
outsource a core business activity.Competitive and technological change may produce a situation in which the
noncore business a company has outsourced become the basis for competitive advantage. Second, companies to
which work is outsourced may become competitors.5.1
40 Virtual Organizations
A virtual organization is part of a network in which many companies share skills, costs, capabilities, markets,
and customers with each other.5.2
41 Virtual Organizations
AdvantagesDisadvantageslet companies share costsfast and flexiblebeing the best should provide better
productsdifficult to control the quality of partnersrequires tremendous management skills5.2
Presentation on theme: "Designing Adaptive Organizations"— Presentation transcript:
1 Designing Adaptive Organizations
Chapter 9Designing Adaptive OrganizationsDr. Ellen A. Drost
2 What Would You Do? Yahoo Headquarters, Sunnyvale, California
Where do you start to fix a company that has a $100 million loss, falling ad sales, plummeting stock prices, and
an unmanageable organizational structure?Yahoo has done a poor job in establishing relationships with
customersWhat Would You Do? Yahoo Headquarters, Sunnyvale, California.Faced with a $100 million loss,
plummeting ad sales, a stock price that has fallen from a high of $237 to less than $10 a share, layoffs, Yahoo
doesn’t know what to fix first!One problem is an organizational structure of 3,200 employees—and 44 different
business units. And, there’s no direct sales unit responsible for cultivating customers! In the old days, customers
called them, and this led to arrogance. Another problem was the informal culture with no controls.Where do you
start fixing Yahoo? What structure should Yahoo adopt? What about the informal culture? How can you deal
with decentralized decision making without squeezing out the entrepreneurial thinking and energy? What would
you do?What structure should Yahoo adopt? What should you do about the informal culture? How can better
decisions be made for the company?
3 Organizational Structure
The vertical and horizontal configuration of departments, authority, and jobs within a company.Organizational
ProcessThe collection of activities that transform inputs into outputs that customers value.This chapter begins
by reviewing the traditional organizational structure approach to organizational design. Organizational structure
is the vertical and horizontal configuration of departments, authority, and jobs within a company. Exhibit 9.1
shows Microsoft’s organizational chart.In the second half of the chapter, you will learn how contemporary
organizations are becoming more adaptive by redesigning their internal and external processes. An
organizational process is the collection of activities that transforms inputs into outputs that customers value.
4 Organizational Structure Process View of Microsoft’s Organization
Exhibit 9.2 shows the basic internal and external processes that Microsoft uses to write computer software,
beginning from customer feedback and ending with software distribution and sales. The cycle begins
again.Exhibit 9.2
5 Designing Organizational Structures
After reading these sections, you should be able to:describe the departmentalization approach to organizational
structure.explain organizational authority.
6 Departmentalization Customer Geographic Matrix Functional Product 1
Departmentalization is a method of subdividing work and workers into separate organizational units that take
responsibility for completing particular tasks.Organizational structures have been created by departmentalizing
work according to five methods, described on the slides that follow.1
7 Functional Departmentalization
The most common organizational structure is functional departmentalization. Companies tend to use this
structure when they are small or just starting out. Functional departmentalization organizes work and workers
into separate units responsible for particular business functions or areas of expertise. For example, a common
set of functions would consist of accounting, sales, marketing, production, and human resources
departments.However, not all functionally departmentalized companies have the same functions, as compared
in exhibit 9.3.1.1
8 Functional Departmentalization
AdvantagesDisadvantagesWork done by highly skilled specialistsLowers costs through reduced
duplicationCommunication and coordination problems are lessenedCross-department coordination can be
difficultMay lead to slower decision makingProduces managers with narrow experiencesFunctional
departmentalization has some advantages. First, it allows work to be done by highly qualified specialists. While
the accountants in the accounting department take responsibility for producing accurate revenue and expense
figures, the engineers in research and development can focus their efforts on designing a product that is reliable
and simple to manufacture. Second, it lowers costs by reducing duplication. When the engineers in research and
development come up with that fantastic new product, they don't have to worry about creating an aggressive
advertising campaign to sell it. That task belongs to the advertising experts and sales representatives in
marketing. Third, with everyone in the same department having similar work experience or training,
communication and coordination are less problematic for departmental managers.However, functional
departmentalization has a number of disadvantages, too. To start, cross-department coordination can be
difficult. Managers and employees are often more interested in doing what's right for their function than in
doing what's right for the entire organization. A good example is the traditional conflict between marketing and
manufacturing. Marketing typically pushes for spending more money to make more products with more
accessories and capabilities to meet customer needs. By contrast, manufacturing pushes for fewer products with
simpler designs, so that manufacturing facilities can ship finished products on time and keep costs within
expense budgets. As companies grow, functional departmentalization may also lead to slower decision-making,
and produce managers and workers with narrow experience and expertise.1.1
9 Product Departmentalization
United TechnologiesCarrierHamilton SundstrandChubbOtisPratt & WhitneyUTC PowerAdapted from Exhibit
9.4--Administrative services--Communication & public relations --Customer service & support--E-Business --
Engineering --etc…SikorskyProduct departmentalization organizes work and workers into separate units
responsible for producing particular products or services. For example, United Technologies is organized into
product lines, a portion of them shown in this slide.For a complete structure, refer to Exhibit 9.4.1.2
10 Product Departmentalization
AdvantagesDisadvantagesDuplication of activitiesDifficult to coordinate across departmentsManagers
specialize, but have broader experiencesEasier to assess work-unit performanceDecision-making is fasterOne of
the advantages of product departmentalization is that, like functional departmentalization, it allows managers
and workers to specialize in one area of expertise. However, unlike the narrow expertise and experiences in
functional departmentalization, managers and workers develop a broader set of experiences and expertise
related to an entire product line. Likewise, product departmentalization makes it easier for top managers to
assess work-unit performance. Finally, because managers and workers are responsible for the entire product line
rather than for separate functional departments, decision-making should be faster, because there are fewer
conflicts (compared to functional departmentalization).The primary disadvantage of product
departmentalization is duplication. For example, you can see in Figure 9.4 that the Otis Elevators and Pratt &
Whitney Divisions both have duplication of departments, such as customer service, engineering, human
resource, etc. Duplication like this often results in higher costs.A second disadvantage is that it can be difficult
to achieve coordination across the different product departments. For example, United Technologies would
probably have difficulty standardizing its policies and procedures in product departments as different as the
Carrier and Sikorsky divisions.1.2
11 Customer Departmentalization
U.S. BusinessesLocal ServiceSupply ChainIntegrationLocal ServiceSprint CorporationInternational
BusinessesLong- Distance ServiceLogistics NetworkSolutionsWireless ServicesDistribution CentersWireline &
Wireless ServicesBusiness SolutionsConsumer SolutionsSprint North SupplyLocal Telecom Division(Partial
Listing)Customer departmentalization organizes work and workers into separate units responsible for particular
kinds of customers.Exhibit 9.5 shows that Sprint is organized into departments that cater to businesses,
consumers, homes, and companies requiring supply chain services.1.3Adapted from Exhibit 9.5
12 Customer Departmentalization
AdvantagesDisadvantagesFocuses on customer needsProducts and services tailored to customer
needsDuplication of resourcesDifficult to coordinate across departmentsEfforts to please customers may hurt
the companyThe primary advantage to customer departmentalization is that it focuses the organization on
customer needs rather than on products or business functions. Furthermore, creating separate departments to
serve specific kinds of customers allows companies to specialize and adapt their products and services to
customer needs and problems.The primary disadvantage of customer departmentalization is that, like product
departmentalization, it leads to duplication of resources. Furthermore, like product departmentalization, it can
be difficult to achieve coordination across different customer departments. Finally, the emphasis on meeting
customers' needs may lead workers to make decisions that please customers but hurt the business.1.3
13 Geographic Departmentalization
Coca-Cola Enterprises Territories of OperationGeographic departmentalization organizes work and workers
into separate units responsible for doing business in particular geographical areas.Exhibit 9.6 shows the
geographic departmentalization used by Coca-Cola Enterprises.1.4Exhibit 9.6
14 Geographic Departmentalization
AdvantagesDisadvantagesResponsive to the demands of different market areasUnique resources located close
to the customerDuplication of resourcesDifficult to coordinate across departmentsThe primary advantage of
geographic departmentalization is that it helps companies respond to the demands of different markets. This can
be especially important when selling in different countries. For example, CCE’s geographic divisions sell
products suited to the taste preferences in different countries. CCE bottles and distributes the following products
in Europe but not in the U.S.: Aquarius, Bonaqua, Burn, Canada Dry, Coca-Cola light, Cresta flavors, Five
Alive, Kia-Ora, Kinley, Lilt, Malvern, and Oasis. Another advantage is that geographic departmentalization can
reduce costs by locating unique organizational resources closer to customers. For instance, it is much cheaper
for CCE to build bottling plants in Belgium than to bottle Coke in England and then transport it across the
English Channel.The primary disadvantage of geographic departmentalization is that it can lead to duplication
of resources. For example, while it may be necessary to adapt products and marketing to different geographic
locations, it's doubtful that CCE needs significantly different inventory tracking systems from location to
location. Also, even more so than with the other forms of departmentalization, it can be especially difficult to
coordinate departments that are literally thousands of miles from each other and whose managers have very
limited contact with each other.1.4
15 Matrix Departmentalization
Adapted from Exhibit 9.7CitiGroup InternationalNorth America(excluding Mexico)Europe, Middle
East,AfricaAsia PacificGlobal Corporate & InvestmentBankGlobal Investment ManagementGlobal
ConsumerSmith BarneyCountry Managers in Spain, UAE, Kenya, etc.Country Managers in China, Australia,
etc.Matrix departmentalization is a hybrid structure in which two or more forms of departmentalization are used
together. The most common matrix combines product and functional forms of departmentalization.Several
things distinguish matrix departmentalization from the other traditional forms of departmentalization. First,
most employees report to two bosses, a functional boss and a project or product boss. Second, by virtue of the
function-by-project design, matrix structures lead to much more cross-functional interaction than other forms of
departmentalization. In fact, while matrix workers are members of only one functional department (based on
their work experience and expertise), it is common for them to be members of several ongoing project groups.
Third, because of the high level of cross-functional interaction, matrix departmentalization requires significant
coordination between functional and project managers. In particular, these managers have the complex job of
tracking and managing the multiple project and functional demands on employees' time.1.5
16 Matrix Departmentalization
Matrix departmentalization is a hybrid structure in which two or more forms of departmentalization are used
together. The most common matrix combines product and functional forms of departmentalization.Several
things distinguish matrix departmentalization from the other traditional forms of departmentalization. First,
most employees report to two bosses, a functional boss and a project or product boss. Second, by virtue of the
function-by-project design, matrix structures lead to much more cross-functional interaction than other forms of
departmentalization. In fact, while matrix workers are members of only one functional department (based on
their work experience and expertise), it is common for them to be members of several ongoing project groups.
Third, because of the high level of cross-functional interaction, matrix departmentalization requires significant
coordination between functional and project managers. In particular, these managers have the complex job of
tracking and managing the multiple project and functional demands on employees' time.1.5
17 Matrix Departmentalization
AdvantagesDisadvantagesRequires high levels of coordinationConflict between bossesRequires high levels of
management skillsEfficiently manage large, complex tasksPool of available resourcesThe primary advantage of
matrix departmentalization is that it allows companies to efficiently manage large, complex tasks like
researching, developing, and marketing pharmaceuticals. Efficiency comes from avoiding duplication. For
example, rather than having an entire marketing function for each project, the company simply assigns and
reassigns workers from the marketing department as they are needed at various stages of product completion.
More specifically, an employee from a department may simultaneously be part of five different ongoing
projects, but may only be actively completing work on a few projects at a time. Another advantage is the ability
to carry out large, complex tasks. Because of the ability to quickly pull in expert help from all the functional
areas of the company, matrix project managers have a much more diverse set of expertise and experience at
their disposal than do managers in the other forms of departmentalization.The primary disadvantage of matrix
departmentalization is the high level of coordination required to manage the complexity involved with running
large, ongoing projects at various levels of completion. Matrix structures are notorious for confusion and
conflict between project bosses, or between project and functional bosses. Disagreements or misunderstanding
about project schedules, budgets, available resources, and the availability of employees with particular
functional expertise are common. Another disadvantage is that matrix structures require much more
management skill than the other forms of departmentalization.Because of these problems, many matrix
structures evolve from the simple matrix, in which project and functional managers negotiate conflicts and
resources, to the complex matrix, in which specialized matrix managers and departments are added to the
organizational structure. In the complex matrix, project and functional managers report to the same matrix
manager, who helps them sort out conflicts and problems.1.5
18 Organizational Authority
Delegation of AuthorityDegree ofCentralizationChain of CommandLine versus Staff AuthorityAuthority is the
right to give commands, take action, and make decisions to achieve organizational objectives.Traditionally,
organizational authority has been characterized by the following dimensions: chain of command, line versus
staff authority, delegation of authority, and degree of centralization.2
19 Chain of Command The vertical line of authority in an organization
Clarifies who reports to whomUnity of commandworkers report to only one bossmatrix organizations violate
this principleThe chain of command is the vertical line of authority that clarifies who reports to whom
throughout the organization. People higher in the chain of command have the right, if they so choose, to give
commands, take action, and make decisions concerning activities occurring anywhere below them in the chain.
In the following discussion about delegation and decentralization, you will learn that managers don’t always
choose to exercise their authority directly.One of the key assumptions underlying the chain of command is unity
of command, which means that workers should report to just one boss. In practical terms, this means that only
one person can be in charge at a time. Matrix organizations, in which employees have two bosses, automatically
violate this principle. This is one of the primary reasons that matrix organizations are difficult to manage. The
purpose of unity of command is to prevent the confusion that might arise when an employee receives
conflicting commands from two different bosses.When Steve Ballmer took over the CEO position at Microsoft
from Bill Gates, the new chain of command was surprisingly unclear. Once they became comfortable with the
change, however, the new structure proved to be a success.2.1
20 Line versus Staff Authority
Line authoritythe right to command immediate subordinates in the chain of commandStaff authoritythe right to
advise but not command othersversusA second dimension of authority is the distinction between line and staff
authority. Line authority is the right to command immediate subordinates in the chain of command. For
example, in the Microsoft organizational chart in Figure 9.1, CEO Steve Ballmer has line authority over the
manager of the Homes and Entertainment Group.Staff authority is the right to advise but not command others
who are not subordinates in the chain of command. For example, at Microsoft, a manager in human resources
might advise the vice president of MSN on making a hiring decision but cannot order him to hire a certain
applicant.The terms “line” and “staff” are also used to describe different functions within the organization. A
line function is an activity that contributes directly to creating or selling the company’s products. So, for
example, activities that take place within the manufacturing and marketing departments would be considered
line functions. A staff function is one that does not contribute directly to creating or selling the company’s
products, but instead supports line activities. Typical staff functions within an organization are accounting,
human resources, and legal services. For example, marketing managers might consult with the legal staff to
make sure the wording of a particular advertisement is legal.2.2
21 RenditionHow would you describe the workplace atmosphere in this scene? Would you say it demonstrates
behavioral informality or formality?Do you think the scene shows line authority or staff authority between these
two men?What kind of feedback is Alan Smith getting from Senator Hawkins? Is it primarily positive or
negative?“What if someone you love just disappeared?” This is the question posed by the 2007 dramatic thriller
Rendition. Anwar El-Ibrahimi (Omar Metwally) boards a flight in South Africa but never arrives home to his
family in the States. His pregnant wife Isabella (Reese Witherspoon) doesn’t know that he has been named as a
suspected terrorist and sent to a secret detention facility in North Africa, where he is tortured and interrogated.
Eventually, CIA analyst Douglas Freeman (Jake Gyllenhaal), who has overseen the interrogation, becomes
convinced of El-Ibrahimi’s innocence, but he is ordered to continue with the detention. In this scene, Senator
Hawkins (Alan Arkin) is talking to congressional aide Alan Smith (Peter Sarsgaard) about the situation and
explaining why they think there may be a connection between the terrorists and El-Ibrahimi.© 2014 Cengage
Learning
22 Delegation of Authority
The assignment of direct authority and responsibility to a subordinate to complete tasks for which the manager
is normally responsible.Managers can exercise their authority directly by completing the tasks themselves, or
they can choose to pass on some of their authority to subordinates. Delegation of authority is the assignment of
direct authority and responsibility to a subordinate to complete tasks for which the manager is normally
responsible.2.3
23 Delegation of Authority
When a manager delegates work, three transfers occur. First, the manager transfers full responsibility for the
assignment to the subordinate. Indeed, most managers have way too much to do. So, from a practical
perspective, they can't assume new responsibilities that come with change and growth until they fully delegate
old ones.Another problem is that managers often fear that the task won't be done as well if they don’t do it
themselves. Second, delegation transfers to the subordinate full authority over the budget, resources, and
personnel needed to do the job. To do the job effectively, subordinates must have the same tools and
information at their disposal that managers had when they were responsible for the same task. The third transfer
that occurs with delegation is the transfer of accountability. The subordinate now has the authority and
responsibility to do the job, and is then accountable for getting the job done. In other words, managers give
subordinates their managerial authority and responsibility in exchange for results.2.3Adapted from Exhibit 9.8
24 How to be a More Effective Delegator
Trust your staff to be a good jobAvoid seeing perfectionGive effective job instructionsKnow your true
interestsFollow up on progress.Praise the efforts of your staff.Don’t wait to the last minute to delegate.Ask
questions, expect answers, assist employees.Provide the resources you would provide if doing the assignment
yourself.Delegate to the lowest possible level.2.3Adapted from Exhibit 9.9
25 Degree of Centralization
Centralization of authorityprimary authority is held by upper managementDecentralizationsignificant authority
is found in lower levels of the organizationStandardizationsolving problems by applying rules, procedures, and
processesCentralization of authority is the location of most authority at the upper levels of the organization. In a
centralized organization, managers make most decisions, even the relatively small ones.Decentralization is the
location of a significant amount of authority in the lower levels of the organization. An organization is
decentralized if it has a high degree of delegation at all levels. In a decentralized organization, workers closest
to problems are authorized to make the decisions necessary to solve the problems on their own. Decentralization
has a number of advantages. It develops employee capabilities throughout the company, and leads to faster
decision making and more satisfied customers and employees. With results like these, the key question is no
longer whether companies should decentralize, but where they should decentralize. One rule of thumb is to stay
centralized where standardization is important and to decentralize where standardization is
unimportant.Standardization is solving problems by consistently applying the same rules, procedures, and
processes.2.4
26 Designing Organizational Processes
After reading these sections, you should be able to:explain the methods that companies are using to redesign
international organizational processes (i.e., intraorganizational processes).describe the methods that companies
are using to redesign external organizational processes (i.e., interorganizational processes).Nearly 40 years ago,
Tom Burns and G.M. Stalker described how two kinds of organizational designs, mechanistic and organic, are
appropriate for different kinds of organizational environments. Mechanistic organizations are characterized by
specialized jobs and responsibilities, precisely defined, unchanging roles, and a rigid chain of command based
on centralized authority and vertical communication. This type of organization works best in stable, unchanging
business environments. By contrast, organic organizations are characterized by broadly defined jobs and
responsibility, loosely defined, frequently changing roles, and decentralized authority and horizontal
communication based on task knowledge. This type of organization works best in dynamic, changing business
environments.
27 Intraorganizational Processes
ReengineeringEmpowerment4
28 ReengineeringThe fundamental rethinking and radical redesign of business processesIntended to achieve
dramatic improvements in performanceChange the orientation from vertical to horizontalChanges task
interdependenceReengineering is "the fundamental rethinking and radical redesign of business processes to
achieve dramatic improvements in critical, contemporary measures of performance, such as cost,
quality, service and speed." Hammer and Champy further explained the four key words shown in italics in this
definition. The first key word is "fundamental." When reengineering organizational designs, managers must ask
themselves, "Why do we do what we do?" and "Why do we do it the way we do?" The usual answer is
"Because that's the way we've always done it."The second key word is "radical." Reengineering is about
significant change, about starting over by throwing out the old ways of getting work done.The third key word is
"processes." Hammer and Champy noted that "Most business people are not process oriented; they are focused
on tasks, on jobs, on people, on structures, but not on processes."The fourth key word is "dramatic."
Reengineering is about achieving "quantum" improvements in company performance. Reengineering changes
an organization's orientation from vertical to horizontal. Instead of "taking orders" from upper management,
lower and middle level managers and workers "take orders" from a customer who is at the beginning and end of
each process.In essence, reengineering changes work by changing task interdependence, the extent to which
collective action is required to complete an entire piece of work.4.1
29 Empowerment A feeling of intrinsic motivation
Empowering WorkersPermanently passing decision-making authority and responsibilities from managers to
workers by giving them the information and resources they need to make good decisionsA feeling of intrinsic
motivationWorkers perceive meaning in their workEmployees are capable of self-determinationEmpowering
workers means permanently passing decision-making authority and responsibility from managers to workers.
However, for workers to be fully empowered, companies must give them the information and resources they
need to make and carry out good decisions, and then reward them for taking individual initiative.Empowerment
is a feeling of intrinsic motivation, in which workers perceive their work to have meaning, and perceive
themselves to be competent, having an impact, and capable of self-determination. Work has meaning when it is
consistent with personal standards and beliefs. Workers feel competent when they believe they can perform an
activity with skill. The belief that they are having an impact comes from a feeling that they can affect work
outcomes. A feeling of self-determination arises from workers’ belief that they have the autonomy to choose
how best to do their work.Empowerment can lead to changes in organizational processes, because meaning,
competence, impact, and self-determination produce empowered employees who take active rather than passive
roles in their work.4.2
30 Interorganizational Processes
ModularOrganizationsVirtual OrganizationsExcept for the core business activities that they can perform better,
faster, and cheaper than others, modular organizations outsource all remaining business activities to outside
companies, suppliers, specialists, or consultants. The term "modular" is used because the business activities
purchased from outside companies can be added and dropped as needed, much like adding pieces to a three-
dimensional puzzle.By contrast to modular organizations in which the interorganizational process revolves
around a central company, a virtual organization is part of a network in which many companies share skills,
costs, capabilities, markets, and customers with each other. However, unlike modular organizations, in which
outside organizations are tightly linked to one central company, virtual organizations work with some
companies in the network alliance, but not with all.5
31 Modular Organizations
Exhibit 9.13 depicts a modular organization in which the company has chosen to keep training, human
resources, sales, etc., as core business activities, but it has outsourced the noncore activities of product
distribution, Web page design, advertising, etc.5.1Exhibit 9.13
32 Modern Shed1. Describe how Modern Shed functions as a modular organization. 2. What are the advantages
and disadvantages of Modern Shed’s organizational structure?Modern Shed, based in Seattle, builds paneled
dwellings for use as studio spaces, home offices, pool houses, project sheds, guesthouses, and more. Like the
sheds, the company is built to be adaptive, scalable, and suited to the needs of the environment. Modern Shed
counts only 12 to 14 full time employees. But at times, its output rivals that of a large builder, thanks to
collaboration with outside sales reps and a dealer network comprised of 35 independent contractors. According
to Smith, the logical process of building sheds from smaller scale structures to larger ones is a metaphor for how
modern organizations should be built. “You can use the analogy for organizations and people as well as
structures,” Smith states. “If you go too big you don’t understand it; you have to start small.”© 2014 Cengage
Learning
33 Modular Organizations
AdvantagesDisadvantagescan cost less to run than traditional organizationslets organizations focus on core
competenciesloss of control from outsourcingmay reduce their competitive advantageModular organizations
have several advantages. Because modular organizations pay for outsourced labor, expertise, or manufacturing
capabilities only when needed, they can cost significantly less to run than traditional organizations. It lets a
company focus on their core competencies. To obtain these advantages, it is important that modular
organizations work closely with reliable partners that they trust.Disadvantages include the loss of control that
occurs when key activities are outsourced to other companies. Also it reduces a company’s competitive
advantage if they mistakenly outsource a core business activity.Competitive and technological change may
produce a situation in which the noncore business a company has outsourced become the basis for competitive
advantage. Second, companies to which work is outsourced may become competitors.5.1
34 Virtual Organizations
A virtual organization is part of a network in which many companies share skills, costs, capabilities, markets,
and customers with each other.5.2Exhibit 9.14
35 Virtual Organizations
AdvantagesDisadvantageslet companies share costsfast and flexiblebeing the “best” should provide better
productsdifficult to control the quality of partnersrequires tremendous management skillsFor more information
on how a virtual organization works, seeWeb Link5.2
Designing Adaptive Organisations
Three weeks ago, the Chinese government announced a further ‘cut off’ of rare earth mineral export quotas for
2011. After a rare earth mineral export cut of 40% by the Chinese this year, this is an unexpected blow to
organizations in the computers and electronics industry. (Bloomberg News, 2010)
Most organizations today, operate in similarly unpredictable, unstable and dynamic external environments that
are mainly consequences of “rapid globalization”, “accelerating innovation” and “intense competition”.
(Murray, 2010)
(Daft, 2010)The diagram (right) explicates that environments with a large number of external factors, that
change rapidly, are highly uncertain. It therefore concludes, that organizations operating in highly-uncertain
environments need to ‘adapt’ to the environment. (Daft, 2010)
The term ‘adapt’ in this context refers to an organisations’ ability to ‘actively cope’ with the changes in its
external environment. (Harwood, 1991)
As discussed before, we live in an era of uncertainty where age-old institutions like Lehman Brothers and Bear
Stearns vanish overnight and brand new ventures like Google and Twitter appear from out of the blue (Murray,
2010). Therefore, this essay takes on a postmodernist approach and exemplifies effective ways to adapt to
uncertainties in the environment.
Strategy, Structure and Environment
Porter described two generic strategies to cope with external environments. His strategy of cost leadership
(attempting internal efficiency) relates more to stable environments while the strategy of differentiation
(attempting innovation) relate to unpredictable environments. (Daft, 2010)
(Daft, 2010)The diagram (right) matches organisational structure to Porter’s strategic goals. Here, organic
structures are pertinent to organisations that adopt strategic goals of differentiation while a mechanistic structure
fits well with organisations that attempt cost leadership (Daft, 2010).
That being said, in a post-modernist society characterized by constant instability, it is important that
organisations striving for efficiency are also able to adapt to the changes in the external environment. Consider
for example McDonalds, a highly bureaucratic fast-food chain in the last decade that led to the concept of
McDonaldization – an extension of Weber’s theory of rationalization (Ritzer, 1996). McDonalds strives for
efficiency in their operations and their strategic goal is to provide their customers with the quickest restaurant
experience. More recently however, with increasing competition in the external environment, the fast food-
chain incorporated decentralization to their business model. Consequently, now, at the corporate level, a global
framework of common goals, policies and guidelines are outlined, while individual geographic business units
are expected to develop programs in compliance with local market conditions. (Hatch, 2006)
Contrary to popular belief, Weber’s model of bureaucratic control implies decentralized decision-making
(Walton, 2005). Although McDonalds has adopted decentralization, it can still be considered a bureaucratic
organisation (assembly-line to serve customers) except, now; a decentralized decision-making approach has
made the organisation capable of adapting to market conditions.
Albeit, bureaucracies (incorporating decentralization) are able adapt to the environment, organizational designs
(new organisational forms) stressing flatter structures, multi-skilled capabilities and a lower degree of
informality (Clegg et al, 2008) are more efficient in dealing with changes in the environment. (Walton, 2005)
For instance, United Technologies Corporation in the US has adapted a divisional structural approach allowing
it to create divisions with separate functional departments for its different products – Carriers (air-conditioning
and heating), Otis (elevators and escalators) and Sikorsky (helicopters) (Daft, 2010). Decision-making is
decentralized in such structures and divisions can be based on product-lines, customer segments or geographic
locations. (Hatch, 2006)
SEI, an investment services company, operates in a team based structure where work is distributed amongst 140
teams approximately. Teams that focus on specific markets or serve major customers are permanent while most
teams are designed to work on short-term assignments or problems. SEI functions in an open office
environment where most desks are on wheels. Employees constantly change assignments and move from one
team to the other. Organisations operating in team based structure readily adapt to the environment since it
pushes responsibility to lower levels and allows managers to delegate authority. (Daft, 2010)
Network structures are also flexible and easily adapt to market conditions. Strida, a company selling thousands
of high-tech folding bicycles to people all over the world, is run by duo -Bass and Bennet. All processes
including design, manufacturing, logistics, customer services, accounting are outsourced to other organisations
while the duo only manage and ensure the smooth functioning of the partnerships in this network. (Daft, 2010)
Virtual networks are increasing in popularity. The best example of a virtual-network organisation is eBay – a
market that allows buys and sellers to negotiate and make transactions over the Internet, not requiring any
physical contact. (Hatch, 2006)
Danny Miller, in an empirical evaluation to explore the relationships of business strategies to the structures and
environments of undiversified firms, concluded that although the right strategy can help organisations adapt to
the changing environment, it alone cannot influence organisational performance. Furthermore, the study also
indicated that the structure of an organisation alone does not have a direct impact on the environment unless
aligned with the best strategy. (Miller, 1988)
For instance, Apple Computers in 1985 faced deterioration in revenue due the company’s inadequate attention
to the needs of customers. In response to company losses, 20% of the staff was laid off. This made no difference
to company performance. However, in a further attempt to gain momentum, the company turned its strategic
focus towards creating cooperative alliances with customers. With a limited amount of staff at hand, the
company amalgamated the different segments at Apple – each performing individual functions – into a team.
Apple’s crisis in 1985 and its combative strategy and restructuring is what laid the foundation for a company
that is known to take calculated risks and speedily adapt to new market situations. (Harwood, 1991)
Corporate Culture and the External Environment
A research conducted at Harvard found that a strong corporate culture alone does not ensure business success
unless “the culture encouraged healthy adaptation to the external environment” (Daft, 2010, p80)
(Daft, 2010) As per the diagram (left), it is important that organizations attempting to adapt to the external
environment adopt either:
A culture allowing organisations to adapt (adaptability culture) to the external environment. (Daft, 2010). Dow
Chemical rebuilt its corporate culture to that of which would personify a better appreciation to economic
elements. In its attempt to do so, excessive hierarchies were removed from its structure to speed decision-
making and a concept of “opportunity teams” was created to encourage innovation. The company also
appointed a manager solely for the process of “de-bureaucratizing”. Dow’s culture now tolerates
‘unconventional behaviour’ and values ‘venturesomeness’. (Harwood, 1991)
A culture encouraging employee participation (involvement culture) in adapting to the needs of the external
environment. (Daft, 2010). IBM, in its attempts to adapt to the changes in the external environment empowers
its workforce with responsibility and decision making power. Employees at IBM are encouraged to take risks
and are quite often reminded that it is their business. IBM is characterized by a flat organisation structure
entailing a broad span of control. (Harwood, 1991)
Conclusion
Alternatives to bureaucracies – flattening of organisational hierarchies through delayering, temporary structures
(task forces, adhocracies, project teams) and permanent structures (quality circles, matrix forms) (Walton, 2005)
– have emerged to adapt to the uncertainties of the environment. These alternatives combined with the best
strategy and corporate culture help organisations adapt to postmodernist society.

 Managing Change and Innovation

Presentation on theme: "Managing Change and Innovation"— Presentation transcript:
1 Managing Change and Innovation
Define organizational change and explain the forces driving innovation and change in today’s
organizations.After studying this chapter, students should be able to:Identify the three innovation strategies
managers implement for changing products and technologies.Explain the value of creativity, idea incubators,
horizontal linkages, open innovation, idea champions, and new-venture teams for innovation.Discuss why
changes in people and culture are critical to any change process.Define organization development (OD) and
large-group interventions.Explain the OD stages of unfreezing, changing, and refreezing.Identify sources of
resistance to change.Explain force-field analysis and other implementation tactics that can be used to overcome
resistance.Chapter 11Managing Change and Innovation
2 Why Change?IBM(1960 – 2000) From hardware, software company(2000 – present) To a service company
(mainly, consulting)If organizations don’t successfully change and innovate, they dieAfter studying this
chapter, students should be able to:Define organizational change and explain the forces driving innovation and
change in today’s organizations.Identify the three innovation strategies managers implement for changing
products and technologies.Explain the value of creativity, idea incubators, horizontal linkages, open innovation,
idea champions, and new-venture teams for innovation.Discuss why changes in people and culture are critical to
any change process.Define organization development (OD) and large-group interventions.Explain the OD
stages of unfreezing, changing, and refreezing.Identify sources of resistance to change.Explain force-field
analysis and other implementation tactics that can be used to overcome resistance.Copyright ©2012 by South-
Western, a division of Cengage Learning. All rights reserved.
3 Innovation & Changing Workplace
The adoption of a new idea or behavior by an organizationChange and innovation can come from outside
forcesManagers want to initiate change from the insideDisruptive innovation is a goal for global
competitionTrickle-up / reverse innovation: Jeep at ChinaARE YOU INNOVATIVE?Personal innovativeness
reflects the awareness of the need to innovate and a readiness to try new things. Innovativeness is considered a
positive thing for people in many companies where individuals and organizations are faced with a constant need
to change. This exercise helps students determine their level of personal innovativeness.INNOVATION AND
THE CHANGING WORKPLACEOrganizational change is defined as the adoption of a new idea or behavior
by an organization. In today’s highly complex and rapidly changing world, organizations need to continuously
adapt to new situations if they are to survive and prosper. Advances in information technology and the Internet
are driving many of the changes in today’s world and today’s organizations. Organizations must embrace many
types of change.Disruptive innovation refers to innovations in products, services, or processes that radically
change an industry’s rules of the game for producers and consumers. CDs all but wiped out the phonograph
industry, and now iPods and streaming music are threatening the same fate for CDs. Western firms are
increasingly using an approach referred to as trickle-up innovation or reverse innovation. Rather than
innovating in affluent countries and transferring products to emerging markets, companies are now creating
innovative low-cost products for emerging markets and then quickly and inexpensively repackaging them for
sale in developed countries.
4 Organizational Change
Change is not easy;organizations must take an ambidextrous approachIncorporating structures and processes
that are appropriate for:Creative impulse and for the systematic implementationManagers encourage flexibility
and freedom to innovateAn ambidextrous approach means incorporating structures and processes that are
appropriate for both the creative impulse and for the systematic implementation of innovations. With this
approach, managers encourage flexibility and freedom to innovate and propose new ideas with creative
departments, venture teams, and other mechanisms, but they also use a more rigid, centralized, and standardized
approach for implementing innovations.
5 Changing Things: New Products and Technologies
Product Change – a change in the organization’s product or service outputsTechnology Change – a change in
the organization’s production processThree innovation strategies:exploration,cooperation,
andentrepreneurshipCHANGING THINGS: NEW PRODUCTS AND TECHNOLOGIESTo thrive in today’s
hypercompetitive environment, companies must innovate more, and more quickly, than ever. One vital area for
innovation is introducing new products and technologies.A product change is a change in the organization’s
product or service outputs. Product and service innovation is the primary way in which organizations adapt to
changes in markets, technology, and competition.A technology change is a change in the organization’s
production processes—how the organization does its work. Technology changes are designed to make the
production of a product or service more efficient.
6 Three Innovation Strategies
7 ExplorationCreativity – novel ideas that meet perceived needs or offer opportunitiesIdea incubator – a safe
harbor where employees can develop ideas and experiment without interference from company bureaucracy or
politicsYahoo  Brickhouse  Top management supportExplorationExploration involves designing the
organization to encourage creativity and the initiation of new ideas. It is the stage where ideas for new products
and technologies are born. Creativity is the generation of novel ideas that might meet perceived needs or
respond to opportunities for the organization.Creativity is the essential first step in innovation. Creative people
are known for originality, curiosity, open-mindedness, a focused approach to problem solving, persistence, a
relaxed and playful attitude, and receptiveness to new ideas. Managers are responsible for creating a work
environment that allows creativity to flourish. Creative organizations have an internal culture of playfulness,
freedom, challenge, and grass-roots participation.The idea incubator is another popular way to encourage new
ideas within an organization. An idea incubator provides a safe harbor where ideas from employees throughout
the company can be developed without interference from company bureaucracy or politics.Copyright ©2012 by
South-Western, a division of Cengage Learning. All rights reserved.
8 Characteristics of Creative People and Organizations
9 The World’s Most Innovative Companies
10 Cooperation – (1) Internal Coordination
Horizontal Linkage Model:Simultaneously contribute to innovationHorizontal coordination
mechanisms:Marketing = Research = ManufacturingKey to Success:MANAGEMENT – Planning, organizing,
leadership, controlTeam BuildingProject ManagerCooperationInternal Coordination Exhibit 11.4Successful
innovation requires expertise from several departments simultaneously. The horizontal linkage model is one
approach to successful innovation. In this model, people from several departments meet frequently in teams and
task forces to share ideas and solve problems. The horizontal linkage model is increasingly important in today’s
high-pressure business environment that requires developing and commercializing products and services
incredibly fast.A fast-cycle team is a multifunctional, and sometimes multinational, team that works under
stringent timelines and is provided with high levels of resources and empowerment to accomplish an
accelerated product development project.
11 Cooperation – (2) External Coordination
Includes customers, partners, suppliersOpen innovation – commercialization of ideas beyond the
organizationP&G – PatentLEGO + Hollywood studiosCrowdsoucingThreadless – web 2.0 (open, share,
participate)External CoordinationOrganizations also look outside their boundaries to find and develop new
ideas. Some organizations build formal strategic partnerships such as alliances and joint ventures to improve
innovation success. Outsourcing partnerships can help companies get things done very quickly. Today’s most
successful companies are including customers, strategic partners, suppliers, and other outsiders directly in the
product and service development process.Open innovation is one of the hottest trends. Open innovation means
extending the search for and commercializing new ideas beyond the boundaries of the organization and even
beyond the boundaries of the industry. Smart companies find and use ideas from anywhere within and outside
the organization.
12 Coordination Model for Innovation
13 Innovation RolesManagers should support entrepreneurship activities and foster idea championsEnergy and
effort is required to promote a new ideaSponsors approve and protect ideas when critics challenge the
conceptNew-venture teams give free rein to creativitySkunkworks are informal, autonomous, secretive groups
that focus on breakthrough ideasNew-venture funds provide resources for new ideasEntrepreneurship Exhibit
11.5Creating mechanisms to make sure new ideas are carried forward, accepted, and implemented is the third
aspect of product and technology innovation. The formal definition of an idea champion is a person who sees
the need for and champions productive change within the organization. Personal energy and effort are required
to successfully promote a new idea. Champions are passionately committed to a new product or idea despite
rejection by others.Successful innovation in most companies involves interplay of different people. The
inventor comes up with the new idea and understands its technical value. The champion believes in the idea,
confronts the organizational realities of costs and benefits, and gains the political and financial support needed
to bring it to reality. The sponsor is a high-level manager who approves and protects the idea, and removes
organizational barriers to its acceptance. The critic counterbalances the zeal of the champion by challenging the
concept, thereby preventing people in the other roles from adopting a bad idea.Entrepreneurship is often
facilitated through a new-venture team, which is a unit separate from the rest of the organization that is
responsible for developing and initiating a major innovation. A skunkworks is a variation of a new-venture team
in which a separate small, informal, highly autonomous, and often secretive group focuses on breakthrough
ideas for the business. A new-venture fund provides resources from which individuals and groups can draw to
develop new ideas, products, or businesses.
14 Four Roles in Organizational Change
15 Changing People and Culture
Changes in how employees think; Changes in mind-setPeople change = Training and Development
(T&D)Culture change = Organizational Development (OD)Large culture change is not easyCHANGING
PEOPLE AND CULTUREChanges in culture and people pertain to how employees think. These are changes in
mindset rather than technology, structure, or products and services.People change pertains to just a few
employees, such as sending a handful of managers to a training course to improve their management
skills.Culture change pertains to the organization as a whole, such as shifting the basic mind-set from an
organizational focus on rules and policies to an organizational focus on doing whatever is necessary to satisfy
customers.
16 Training and Development
Training – Frequently used approach to changing people’s mind-setsTraining and development is emphasized
for managersBehavior and attitudes will influence people and lead to culture change
17 Organizational Development
Planned, systematic process of change using behavioral science (psychology)Addresses three types of
problems:Mergers and acquisitions (M&A)Organizational decline and revitalizationConflict
managementOrganization development (OD) is a planned, systematic process of change that uses behavioral
science knowledge and techniques to improve an organization’s health and effectiveness through its ability to
adapt to the environment, improve internal relationships, and increase learning and problem-solving
capabilities. OD can help manager’s address at least three types of current problems.Mergers/acquisitions. The
disappointing financial results of many mergers and acquisitions are caused by the failure of executives to
determine whether the administrative style and corporate culture of the two companies fit. They fail to
recognize that the firms may have widely different values, beliefs, and practices. These differences create stress
and anxiety for employees, and these negative emotions affect future performance. OD experts can help smooth
the integration of the firms.Organizational decline/revitalization. Organizations undergoing a period of decline
and revitalization experience a variety of problems such as low level of trust, lack of innovation, high turnover,
and high levels of conflict and stress. The period of transition requires opposite behaviors to include confronting
stress, creating open communication, and fostering creative innovation. OD techniques can contribute greatly to
cultural revitalization by managing conflicts, fostering commitment, and facilitating communication.Conflict
management. Conflict can occur at any time and place within a healthy organization. OD efforts can help
resolve conflict problems.
18 OD ActivitiesTeam-building activities: Enhancing cohesiveness and success of organizational groups and
teamsSurvey-feedback activities: an employee questionnaire asking “values, climate, participation, leadership,
and group cohesion”Large-group interventions: participants from all parts of the organization to discuss
problems or opportunities and plan for changeOD ActivitiesTeam-building activities enhance the cohesiveness
and success of organizational groups and teams.Survey-feedback activities begin with an employee
questionnaire asking about items such as values, climate, participation, leadership, and group cohesion. An OD
consultant provides feedback to the employees regarding their responses and problems identified from the
survey or questionnaire.Large-group interventions are more attuned to bringing about fundamental
organizational change in today’s complex, fast-changing world. Large-group intervention brings together
participants from all parts of the organization to discuss problems or opportunities and plan for
change.Discussion Question #10: How do large-group interventions differ from OD techniques such as team-
building and survey feedback?
19 OD Steps Unfreezing: Changing: Refreezing.
Participants must be made aware of problems and be willing to change; Diagnosis  Identifies work-related
problemsChanging:when employees learn new skills to be used in the workplace; Intervention; Implements a
plan for training managers and employees; Include team building, survey feedback, intergroup coaching,
process-consultation, or symbolic leadership.Refreezing.When individuals acquire new attitudes or values;
Rewarded; Institutionalized in the organizational cultureOD StepsUnfreezing. Participants must be made aware
of problems and be willing to change. This step is often associated with diagnosis. An outside expert called a
change agent, an OD specialist, performs a systematic diagnosis of the organization. The diagnosis identifies
work-related problems.Changing. Changing occurs when individuals learn new skills to be used in the
workplace. This is sometimes known as intervention, during which the change agent implements a plan for
training managers and employees. This may include team building, survey feedback, intergroup coaching,
process-consultation, or symbolic leadership.Refreezing. Refreezing occurs when individuals acquire new
attitudes or values and are rewarded for them by the organization. The impact of new behaviors is evaluated and
reinforced; the change agent supplies new data that show positive changes in performance. Changes are
institutionalized in the organizational culture, so that employees begin to view the changes as a normal, integral
part of the organization.
20 11.6 OD Approaches to Culture Change
21 Implementing Change Outline the Need for Change
Show the performance gap (disparity) b/w existing & desired performance levelsGet employees involved in the
change as early as possible; in the planning stage; Empower them!Understand the Resistance to ChangeSelf-
InterestLack of Understanding and TrustUncertaintyDifferent Assessments and GoalsJob
securityIMPLEMENTING CHANGENeed for ChangeExternal or internal forces translate into a perceived need
for change within the organization. Problems are often subtle, so managers must recognize them and make
others aware of the need for change. Typically, recognition of problems occurs when there is a performance
gap, a disparity between existing and desired performance levels.Managers must be alert to problems and
opportunities because the need for change sets the stage for actions that create a new product or technology. Big
problems are easy to spot, but organizations may be in greater danger when the environment changes slowly,
because managers may fail to trigger an organizational response.Resistance to ChangeIdea champions and
members of new-venture groups often discover that other employees are unenthusiastic about their new ideas.
Managers and employees not involved in developing an innovation often prefer the status quo. Employees
appear to resist change for the following reasons, and understanding these reasons helps managers implement
change more effectively.Self-interest. Employees typically resist a change they believe will take away
something of value. A proposed change in job design, structure or technology may lead to a perceived loss of
power, prestige, pay, or company benefits. The fear of personal loss is perhaps the biggest obstacle to
organizational change.Lack of understanding and trust. Employees often do not understand the intended
purpose of a change or distrust management’s intentions for the change. If previous working relationships with
an idea champion have been negative, resistance may occur.Uncertainty. Uncertainty is the lack information
about future events. Uncertainty represents a fear of the unknown, as employees do not know how a change will
affect them. Uncertainty is especially threatening for employees who have a low tolerance for change and fear
the unusual.Different assessments and goals. Employees who will be affected by innovation may assess the
proposed change differently than an idea champion or new-venture team. Critics voice legitimate disagreements
over the proposed benefits of a change.These reasons for resistance are legitimate in the eyes of employees
affected by the change. The best procedure for managers is not to ignore resistance, but to diagnose the reasons
for resistance to change and design strategies to gain acceptance by users. Strategies for overcoming resistance
to change typically involve two approaches: the force field technique and use of selective implementation
tactics.
22 11.7 Force-Field AnalysisChange is a result of the competition between driving and restraining
forcesDriving forces – problems or opportunities that provide motivation for changeRestraining forces –
barriers to changeForce-Field Analysis Exhibit 11.7Force-field analysis suggests that change is a result of the
competition between driving and restraining forces. Driving forces can be thought of as problems or
opportunities that provide motivation for change within the organization. Restraining forces are the various
barriers to change, which could be things such as a lack of resources, resistance from middle managers, or
inadequate employee skills. By selectively removing the barriers that restrain change, the driving forces will be
strong enough to enable implementation of the innovation.
23 Force-Field Analysis: A Case
Using Force-Field Analysis to Change from Traditional to Just-in-Time Inventory System
24 Tactics for Overcoming Resistance to Change
Implementation TacticsCommunication and education are used when users and others who may resist
implementation need solid information about the change. Education is important when the change involves new
technical knowledge or the users are unfamiliar with the idea.Participation involves users and potential resisters
in designing the change. This approach is time consuming, but it pays off because users understand and become
committed to the change. Participation also helps managers determine potential problems and understand the
differences in perceptions of change among employees.Negotiation, a more formal means of achieving
cooperation, uses formal bargaining to win acceptance and approval of a desired change. Companies that have
strong unions frequently must formally negotiate change with the unions. The change may then become part of
the union contract.Coercion means managers use formal power to force employees to change. Resisters are told
to accept the change or lose rewards or their jobs. In most cases, this approach should not be used because
employees feel like victims, are angry at change managers, and may even sabotage the changes. Coercion may
be necessary in crisis situations when a rapid response is urgent.The visible support of top management also
helps overcome resistance to change. Top management support symbolizes to all employees that the change is
important for the organization. Without top management support the desired change will probably not happen.
25 Discussion QuestionsDefine organizational change and explain the forces driving innovation and change in
today’s organizations. Identify the three innovation strategies managers implement for changing products and
technologies.Explain the value of creativity, idea incubators, horizontal linkages, open innovation, idea
champions, and new-venture teams for innovation.Discuss why changes in people and culture are critical to any
change process.Define organization development (OD) and large-group interventions. Explain the OD stages of
unfreezing, changing, and refreezing. Identify sources of resistance to change. Explain force-field analysis and
other implementation tactics that can be used to overcome resistance.Define organizational change and explain
the forces driving innovation and change in today’s organizations.Organizational change is defined as the
adoption of a new idea or behavior by an organization. Forces for change exist in both the external environment
and within the organization. External forces originate in all environmental sectors including customers,
competitors, technology, economic, and international events. Internal forces for change arise from internal
activities and decisions. Demands by employees, labor unions, and production inefficiencies can all generate a
force to which management must respond with change. Rapidly increasing competition in all areas is driving
the need for innovation. One vital area for innovation is introducing new products and technologies. These new
products and technologies, in turn, require substantial changes in virtually every aspect of organizations.Identify
the three innovation strategies managers implement for changing products and technologies.The three
innovation strategies managers implement for changing products and technologies are exploration, cooperation,
and entrepreneurship. Exploration involves designing the organization to encourage creativity and the initiation
of new ideas. Cooperation refers to creating conditions and systems to facilitate internal and external
coordination and knowledge sharing. Entrepreneurship means that managers put in place processes and
structures to ensure that new ideas are carried forward for acceptance and implementation.Explain the value of
creativity, idea incubators, horizontal linkages, open innovation, idea champions, and new-venture teams for
innovation.Creativity is the development of novel solutions to perceived problems. Creative individuals develop
ideas that can be adopted by the organization. If creative conditions are successful, new ideas will be generated
that must be carried forward for acceptance and implementation.An idea incubator is run entirely in-house but
provides a safe harbor where ideas from employees throughout the organization can be developed without
interference from company bureaucracy or politics. Employees with good ideas can take them to the idea
incubator for consideration and development, rather than having to shop their ideas all over the company and
hoping someone pays attention.Horizontal linkages provide a framework for shared development of innovations
among several departments. This approach saves both time and money in the development of innovations by
increasing coordination among departments.Open innovation means extending the search for and
commercialization of new ideas beyond the boundaries of the organization and even beyond the boundaries of
the industry. Most companies generate their own ideas in house and then developed, manufactured, marketed,
and distributed them, a closed innovation approach. With open innovation, even customers are brought into the
innovation loop. This allows the company to get many perspectives and develop products and services that
result from a host of diverse ideas.An idea champion is a person who sees the need for and champions
productive change within the organization. Personal energy and effort are required to successfully promote a
new idea. Champions are passionately committed to a new product or idea despite rejection by others.A recent
idea for facilitating corporate innovation is called a new-venture team. This team is a unit separate from the rest
of the organization that is responsible for developing and initiating a major innovation. Its separate facilities and
location free it from organizational rules and procedures.Discuss why changes in people and culture are critical
to any change process.Changes in people and culture pertain to how employees think. These changes involve
the adoption of a new mindset. People change pertains to just a few employees, such as sending a handful of
middle managers to a training course to improve their leadership skills. Culture change pertains to the
organization as a whole, such as shifting the basic organizational mind-set from one focused on rules and
policies to one focused on doing whatever is necessary to ensure customer satisfaction.Define organization
development (OD) and large-group interventions.Organization development (OD) is a planned, systematic
process of change that uses behavioral science knowledge and techniques to improve an organization’s health
and effectiveness through its ability to adapt to the environment, improve internal relationships, and increase
learning and problem-solving capabilities. It focuses on the human and social aspects of the organization and
works to change attitudes and relationships among employees, helping to strengthen the organization’s capacity
for adaptation and renewal.The large-group intervention approach brings together participants from all parts of
the organization—often including key stakeholders from outside the organization as well—to discuss problems
or opportunities and plan for change.Explain the OD stages of unfreezing, changing, and refreezing.Unfreezing
means that people throughout the organization are made aware of problems and the need for change. This stage
creates the motivation for people to change their attitudes and behaviors.Changing occurs when individuals
experiment with new behavior and learn new skills to be used in the workplace. This process is sometimes
known as intervention, during which the change agent implements a specific plan for training managers and
employees.Refreezing occurs when individuals acquire new attitudes or values and are rewarded for them by
the organization. The impact of new behaviors is evaluated and reinforced, and the change agent supplies new
data that show positive changes in performance.Identify sources of resistance to change.Employees appear to
resist change for several reasons, and understanding them helps managers implement change more effectively.
Due to self-interest, employees typically resist a change they believe will take away something of value.
Because of lack of understanding and trust, employees often do not understand the intended purpose of a change
or distrust the intentions behind change. Uncertainty is the lack of information about future events. This fear of
the unknown causes employees to resist a change when they do not know how they will be affected. Another
reason for resistance to change occurs when people who will be affected by innovation have different
assessments and goals than an idea champion or new-venture group. These reasons for resistance are legitimate
in the eyes of employees affected by the change.Explain force-field analysis and other implementation tactics
that can be used to overcome resistance.Force-field analysis suggests that change is a result of the competition
between driving and restraining forces. Driving forces can be thought of as problems or opportunities that
provide motivation for change within the organization. Restraining forces are the various barriers to change,
which could be things such as a lack of resources, resistance from middle managers, or inadequate employee
skills. By selectively removing the barriers that restrain change, the driving forces will be strong enough to
enable implementation of the innovation.Participation involves users and potential resisters in designing the
change. This approach is time consuming, but it pays off because users understand and become committed to
the change. Negotiation, a more formal means of achieving cooperation, uses formal bargaining to win
acceptance and approval of a desired change.Communication and education are used when users and others who
may resist implementation need solid information about the change.Other implementation tactics that can be
used to overcome resistance include:Coercion means managers use formal power to force employees to change.
Resisters are told to accept the change or lose rewards or their jobs. In most cases, this approach should not be
used because employees feel like victims, are angry at change managers, and may even sabotage the changes.
Coercion may be necessary in crisis situations when a rapid response is urgent.The visible support of top
management also helps overcome resistance to change. Top management support symbolizes to all employees
that the change is important for the organization. Without top management support the desired change will
probably not happen.
26 Discussion Questions (continued)
Describe how IBM has changed during last two decades.Explain the major motive of Chrysler to produce Jeep
at China in early 2000s, in terms of change management.Explain ambidextrous approach in change
management.Describe Yahoo’s Brickhouse, from the innovation strategy perspectives.Explain briefly key to
success of horizontal linkage.Describe P&G’s purchase of patents, in terms of innovation strategy.Explain how
LEGO survived in early 2000s, by innovation strategy.Explain briefly crowdsourcing.List three features of Web
2.0, in contrast to Web 1.0.Describe innovation strategies of Treadless.Explain briefly a skunkworks. IBM:
Manufacturing  ServiceJeep: Trickle up / reverse innovationHorizontal Linkage: Key to Success:Yahoo –
Brickhouse: Idea incubator – Exploration Strategy in Innovation StrategiesAmbidextrous
ApproachMANAGEMENT – Planning, organizing, leadership, controlP & G – Purchase of Patents: open
innovation in Cooperation Strategy in Innovation StrategiesProject ManagerTeam BuildingList three features of
Web 2.0, in contrast to Web 1.0.:Open,Share,ParticipateExplain how LEGO survived in early 2000s, by
innovation strategy.Cooperation strategy – open innovation with Hollywood studios when LEGO ran out of
imagination & creativity, LEGO partnered with Hollywood studios. LEGO - Star Wars series were a big hit,
and became cash cow for the firm, which enabled the firm to survive.Treadless: Web crowdsourcing
Managing change and innovation - Getting the most from the innovation funnel
As complexity increases, managing change and innovation becomes increasingly difficult. Despite (or because
of) easy availability of information, the ability to project future outcomes has moved from an environment of
manageable risk to rising degrees of uncertainty. The speed at which information is transformed into actionable
knowledge is not keeping pace with changes in the business environment.
Manageable risk implies that there is sufficient knowledge to at least quantify the probabilities of specific
outcomes. Uncertainty, as characterized by Frank Knight (1921), suggests that the level of risk becomes
unknowable. In this type of environment the time to learn becomes the fundamental restriction to effective
innovation. New knowledge must be created to determine the changes (or improvements) that will provide
benefit and meet goals.
Managing change and innovation to accelerate critical learning

Innovation inherently requires some level of change. Change requires

learning. However, humans and organizations tend to learn as a reaction to events. Business incentives provide
additional motivation to exploit existing knowledge. What change triggers will motivate the investment in new
learning needed to innovate?
Triggers come from both internal and external sources and include:
External triggers
 Customer needs, desires or expectations
 Competitive offers
 New technology
 Changing demographics
 Economic cycle
 Geo-political events
 Environmental change
 Societal change
 Industry structural changes
 Regulation change
Internal triggers
 Decisions
 Problems in operations
 Company growth or decline
 Leadership and personnel change
 Changes to inter-organization alliances
Innovation provides a response to these change triggers. Types of innovation help characterize these responses,
suggesting innovation that could provide a more effective response to a specific change environment or trigger.
With high uncertainty and possibility, managing change and innovation effectively requires that learning
investments be focused on the areas of change that represent the highest risk and/or opportunity for continued
sustainability and growth of the business.
Of this long list of change triggers, only decisions come fully under control of the firm. Innovation processes
typically include external and internal scanning to provide early identification of change triggers, moving
company responses into the strategic decision and innovation funnel.
Manage decision making to reduce resistance
Resistance and challenges to change develop in response to factors that increase emotions in decision making.
These include:
 Self-Interest and fear of personal loss
 Lack of trust and understanding, particularly with regard to intentions and purpose

 Uncertainty and lack of information that makes it difficult to project

likely future events
 Different goals and assessments by people who will be impacted by a change
Decisions need to be made at every level to support desired change. This implies that people with
different decision making styles must get the information, communication and motivation needed to decide to
align and respond positively.
Managing change and innovation should also address questions important to business sustainability and growth.
 How much will innovation cost?
 How will it be measured?
 What is the return on innovation?
 Is the cost of failure predictable and acceptable?
 How many of the decisions fundamental to the current business model will need to change?
 What are the likely consequences of a failure to change?
In high uncertainty, the learning investment needed to address these questions becomes difficult to predict, and
managing change will need to focus on learning that verifies potential. Stage gates, when used as learning
milestones can help manage the learning investment.
Are gated processes still relevant?
When used appropriately, gated processes can provide an effective framework for managing change and
innovation. However, gate review boards must represent true decision making bodies. For innovation, they must
encourage accelerated, validated learning that reduces uncertainty with minimum investment. Decisions
completed at each gate should inherently support the change process needed for the organization to encourage
the success of an innovation.
Consider the following innovation gate decisions:
 1. Idea identification - Ideas are evaluated for further resourcing. Criteria will often demonstrate the
ability to be accommodated in the current business model, although spinoffs may be supported. Balance
must be developed that will promote promising ideas while preventing being overwhelmed by
evaluation of too many ideas.
2. Concept validation - The concept is developed enough to determine the investment needed to validate
key elements of viability such as value proposition, competitive advantage, and likely returns.
3. Demonstration development plan - A plan is developed to provide a proof of concept demonstration to
customers. For startups, this could be a product that might be used with non-paying customers. This plan
will seek to minimize investment needed to validate key hypotheses with targeted customers. A
demonstration vehicle that can accommodate quick and low cost requirements changes will accelerate
the learning process.
4. Customer value validation - The value to the customer is established through their interactions with the
demonstration product. Metrics that show causality will provide the learning that will continue to reduce
uncertainty.
5. Growth plan - commitment to commercialize - For businesses with an established business model, the
plan for full commercialization is developed. This may be the entry business gate to the more
predictable (knowable risks) development process. For newer businesses, investment is made to develop
a product that can scale as business grows.
Each successive gate in the innovation funnel reduces uncertainty that would prevent additional investment. The
decisions made provide evidence of meeting established factors needed for success. Factors that facilitate
change are increased while factors that work to resist change are reduced. Needed communication and
education are built into the process.
Managing change in the product innovation process
Adapting to uncertain environments with rapid change has encouraged adoption of agile methods in software
development. Acceptance of this approach recognizes that cycle times for large scale development have not
been able to meet the needs of the current change environment. Learning and adapting to changing priorities has
been a key factor in choosing these methods.
Similarly, the effectiveness of managing change and innovation will ultimately be constrained by the limits of
an organization's learning and decision making processes. These processes should return more than they cost
and facilitate the knowledge creation needed for decision making in uncertain environments.
From Managing Change and Innovation to Innovation Management Home
Change management isn’t what it used to be. I know, I know…we hear that about everything in business these
days, but it doesn’t make it less true. In the past, change management was about mobilizing your employees
around the newest strategies, strategic intent or skill building movements. Today, in the innovative environment
where constant change is a daily reality often forced upon us by new technologies, new competition, or global
pressures, it is not about one big organizational push to reach a specific goal. It is about how you as an
individual contributor maintain a spirit of constant agility, flexibility and innovation without losing site of your
strategic and performance goals.
The bottom line is this: How do you get the insight to adapt goals when needed, based on new information or
new innovation? What it comes down to is what can an organization do to equip their employees with the skills
they need to:
 Communicate effectively?
 Adapt when needed?
 Focus during chaos?
 Notice what’s important and what’s not?
 Manage daily business in the midst of constant change?
 Create success and recognize it?
 Learn from mistakes?
Let’s take it one area at a time.
Communicate effectively
Start with a rapid rate of change and then sprinkle in all the various personality styles in your organization and
what do you get? Well, let’s put it this way: If it were a cake, it probably wouldn’t rise.
As any personality assessment tool will tell you, there are many different communication styles. In my words,
I’d boil it down to six primary types of communicators:
 Details and facts
 Big picture
 Emotional – from the gut
 “This is what I think and you better think it, too”
 Let’s not ruffle any feathers
 Everything is all good or bad
This is why a tool like The Six Thinking Hats, developed by Dr. Edward de Bono, makes a major impact to
improving the quality of communication. It shows you how to separate out your thinking – the creative from the
critical, the emotional from the facts. As reported by users of the method, it also helps you to listen better,
because you do not have to search for the intent of the comment. What are the Six Hats?
White Hat: Information known and needed
Red Hat: Gut feeling – intuition – How I feel right now
Yellow Hat: Benefits – why it might work
Black Hat: Risks – why it might not work
Green Hat: Alternatives / Possibilities
Blue Hat: Thinking about the thinking – set thinking sequence, agenda, next steps
This tool can be used individually, in a team or in coaching, drastically reducing the amount of confusion,
frustration and miscommunication.
Adapt when needed
You may start off with a very good plan but then something changes. Very often, people say, “Oh, well,” and
keep implementing their plan. It was a very solid plan when they started; people as a general rule seem to have a
hard time letting go of it – even when it is painfully obvious that it is no longer the best move.
Why is this? It’s my belief that it is because once a plan is in place, people focus all their energy on
implementing it. We forget to review the plan to make sure it still fits our changing world. Most people do not
have a process for challenging things that seem to be going well or where problems haven’t been clearly
identified.
There is a tool in lateral thinking called Challenge that helps people routinely challenge areas where no
problems have been identified. Challenge encourages a companywide innovative perspective: “There isn’t
anything wrong here, but maybe there is a better way.” Although it may feel uncomfortable at first, embedding
Challenge into a culture promotes a feeling of being back in control and on top of things. Employees are
prepared to approach and explore what needs to be adapted, without pointing out a problem or a mistake. After
all, there may not be something specific to point to, as far as a problem with the plan or strategy.
Information doesn’t come to us all at once, conveniently scheduled to arrive the day of our strategic planning
session. Instead, new information flows to us over time. Therefore, there will always be moments in time when
change is required – not because of a faulty plan but because there is a new reality to take into consideration.
Focus during chaos
Do you ever have the feeling that your mind is spinning around in so many directions that you just don’t know
what to think? You can’t even track everything you are thinking about because it is just too much at once. If you
are like most people that your answer is not only yes, but HELL, YES!
When you experience this you need to stop, take a deep breath and then ask yourself what you are focusing
on. Most of the time, you will find that you are trying to think about too many things at once. Write down all
the areas that you are thinking about – separate them out. The blue hat process of Six Hats or the Focus tool in
lateral thinking can help you to do this in a structured way.
Then how do you prioritize where you should spend your time?
The toolset in de Bono’s Six Value medals will help you to do a quick value scan and assessment. Reading the
scan will make very clear which value packages deserve top priority. It’s calming and productive to use tools to
focus thinking during high pressure, chaotic moments.
Notice what’s important and what’s not
This seems like a mystical thing to do but it really isn’t. The routine use of thinking tools dissolves a lot of the
chaos and clutter in you mind, providing a clear view of values and priorities. The Six Hats and lateral thinking
tools outlined above are a head start in this direction. Learning how to direct your attention, and the attention of
those around you, using additional management thinking tools in our management thinking portfolio, refines
and strengthens your ability to keep yourself and your team on track.
Manage daily business in the midst of constant change
The biggest issue here is to review your policy and procedures every quarter – not once a year, or never, as most
organizations do. Why is this so important? Because people get trapped by their policies and procedures that
were created within a different environment. By reviewing once a quarter, you’ll be able to make adjustments
that are necessary and timely, so that you don’t get bogged down in your daily work activities or spend a lot of
time dealing with exceptions.
A tool that will help here is Dr. Edward de Bono’s Simplicity. The Simplicity tools show you how to create a
simplicity team that is always checking for a more productive and less complex way to operate. This will not
only reduce complexity, but will stop you from wasting energy implementing policies that are no longer
relevant.
Create success and recognize it
When making your plans and strategies, state what success looks like in the short term, long term, and big
picture. When predicting what we want success to look like, we need to break it down into smaller pieces – not
just one big financial goal.
By breaking success indicators down into small parts, you will then be able to recognize the progress you are
making. A nice side benefit is that if you are not having success, then you can make adjustment earlier and
avoid a big failure. For example, in reviewing our early success indicators, we noticed that we were not
achieving our targets. Our team made the needed adjustments and not only are we back on track, but we
reduced a couple of under-performing budget items. Therefore, we project coming in under budget by $25,000.
Once you know what success looks like, what systems should you have in place for making it visible? There are
many ways to do this. Here are some general ideas to help get you started:
 Reward it
 Create a success/”brag board” (virtual or real world or both) for your team or department
 Include a weekly success stories time during each staff meeting
 Create a success calendar – you can use this at performance review time
Overall, have fun with it. Success is exciting and energizing to talk about and recognize.
You cynics out there may be thinking, “It’s our jobs to create success. If we aren’t succeeding then we have a
big problem. I shouldn’t need a pat on the back or need to toot my own horn for doing my job.”
I’d say, you’re half right and half wrong. What you’ve got right is that you are expected to be successful in your
job. What you are missing is that if you aren’t being clear about what success looks like and recognizing it
when it’s achieved, you will likely not notice when you need to make adjustments. After all, you very likely are
implementing your plan perfectly and that feels good and feels like success. That’s why it’s important to keep
an eye on the indicators of success of the task, project, etc. and talk about them. It’s not about tooting your own
horn but about checking your sails along the way to your destination.
Learn from mistakes
Ask successful people and heads of organizations if they have made any mistakes. They will tell you that they
have, and they have made lots of them. So, why are people so afraid to make mistakes? Because they think
they’ll lose their job or not get promoted?
What they don’t realize is that the people they report to are more interested in what they learned, the quality of
the thinking that went into their decision and how they have grown from the experience than the mistake
itself. Plus, you have to be willing to take some risk if you want to get anywhere new. If you never make any
mistakes, chances are you aren’t taking any risks and you are not adding new value.
Very often when a mistake is made and there was good quality thinking that went into that decision, there is still
a huge value to the organization. Why? Because in most cases, the learning itself created something new for the
organization that turned out to be of great value.
There is a big difference in making a mistake (bad decision) because you were lazy or just didn’t stop to think
through it properly and making a mistake that was based on good quality thinking.
Conclusion
The successful leaders of the future will be those individuals who not only learn how to cope but to excel while
everything is changing around them. This will take guts and smarts. Equip yourself with the best thinking
methods you can get your hands on and you just might find that it’s not so scary out there after all, but actually
a world full of more opportunities than ever before.
Natalie Jenkins is an specialist in the area of innovative thinking skills. She dovetails her love for creativity and
thinking by leading the national sales effort for de Bono Consulting (recently merged with Innova Training &
Consulting), the leading U.S. distributor for de Bono Thinking Systems.
November 18th, 2008|Tags: adaptation, Change Management, Communication, in-depth article, Innovation
Strategy, lessons learned, Success
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How Can an Organization Manage Change & Innovation in an Optimal Way?
by Leigh Richards
Related Articles
 1What Are the Steps to Encourage Change for Employees?
 2Characteristics of Change Management
 3Techniques to Manage Change in an Organization
 4Employee Tips for Managing Stress Due to Organization Change
Nothing is more certain than change. While many speak as if change is a reflection of the 21st century, the
world has actually been changing for many, many years. The ability to manage that change effectively,
especially in business organizations, is critical. The effects of change can be negative or positive. Successful
management will ensure the latter.
Accept Change
In this technology-driven global economy, it is important to accept the inevitability of change and communicate
this to employees. You do not want to raise expectations that the rate of change will eventually slow. Instead,
companies serve their employees best when they acknowledge change is constant, but manageable.
Practice Openness
Organizations manage change most effectively when alert to its impact upon staff. Thus, commit to fostering an
environment of openness. Establish an environment of trust through open-door policies, tools allowing two-way
feedback and--most importantly--the willingness to listen non-defensively to all feedback, even when critical.
Solicit Input
Employees do not oppose change; they oppose change they have no opportunity to influence. If you welcome
their input, they will better appreciate and accept the reasons for change. Also, your business just may benefit
from their insights. After all, they are on the front lines with the best grasp of customer needs and preferences.
Provide Training
Organizations should first assess employee knowledge and skill level to determine their readiness for change. If
they are found wanting, then they should first receive appropriate training to get better equipped to meet the
demands of the new change or innovation. Adapting to change often requires mastery of new processes and
skills.
Accept and Recognize
It is inevitable that some failure will occur as management and employees work to implement change.
Accepting failure as an inevitable part of the learning process sends a positive message to employees.
Organizations managing change and innovation most effectively are the ones taking time to recognize and
celebrate success. They acknowledge change can be stressful, requiring long hours and extra effort.
Recognizing this will go a long way toward motivating employees to continue responding positively.

- Loss of power, status or security

Managing Change 3/3
Ways of Overcoming Resistance:
- Establishing a posi ve trust climate
- Set clear objec ves
- Explaining the need for the change
- Create a win-win situa on
- Involving employees
- Providing support and evalua on
- Create urgency
Lewin and Comprehensive Change Model
Lewin Model (Kurt Lewin, 1950)
1. Unfreezing (involves reducing the forces that are maintaining the status quo)
2. Moving (change process in which employees learn new, desirable behaviours, skills,
values, and aFtudes) o
3. Refreezing (desirable performance becomes the permanent way of doing things, or
the new status quo, that employees conform to)
Organiza onal Development Interven ons
Team building:
- An OD interven on designed to help work groups increase structural and team
dynamics performance.
Process consulta on:
- An OD interven on designed to improve team dynamics.
Force*eld analysis:
- An OD interven on that diagrams the current level of performance, the forces
hindering change, and the forces driving toward change.
Survey feedback:
- An OD interven on that uses a ques onnaire to gather data to use as the basis for
change

 Leadership and Motivation

Leadership and Motivation
Motivation is a goal-oriented characteristic that helps a person achieve his objectives. It pushes an individual to
work hard at achieving his or her goals. An executive must have the right leadership traits to influence
motivation. However, there is no specific blueprint for motivation.
As a leader, one should keep an open perspective on human nature. Knowing different needs of subordinates
will certainly make the decision-making process easier.
Both an employee as well as manager must possess leadership and motivational traits. An effective leader must
have a thorough knowledge of motivational factors for others. He must understand the basic needs of
employees, peers and his superiors. Leadership is used as a means of motivating others.
Given below are important guidelines that outline the basic view of motivation:
 Harmonize and match the subordinate needs with the organizational needs. As a leader, the executive
must ensure that the business has the same morals and ethics that he seeks in his employees. He should
make sure that his subordinates are encouraged and trained in a manner that meets the needs of the
business.
 Appreciation and rewards are key motivators that influence a person to achieve a desired goal.
Rewarding good/ exceptional behavior with a small token of appreciation, certificate or letter can be a
great motivator. If a certificate is awarded to a person, it should mention the particular act or the quality
for which the individual is being rewarded.
 Being a role model is also a key motivator that influences people in reaching their goals. A leader should
set a good example to ensure his people to grow and achieve their goals effectively.
 Encouraging individuals to get involved in planning and important issues resolution procedure not only
motivates them, but also teaches the intricacies of these key decision-making factors. Moreover, it will
help everyone to get better understanding of their role in the organization. The communication will be
unambiguous and will certainly attract acknowledgement and appreciation from the leader.
 Developing moral and team spirit certainly has a key impact on the well-being of an organization. The
metal or emotional state of a person constitutes his or her moral fabric. A leader’s actions and decisions
affect the morale of his subordinates. Hence, he should always be aware of his decisions and activities.
Team spirit is the soul of the organization. The leader should always make sure his subordinates enjoy
performing their duties as a team and make themselves a part of the organization’s plans.
 A leader should step into the shoes of the subordinates and view things from subordinate’s angle. He
should empathize with them during difficult times. Empathizing with their personal problems makes
them stronger-mentally and emotionally.
 A meaningful and challenging job accomplished inculcates a sense of achievement among employees.
The executive must make their employees feel they are performing an important work that is necessary
for the organization’s well-being and success. This motivational aspect drives them to fulfill goals.
Remember, “To become an efficient leader, you must be self-motivated”. You must know your identity, your
needs and you must have a strong urge to do anything to achieve your goals. Once you are self-motivated, only
then you can motivate others to achieve their goals and to harmonize their personal goals with the common
goals of the organization.
1 Unit 11 Leadership and Motivation “I start with the premise that the function of leadership is to produce more
leaders, not more followers.” Ralph Nader There are at least two major influences that affect how individuals
perform in their environment. These influences include: i) the type of leadership that exists, and ii) personal
motivation. While neither is scientific in nature, there is significant research that identifies some theories and
general conclusions about why people perform, how they perform, and why some people display different
behaviours that puts them in positions of leadership. In addition to addressing leadership and motivation as
theories rather than as scientific fact, there are other issues about personal behaviour that must be considered.
The most basic concepts are that every person is (a) like every other person; (b) like some other people; and (c)
like no other person. A further explanation may help clarify this statement. Every person is like every other
person in that we have a need for food, water, shelter, etc. We are like some other people in that we have similar
personality traits which cause us to be more dominant and aggressive, while others may be more passive and
submissive. Finally, we are unique in that no other person has the same genetic make-up, past experiences, or
view of the world. It is these differences that suggest an analysis of leadership and motivation can result in
general conclusions about behaviour and performance. Leadership and Motivation Unit 11 2 Human behaviour
is as much a reflection of the differences between individuals as it is a reflection of their similarities. These
individual differences are caused by a number of influences and characteristics. For example, personality traits
focus on individual differences that make each person a unique human being. Our biological make-up
concentrates on how we function as a result of our evolution and human inheritance. Our behaviour is largely
influenced by the system of rewards and punishments that are present in our environment. Our cognitive
approach focuses on how our thinking and memory affects our behaviour. The fact that we are here at this time
with immediate influences, and the ability to express a free will, may present the greatest influence of all. Any
theories about leadership and motivation can be contradicted since these theories have many exceptions. It is
important that these theories are considered general statements that have been confirmed through observational
studies and are applicable only to the extent that they reflect and are influenced by individual behaviour. We
might ask: “Why should we even pursue these topics if there are so many inconsistencies, exceptions, and
variables that affect conclusions?”. If we are searching for scientific evidence that is universally applicable, we
may be wasting our time, but if our goal is to better understand human behaviour and its impacts on personal
performance, the insights gained from such theories and studies are invaluable. Systems formerly made up of
rules, regulations, and procedures are being replaced by requirements for flexibility and customer service
resulting in personal initiative, empowerment, and greater levels of individual decision-making. To achieve this,
it is important to better understand human behaviour and some of the things that impact our actions and
reactions. Motivation Motivation can be defined as “the extent to which persistent effort is directed toward a
goal” (Campbell, Dunnette, Lawler &Weick). Effort: The first aspect of motivation refers to the amount of
effort being applied to the job. This effort must be defined in relation to its appropriateness to the objectives
being pursued. One may, for example, apply tremendous effort to inappropriate tasks that do not contribute to
the achievement of the stated goals. Persistence: The second characteristic relates to the willingness of the
individual to stay with a task until it is complete. For example, an important task that gets accomplished with
effort but allows the person to rest on their laurels for an extended period does not display persistence.
Leadership and Motivation Unit 11 3 Direction: Is the effort directed towards the organization’s goals or related
to the individual’s self-interest? Direction is therefore measured in terms of how persistent effort is applied in
relation to the goals being pursued. Goals: There are two different kinds of goals being pursued simultaneously.
They are individual goals and organizational goals which may produce quite different results if they are not
compatible. Next we should distinguish between motivation and performance. While there may be little doubt
about the motivation of the individual in terms of effort, persistence, and direction, there may be a lot of
questions about the individual’s performance as it relates to the organizational goals. The worker may be really
busy and factors such as skill levels, task understanding, and aptitude may negatively impact performance. On
the other hand, self-interest may create its own motivation not related to the organizational goals. People may
be motivated by factors in the external environment such as pay, supervision, benefits, and job perks. This is
referred to as extrinsic motivation. They may also be motivated by the relationship between the worker and the
task. This type of motivation is called intrinsic motivation. These factors often exist simultaneously, but we will
distinguish between them as they relate to specific levels of motivation. We will explore three theories of
motivation that are based on human needs. In assessing these theories, we will try and identify what motivates
people. Maslow’s Hierarchy of Needs Abraham Maslow developed a theory that humans have five sets of needs
that are arranged in a hierarchy. He contends that people start by trying to satisfy their most basic or compelling
needs and progress toward the most fulfilling. These needs are as follows: 1. Physiological needs: These include
the need for food, water, shelter, clothing and money. Until an individual has access to these necessities, there
can be no further progress. These needs are very basic, and for the most part, society and our social network
have ensured that they are present. Intrinsic values include personal comfort and satisfaction, while the extrinsic
values are most often provided by the organization, the community, or society. 2. Safety needs: These include
security, stability, and a structured environment. Here, the individual expects and pursues job security, a
comfortable work environment, pension and Leadership and Motivation Unit 11 4 insurance plans, and freedom
to organize in order to ensure continuation of these benefits. Individual’s main objective is to ensure that
benefits are protected or employment needs are being met rather than contributing to long-term organizational
goals. Again, we see a dependance on the external environment to provide these supports. Personal motivation
may include the peace of mind that can be provided as a result of these needs being secured. 3. Relationship
needs: Relationship needs include socialization, affection, love companionship, and friendship. The individual
at this level participates for personal or intrinsic rewards. Since no person can live for extended periods without
interaction with other people, the individual may be drawn to participate simply to fulfill this need.
Organizations that provide these opportunities include social clubs, singles clubs, seniors clubs and service
clubs, depending on the level of personal need. The organization can assist by ensuring that the opportunity for
social and relationship expectations are created and met. 4. Esteem needs: These include feelings of adequacy,
competence, independence, confidence, appreciation, and recognition by others. Again, the individual is driven
more by internal or intrinsic needs. The external environment is needed more to provide recognition than to
provide material rewards. At this point, the intrinsic value is more important than that which can be provided by
outside influences. The ego seems to take over here and the need is to ensure that it is satisfied. 5. Self-
actualization: This area is the most difficult to define and therefore, may be the most difficult to explain. Why
does the successful business person need to pursue further wealth when they have already accumulated more
than they will ever need? The answer may lie in the fact that motivation is more internal and therefore, even
more individualistic. Different people have different ideas about what they need to achieve in order to obtain
true happiness. For the wealthy person, money may no longer be the motivator, it may now be a need to
exercise power or the adventure and adrenalin rush created as a result of playing “high stakes games”. This
becomes the intrinsic motivation. People who pursue self-actualization are more accepting of reality,
themselves, and others. Organizational requirements may include the opportunity for creativity and growth.
Frequently, individuals aspiring to this level often operate outside existing organizations and instead build their
own structures to suit their individual needs. In discussing this theory, it appears that the further up the scale an
individual moves, the more the rewards or motivators move from the external environment to an internal need.
It also becomes more difficult to influence motivation, since material rewards become less relevant and internal
Leadership and Motivation Unit 11 5 rewards become more difficult to identify and address. In order to enhance
organizational performance, it is important that the organization recognize the individual need and provide
opportunities for satisfaction. Alderfer’s ERG Theory Clayton Alderfer developed another needs-based theory
that supports in many ways, the theory developed by Maslow, but consists of three rather than five basic needs.
Alderfer also sees his three levels which includes existence, relatedness, and growth (ERG) needs as being
hierarchical, and thus, influenced by personal growth and extrinsic and intrinsic rewards. 1. Existence needs:
These include needs that are satisfied by material substances or conditions. They correspond closely to the
physiological needs identified by Maslow and those safety needs that can be satisfied by material rather than
interpersonal rewards or conditions. They include the need for food, shelter, pay, and safe working conditions.
2. Relatedness needs: These are needs that may be satisfied by communication, or exchange and interaction
with other individuals. There is a dependance on feedback from other organizational or community members to
fulfill these needs. Thus, the motivation is provided by a combination of intrinsic and extrinsic rewards. These
rewards include accurate and honest feedback, which may involve direction and advice rather than
unconditional pleasantness or agreement. 3. Growth needs: These are needs that are fulfilled by strong personal
involvement that fully utilizes our skills, abilities, and creativity. They include Maslow’s self- actualization as
well as esteem needs that rely on intrinsic rewards. Both theories are also similar because they are hierarchical,
and individuals will concentrate on the achievement of the lowest level of need that is not fully satisfied.
Maslow contends that the lowest level of need must be satisfied before an individual can proceed to the next
higher level. Alderfer theorizes that if a higher level need is unsatisfied, the individual will regress to a desire to
satisfy lower-level needs. Maslow believes that once a need is met, it is no longer motivational. Alderfer
theorizes that while an individual may have met a higher-level need in one’s personal life, for example, they
may still be operating much lower on the scale where skills, aptitude, and knowledge may affect performance
and confidence. McClelland’s Theory of Needs Psychologist David McClelland contends that we develop a
relatively stable personality early in life that, once acquired, remains unchanged. McClelland, therefore, does
not see motivation as Leadership and Motivation Unit 11 6 hierarchical. He does not address the issue of
growth, but has been more concerned with the behavioural consequences of need. The three areas of need he
has identified include the need for achievement, the need for affiliation, and the need for power. 1. Need for
achievement: Individuals in this category have a strong desire to perform challenging tasks well. They have a
preference for situations where personal responsibility can be taken for successful outcomes. The goals they set
provide for moderate and calculated risk, and the individual seeks performance feedback to allow for
modification and to ensure success. 2. Need for affiliation: People in this category display a need to establish
and maintain friendly, compatible relationships. They have a need to like other people and want others to like
them. They have an ability to create social networks that will result in meeting these needs. 3. Need for power:
People in this category have a strong need to have influence over others. They wish to make a significant impact
and impression on those with whom they come in contact. This need for power corresponds in many ways to
Maslow’s esteem needs where power is used to get attention or to build personal prestige. Since this theory is
non-hierarchical, the growth pattern between intrinsic and extrinsic rewards that are a major part of the earlier
theories, do not appear to contain the same significance. McClelland contends that people will be motivated to
seek out and perform well in jobs that match their needs. These needs may include either of the three categories
identified above and are not contingent on any progression from one category to another. The testing of these
three theories has resulted in some conclusions that help us identify the strengths and limitations of each
approach. While Maslow’s theory is complicated and contains more steps than the others, there is recognition of
the progression from one level to the other. Alderfer’s three levels seem to be simpler, less rigid, and therefore,
may be more satisfactory to those who wish to understand and apply a model to individual behaviour. Results of
McClelland’s research has been applied in organizational settings and have been supportive of the idea that
particular needs are motivational. Our former theme, ‘when all else is consistent, the individual is different’,
suggests that the application of any theory of motivation has strengths and weaknesses that allow insight into
individual motivation and provide escapes for those times when the theory will let us down. All theories
contribute to a better understanding of human behaviour in general, but specific application of theory depends
on factors that respond to individual needs. Leadership and Motivation Unit 11 7 Motivational Goals Carol
Dweck theorizes that all goals a person might pursue fall into two distinct categories: performance goals and
learning goals. A performance goal is one in which the individual is concerned with acquiring favorable
judgement from his or her peers, supervisors, or authority figures. A learning goal is one in which an individual
uses feedback to increase his or her competence. If this theory is correct, it contains some further implications
for motivation. Firstly, it provides for a much better understanding of intrinsic and extrinsic rewards in relation
to performance. While favorable judgement from peers provides extrinsic rewards, the intrinsic rewards come
from both the acceptance of this judgement, and the direction that it provides for further learning. The
performer sees learning as a life-long process, thus creating even greater levels of motivation. Secondly, this
theory provides a better understanding about failure and its impact on the individual. Since we all fail
sometimes, our ability to respond is an important factor in motivation. A person with a learning goal will
respond to failure by trying even harder to succeed the next time. In contrast, a person with a performance goal
may respond to failure by concluding that they cannot complete the task and may therefore, give up. Dweck
further theorizes that some people believe that personal qualities such as intelligence and ability are fixed and
unchangeable. This belief may lead people with performance goals to conclude that they don’t have what it
takes, and as a result, give up, while others believe that intelligence and ability can change with time, education,
and experience. Their goal, therefore, is not to prove their competence but to increase it, thus success and failure
are learning experiences that cause them to try even harder next time. Failure may even be seen as creating a
greater challenge. Leadership In many circles, there is continuous debate about whether leaders are born or
developed. If we reflect on our earlier discussion about motivation, we will see that humans are very
complicated and are made up of a number of traits. As with motivation, these influences are both inherited and
acquired from our environment and influences, and consequently, leadership theories will continue to be
debated in the future. We will continue this discussion on the assumption that leadership can be developed.
Furthermore, for the purpose of this unit, we will not distinguish between leaders and managers, but will use the
term leader to apply to any earned or appointed role that carries with it the exercise of power and influence over
others. Leadership and Motivation Unit 11 8 Leadership may be defined as: the influence that particular
individuals (leaders) exert upon the goal achievement of others (subordinates) in an organizational context. An
earlier unit on Board Governance addresses in a limited way, the impacts of leaders on performance. We stated
that leaders have an ability to see how different aspects of a situation fit together and influence each other. They
seek out alliances, opportunities, and approach goals in a proactive way. They have a positive effect on others,
which attracts support from those who have similar needs for accomplishment. Their self confidence creates a
belief in other people’s abilities, therefore, emphasis is placed on empowerment and freedom. If we agree with
these statements, then leadership has two distinct aspects: i) the individual who exerts influence, and ii) those
who are the objects of this influence. Successful leadership depends, to a large extent, on the environment and
situation in which these dynamics exist. There are other issues that must also be acknowledged. There are two
types of leaders: emergent leaders - those who earn leadership positions through their expertise, skills, abilities
to influence others, or personal acceptability by the group; and assigned leaders - those who are given power to
exercise influence through appointment. In general terms, both emergent and assigned leaders fulfill two
different functions. They must be able to provide social and emotional support to the group by listening,
acknowledging, team building, and supporting other members in the group. This is referred to as social-
emotional support. The second factor is to provide direction and assistance to the group in accomplishing their
tasks. Successful leaders have the ability to identify and apply the appropriate strategy at the right time. A group
that is confused about the goals of the organization, for example, will not respond well to a social-emotional
approach, nor will a group that is experiencing internal conflict and in need of team building skills respond very
positively to a request to improve individual performance. The Search for Leadership What are the qualities that
make successful leaders? The lack of able officers in both the First and Second World War led to a search for
leaders. This continued after the war to see if there were personality traits that distinguished leaders from
followers. While some general characteristics of leaders emerged, there were no conclusions whether
personality traits made up the leader or if the opportunity for leadership produced the traits. The biggest
weakness in the trait approach to leadership identification is its failure to take into account the task, the
subordinate, and the setting or environment in which work is performed. The study of emergent leaders gives
some good clues to what qualities appointed leaders must have to be successful. Emergent leaders hold their
position as a consequence of their appeal to Leadership and Motivation Unit 11 9 their subordinates. Their role
is safe only as long as the group is attracted to these attributes and conditions. Should these positions change, or
the group finds other influences, a lack of support or outside forces may undermine the leader’s role. The role,
therefore, is dependant on performance and any real or perceived faltering will quickly translate into lack of
support. The present incumbent after losing support becomes “dethroned” or replaced. This fledgling type of
leadership is what we most often observe in community groups and organizations, politics, and citizen-led
efforts. The leader is responsive to the group agenda and is secure only as long as he or she remains responsive.
Since most people are easily influenced and may change their minds as a result of immediate or emerging
needs, support is difficult to maintain. Leaders who find themselves in this position tend to try and “ride out the
storm” before subjecting themselves to any formal leadership review. Assigned leaders draw their power and
influence from sources outside the group, and in most cases, have been given some power to assign tasks, and
hand out rewards and punishments based on performance. Rewards may include compliments, tangible benefits,
and deserved special treatment. When well thought out, with clear criteria rewards that compliment individual
needs can be very motivational. On the other hand, leaders who have no authority to provide rewards may
attempt to create them by giving compliments and praise and making promises they can’t deliver. Over time,
this tends to demotivate, leads to a loss of loyalty, creates dissension and eventually causes the group to become
dysfunctional. Punishments may include reprimands, unfavorable task assignments, and withholding of raises,
promotions, and other rewards. At best, punishments seem to have minimal impact on satisfaction or
productivity. At worst, punishments are seen as random, not contingent on behaviour or performance and most
often poorly administered. Leaders who have access only to punishments often resort to identifying degrees of
unfavorable behaviour, and dole out punishment accordingly. House’s Path-Goal Theory According to Robert
House, the most important activities of leaders are those that clarify the path to various goals of interest to
subordinates, thus effective leaders form a connection between subordinate goals and organizational goals.
Since leadership is about increasing group performance through motivation, the leader must be more concerned
with job satisfaction and the Leadership and Motivation Unit 11 10 creation of a clear picture of how
subordinates can gain rewards based on performance. House’s theory is concerned with four different kinds of
leader behaviour. These include: 1. Directive behaviour: This includes scheduling work, maintaining
performance standards, and letting subordinates know what is expected from them. 2. Supportive behaviour: A
leader displaying this behaviour is friendly, approachable, and concerned with pleasant interpersonal
relationships. 3. Participative behaviour: Leaders who practice this behaviour consult with their subordinates,
and consider their opinions. 4. Achievement-orientated behaviour: This behaviour encourages subordinates to
exert higher efforts and strive for a higher level of goal accomplishment. Leaders demonstrating this behaviour
express confidence that subordinates can reach these goals. Situational Factors Subordinate characteristics and
environmental factors greatly influence the success, and create the opportunity for successful leadership. Firstly,
individual characteristics affect the achievement levels that can reasonably be expected. Secondly, subordinates
have individual needs that must be met if their performance and motivation level is to remain high. Thirdly,
subordinate’s aptitude and abilities will affect both the performance and the response of other co-workers.
Environmental factors that impact on leadership include the following: 1. The appropriateness of the leader’s
style to the situation will have a major impact on the behaviour of the group. 2. Task clarity, urgency and
subordinate empathy will affect performance and motivation. 3. Leader qualifications and knowledge will build
group confidence and loyalty. 4. There is probably no substitute for being in the right place at the right time.
Successful leaders will take advantage of the motivating and satisfying aspects of jobs while offsetting or
compensating for those factors that demotivate or dissatisfy. There is evidence that this theory works better in
predicting job satisfaction and leader acceptance than increasing subordinate performance. Leadership and
Motivation Unit 11 11 Participative Leadership We have seen in an earlier unit (Public Participation) that there
are differing degrees or levels of participation. These range from total involvement of subordinates in planning,
implementation, and evaluation to simple requests for assistance where such participation is a necessary
ingredient for success. Given this fact, we can easily see that participation will not be successful in all
situations. While public or community involvement will provide much better results in compiling a strategic
plan for the community, you would not apply a public participation model if you were trying to escape from a
burning building. Public or community participation can contribute to the following: 1. Motivation:
Participation can contribute to identifying and establishing group goals and how they can be accomplished. It
can also contribute to intrinsic motivation by enriching subordinates jobs through variety, autonomy, and
empowerment. 2. Quality: There is an old saying that “two heads are better than one”. In many cases this is true
of participation. Subordinates have knowledge and expertise that the leader may not have, thus this combination
of leader and subordinate expertise can lead to higher quality processes and solutions. In addition, the qualities
of empowerment allow employees to take direct action to solve problems. 3. Acceptance: Participation can
increase subordinates acceptance of the decision since they were involved in making the decision in the first
place. There is also a better chance of subordinates seeing decisions as being more fair when they have had
input into these decisions. Participative leadership can also create problems. The time and energy spent in
calling meetings, soliciting ideas and training participants may affect deadlines. The involvement of
subordinates may be perceived as a loss or sharing of power, thus creating resentment at the leadership level.
This may affect the performance of leaders which in turn, may affect subordinate performance. Some workers
may not want to be involved in the decision-making aspects of jobs. When the leader is distrusted or when a
poor labor relations climate is present, subordinates may see their participation as “doing management’s job”.
When governments attempt to involve the community in education reform, health care, economic and social
development, it may be perceived as “down loading”, especially if these activities are undertaken in conjunction
with other programs and economic cutbacks. It appears that broad-based participation in short-term projects
may not be as advantageous as implementing a participation model among a group of employees that will be
part of the same Leadership and Motivation Unit 11 12 team for an extended period, and have become very
knowledgeable and proficient at their job. Inability to recognize this can lead to a lack of confidence in the
process, the leaders, and create resistance to participation. Vroom’s and Jago’s Leadership Styles What are
some of the options available to leaders? Victor Vroom and Arthur Jago maintained that there are three different
types of leader behaviour. Leaders use either an autocratic, consultative, or group decision-making style. 1.
Autocratic: This style states that the leader solves the problem or makes the decision using information
available to him or her at the time. In some cases, the leader may consult with subordinates to obtain
information, but at no time does subordinate input include decision-making. The decision is passed on to
subordinates for implementation. 2. Consultative: The leader shares the problem with subordinates and gets
their input. Subordinate involvement is seen as either a collective or individual request for information which
may or may not influence the decision. The leader reserves the right to make that decision. 3. Group: The leader
shares the problem with subordinates as a group, obtains their collective input and tries to reach consensus on
the solution. The leader acts as a facilitator or chairman, trying not to influence input and accepting any solution
that the group may suggest. With these three different approaches, we can also see that there are differing
degrees within this spectrum that the leader may apply. According to Vroom and Jago, the approach depends on
the situation or problem at hand. The leader’s goal should be to make the highest quality decision with the
highest level of subordinate support. Leader Qualities It is apparent that leaders must possess many qualities in
order to be successful and maintain the support of subordinates. The following is a partial list of these qualities.
1. Intellectual stimulation: People are stimulated to think of problems and solutions in new and different ways.
This depends on creativity, novelty and the ability to help people empathize with a new situation. Leadership
and Motivation Unit 11 13 2. Energy: The leader must be willing to exert the energy and effort that is necessary
to see the task through to completion. Leaders show by example. 3. Self-confidence: Leaders are self assured
and possess a confidence in the task, their ability to perform, and the abilities of subordinates to contribute. 4.
Assertiveness: Leaders express their feelings honestly and directly in appropriate, spontaneous, and non-
manipulative ways. Assertiveness communicates respect for others while acting in one’s own best interest. 5.
Dominance: When appropriate, successful leaders must be able to take control and dominate an issue,
environment or situation. The successful leader also knows when to relinquish control and involve others. 6.
Motivation: Successful leaders know what they want, have a clear path to achieving it, and are “driven” by
intrinsic rewards. Whether it’s Maslows need for self-actualization, Alderfer’s growth needs, or McClelland’s
need for power, leaders are driven by a need for success and achievement. 7. Honesty and Integrity: To be
recognized for the right reasons, leaders must be seen as being above reproach. Honesty and integrity are two
factors that allow leaders to enjoy the support of subordinates. Without these qualities, there is a perception of
mistrust which leads to a lack of confidence. 8. Charisma: Charismatic leaders possess the personal qualities
that give them the potential to have extraordinary influence over others. They tend to command strong loyalty
and devotion and in turn, inspire enthusiastic dedication and commitment to the leader and his or her mission.
Dedication is inspired from an emotional commitment and followers come to trust and identify with the leader.
Charismatics tend to possess all of the qualities noted above, and there is some argument that charisma is in
itself a style of leadership. Leadership and Motivation Unit 11 14 A single theory of motivation in isolation may
provide some understanding of human behaviour, but by combining these theories, one may see patterns that
assist in understanding why some people participate as they do. For example, the works of Maslow and Alderfer
to some extent may provide understanding of why some people participate at higher levels than others and
identify some of the rewards that may help this level of participation to continue. Our observations of leaders
when combined with the leadership styles discussed in this unit will help us understand why some leaders
perform successfully, why some encounter difficulties and still others struggle with low levels of support while
displaying high technical abilities. Understanding leadership and motivation opens our minds to new thought
processes of how people behave and why, helps understand some general principles of human behaviour and
allows us to use these theories as a guide for our participation, analysis and understanding of group behaviour.
This understanding can serve us best in selecting individuals who display some of these qualities to fill specific
roles in our organizations and communities. Leadership and Motivation Unit 11 15 Bibliography Funder, David
Charles. The Personality Puzzle. W.W. Norton & Company. New York, 1977. Johns, Gary. Concordia
University. “Theories of Work Motivation” “Leadership” Organizational Behaviour: Understanding and
Managing Life at Work. Harper Collins College Publishers, 1996. Maslow, A. H. Motivation and Personality.
Harper & Row. New York, 1970. Alderfer, C. P. “Existence, Relatedness and Growth: Human Needs in
Organizational Settings”. The Free Press, New York, 1972. McClelland, D. C. Human Motivation. Glenview,
IL. Scott, Foresman, 1985. House, R. J. & Mitchell, T. R. “Path-Goal Theory of Leadership”. Journal of
Contemporary Business. Autumn, 1974. Vroom, V. H. & Jago, A. G. “The New Leadership: Managing
Participation in Organizations”. Prentice-Hall, 1988.
8 Things the Smartest Leaders Do to Motivate Their Employees
Science has found that positive emotions are at the root of human motivation. It's how employees "feel" that
will drive the motivation deep within them. Here's where to start.

By Marcel SchwantesFounder and Chief Human Officer, Leadership From the Core@MarcelSchwantes

GETTY IMAGES
Whether you've been promoted to management recently or have been at it for ten years or longer, one thing
never changes: Human nature -- as in that of your employees -- is often unpredictable. Knowing how to
motivate each person on a team can be so frustrating and challenging.
But it can be done if managers have a basic understanding of human behavior -- what makes people tick. What
science has already found is that positive emotions (how work and culture make employees feel) are at the root
of human motivation. We are wired for it in our creation design.
Therefore, managers must acquire the knowledge of what truly inspires loyal human beings to enthusiastically
perform at a high level.
Let me prescribe eight strategies to help managers create the right atmosphere for motivating others.
1. Start with scheduling more one on one time.
Get off on the right track by making consistent clear goals and expectations an operational reality. You do
that through the lost art of one-on-one conversations -- a great motivational tool. Leaders thrive when they
strengthen relationships with their people by spending more one-on-one time with them to hear their
suggestions, ideas, problems and issues as well as talking about performance issues and their work. But first,
you need to know how to structure these meetings so that it works to your advantage.
2. Find out what motivates them.
Do you know what gets your team members out of bed in the morning? What they're passionate about -- their
goals, aspirations, and interests? In other words, do you really know your team members? Great leaders show an
interest in their people's jobs and career aspirations in order to motivate them the right way. Once that's been
established, they look into the future to create learning and development opportunities for their people. They
find out what motivates their best people by getting to know what desires will drive each team member. This is
about emotional engagement.
3. Provide the resources they need to do their work exceptionally well.
It's a simple question, but you'd be surprised how often it is not asked: What do you need right now to do your
job better? You may be surprised, or even shocked at the answer; it could be that they need access to more
information to make the right decisions, bettter equipment or even another work space. Acting on what you find
out will be a huge motivational booster.
4. Praise and compliment them often.
"I don't like to be recognized," said no human being, ever. Managers have to get into the habit of praising and
complimenting their people for their good qualities and work. The companies in Gallup's study with the highest
engagement levels use recognition and praise as a powerful motivator to get their commitment. They found that
employees who receive it on a regular basis increase their individual productivity, receive higher loyalty and
satisfaction scores from customers, and are more likely to stay with their organization. How regular are we
talking? Praise should be given once per week, according to Gallup.
5. Help co-create purposeful work.
People want meaning and purpose in their work. In the book Give and Take, Wharton professor Adam Grant
says that when people find purpose in their work, it not only improves that person's happiness, it also boosts
productivity. One way to give employees that purpose, according to Grant, is to have them meet the very people
they are helping and serving, even if just for a few minutes. Managers giving their people access to customers
so they can see firsthand the human impact their work makes is the greatest human motivator, says Grant.
6. Help them develop new skills.
Although important, I'm not so much talking about putting them through another required technical or safety
training program to keep them or the business compliant, but actually giving them meaningful new skills or
knowledge in other areas that they can use to leverage their natural strengths for future roles, whether with their
current company or another company. The point is to serve and value them so exceptionally well as people and
workers that they have no reason to leave but use their newfound skills for new projects.
7. Actively involve them.
Great managers recognize that leadership doesn't travel one way but is multi-directional. While it can come
from the top down at critical times, the best scenario is allowing decisions, information, and delegation to travel
from peer to peer or from the bottom up, where the collective wisdom and involvement of the whole
team help solve real issues in real time on the frontlines.
8. Believe in them.
The best managers delegate often and give their employees responsibility for delivering challenging work. If
this doesn't happen in your workplace, consider two hard questions:
 Do you trust your knowledge workers to do what they've been hired to do?
 Do they have the right competence for the job to carry out the work with confidence?
So often managers underestimate the potential and ability of their employees to use their brains! If you
answered yes to the questions above, be of the mindset to always accept that they can do the work. Then, give
them the room to perform and support them with whatever they need to make them even better. This is how you
motivate them to the rafters.
PUBLISHED ON: NOV 30, 2017
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What Daily Leadership Behaviors Inspire Employee Motivation?
The Leader's Belief in Their Employees' Efficacy Promotes- Success
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•••
BY SUSAN M. HEATHFIELD

Updated June 25, 2019

Want to spend your time in leadership activities that inspire motivation, trust, and certainty while dispelling
employee fear, negativity, and skepticism? During times of change, no actions are more powerful than
when leaders make the time to communicate and build relationships.
When leadership shares vision, optimism, and purpose-driven goals, motivation and commitment from
employees is ensured. Jon Gordon, the author of "Soup: A Recipe to Nourish Your Team and Culture," who
participated in an earlier interview about managers and motivation, recommends these six leadership actions to
inspire employee motivation.
Communicate Daily With Employees
Communication is a powerful tool that leadership can use to create an environment that brings forth employee
motivation. Communication provides information, makes employees feel important and recognized, and
provides the glue that binds a workforce with their leadership and their organization. Transparent
communication of goals, financial results, and improving service to customers is imperative if you
want employees to bring their hearts and spirit to work.
"Communicate with transparency, authenticity, and clarity. Whether you have a scheduled morning meeting
each day, make office rounds in the afternoon, or take your team to lunch, make it a priority to make time to
talk to each and every member of your team on a regular basis. You may be busy, but, the truth of the matter is
that you really can't afford not to communicate frequently with your employees,” Gordon recommends.
Transfer Leadership’s Optimism
“As a leader, your most important weapon against pessimism (prevalent in recent years) is to transfer your
optimism and vision to others. This inspires others to think and act in ways that drive results.
”Leadership is a transfer of belief—and great leaders inspire their teams to believe they can succeed. As a
leader and manager, you are not just leading and managing people, but you are also leading and managing their
beliefs. You must utilize every opportunity available to transfer your optimism,” Gordon says.
”From town hall meetings to daily emails to individual conversations to weekly teleconferences, it's imperative
that you share your optimism with your team. Optimism is a competitive advantage, and you need to convey it
in all you say and do. As one of the greatest American innovators, Henry Ford, said, ‘Think you can, or think
you can't—either way you are correct.’”
Leadership Shares the Vision
Gordon recommends that to inspire employee motivation, leadership must, “Share the vision. It's not enough to
just be optimistic. You must give your team and organization something to be optimistic about. Talk about
where you have been, where you are, and where you are going.
"Share your plan for a brighter and better future, talk about the actions you must take, and constantly reiterate
the reasons why you will be successful. Create a vision statement that inspires and rallies your team and
organization."
Leadership Builds Relationships
“Relationships build real motivation. It's much easier to motivate someone if you know them and they know
you. After all, if you don't take the time to get to know the people who are working for you, then how can you
ever truly know the best way to lead, coach, and motivate them effectively? And, for that matter, how can you
expect them to trust and follow you if they don't know you as well?”
"Relationships are the foundation upon which winning teams and organizations are built," says Gordon. "I
advise managers to make their relationship with their employees their number one priority.
"In fact, I've worked with numerous NFL coaches and have seen firsthand how the most successful coaches
and best motivators are those who develop meaningful relationships with their players. The same strategy that
works on the playing field works in the office as well."
Leadership Creates Purpose-Driven Goals
Gordon recommends: “Create purpose-driven goals. When it comes down to it, the real force behind motivation
has nothing to do with money or number-driven goals. Real motivation is driven by purpose and a desire to
make a difference.
"In fact, people are most energized when they are using their strengths for a purpose beyond themselves. When
employees feel as though the work they do is playing an integral role in the overall success of the company and
the world, they are motivated to work harder.”
”Similarly, when they feel as though they are working for something more than just the bottom line, they feel
good about the work they are doing. So as a leader, you will want to motivate your team by focusing less on
number goals and more on purpose-driven goals," Gordon explains.
"It's not the numbers that drive your people but your people and purpose that drive the numbers. Sit down with
each individual on your team and talk through their personal goals and how you see those goals fit into the
bigger picture. Give them a sense of purpose that will fuel their fire towards taking action."
Leadership Nourishes the Team
These may seem like strange words to apply to the workplace. But Gordon insists they are spot-on. He says,
“The main question that every employee in every organization wants to know is, ‘Do you care about me; can I
trust you?’
"If your answer is yes, they will be more likely to stay on the bus and work with you. Employees who feel cared
for, honored, and nourished are more engaged in what they're doing and will work at their highest potential.”
Think about it: Gallup's research shows that employees who think their managers care about them are more
loyal and productive than those who do not think so. If you nourish your team and take the time to invest in
them, they will pay you back in productivity, creativity, and loyalty. If your employees know that you care
about them, they will want to do good work for you. It's the greatest motivator of all.”
"Remember this simple formula," Gordon concludes. "Belief plus action equals results. If you don't believe that
something can happen, then you won't take the actions necessary to create it.
"If you believe that your team can do big things, they will believe it, too. And that belief will fuel the fires of
action and provide you with the results you're looking for."
Nowhere are these six leadership actions more important than in today’s organizations. Leadership strives to
draw forth the best that employees have to offer, their intrinsic motivation and their discretionary energy. With
the active role of your organization’s leadership in these six critical activities, motivation and commitment from
employees are ensured.
Motivating employees is a crucial leadership task, as motivation translates employees’ knowledge, skills, and
abilities into effort and performance by determining the direction, intensity, and duration of work-related
behaviors. This chapter summarizes the leadership implications of four core perspectives on motivation. It
describes why motivating requires a “two-sided understanding” of motivation that in addition to the factors that
increase motivation, also covers influences that can decrease motivation. A case from a leadership seminar
serves to illustrate how the two-sided view on motivation can help leaders translate their goal to motivate into
genuine support. The chapter concludes by discussing how leaders and their employees can cocreate a
motivating work context and how they might benefit from a shift from motivating to enabling motivation.
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217© Springer International Publishing Switzerland 2017
J. Marques, S. Dhiman (eds.), Leadership Today, Springer Texts
in Business and Economics, DOI 10.1007/978-3-319-31036-7_12
C. Stamov Roßnagel (*)
Department of Psychology and Methods , Jacobs University ,
1 Campus Ring , Bremen 28759 , Germany
e-mail: c.stamovrossnagel@jacobs-university.de
12
Leadership and Motivation
Christian Stamov Roßnagel
Abstract
Motivating employees is a crucial leadership task, as motivation translates
employees’ knowledge, skills, and abilities into effort and performance by deter-
mining the direction, intensity, and duration of work-related behaviors. This
chapter summarizes the leadership implications of four core perspectives on
motivation. It describes why motivating requires a “two-sided understanding” of
motivation that in addition to the factors that increase motivation, also covers
infl uences that can decrease motivation. A case from a leadership seminar serves
to illustrate how the two-sided view on motivation can help leaders translate their
goal to motivate into genuine support. The chapter concludes by discussing how
leaders and their employees can cocreate a motivating work context and how
they might benefi t from a shift from motivating to enabling motivation .
Introduction
Leaders show the way and help employees pursue it by empowering and engaging
those employees (see Gill, 2012 ) through the “the ability … to infl uence , motivate,
and enable others to contribute toward the effectiveness and success of the organiza-
tion.” (House et al., 1999 , p. 184). In other words, motivating employees is a
crucial leadership task, as motivation translates an employee’s knowledge, skills,
and abilities into actual work behavior and job performance. While the former
enable workers to carry out their jobs as required, the level of motivation
c.stamovrossnagel@jacobs-university.de
218
determines the amount of effort workers actually put into their jobs. Defi ned as “a
set of energetic forces that originate both within as well as beyond an individual’s
being,” work motivation initiates work-related behavior and determines its “direc-
tion, intensity, and duration” (Pinder, 1998 , p. 11). Pinder’s general defi nition cap-
tures the essence of the broad range of theories work motivation research has
produced in the past 70 or so years (for an overview, see Hertel & Wittchen, 2008 ).
Differences in general assumptions and emphases notwithstanding, those theories
converge in the aim to describe under which conditions employees invest effort in
their work, which work activities they prefer, and what makes employees persist in
their efforts over time.
From a leadership perspective, the multitude of established theories can in prin-
ciple be a real asset as it allows for compiling a comprehensive set of “tools” to
positively infl uence employee motivation. Using these tools effectively and respon-
sibly requires a “two-sided understanding ” of motivation that in addition to the
factors that increase motivation, also covers infl uences that can decrease motiva-
tion. On this backdrop, this chapter summarizes in the fi rst section the leadership
implications of four major perspectives on motivation and emphasizes that intrinsic
motivation should be the goal of motivating. In the second section, a case from our
leadership development seminars serves to illustrate how the two-sided view on
motivation can help leaders translate their goal to motivate into genuine support.
The chapter concludes by discussing how both leaders and their employees might
benefi t from a shift toward enabling motivation .
Leadership Implications of Core Perspectives on Motivation
While no “grand unifi ed theory” of work motivation has yet been proposed (see
Locke & Latham, 2004), several core theoretical perspectives can be identifi ed (see
Grant & Shin, 2011 ) that in principle give leaders a sophisticated set of tools to
promote their employees’ motivation. As one of those core perspectives on motiva-
tion, goal-setting theory (Locke & Latham, 1990 ), focuses on the motivational
effects of goals and emphasizes that diffi cult, specifi c goals motivate high perfor-
mance by focusing attention and increasing effort and persistence. Expectancy the-
ory (Vroom, 1964 ) is a second major perspective. It presumes that employees’
investments of effort follow from three subjective beliefs. To be motivated, employ-
ees must believe that their effort will lead to performance ( expectancy ), that this
performance will lead to outcomes ( instrumentality ), and these outcomes must be
subjectively important ( valence ). The Job Characteristics Model (JCM; e.g.,
Hackman & Oldham, 1980 ; Oldham & Hackman, 2005 ) as the third major perspec-
tive is built on the assumption that certain structural characteristics of work tasks
prompt psychological states that are the prerequisites to high levels of job satisfac-
tion and work motivation. Skill variety, for instance, i.e., the degree to which a job
requires employees to develop and use a variety of skills and talents, is positively
linked to the experienced meaningfulness of that job. Together with responsibility
for outcomes and knowledge of results , experienced meaningfulness is one of three
psychological states that jobholders must experience to be motivated.
C. Stamov Roßnagel
c.stamovrossnagel@jacobs-university.de
219
These theories suggest a number of leadership interventions to increase moti-
vation. From a goal-setting perspective, together with diffi cult goals, feedback
is seen as essential because it enables employees to gauge their progress and
adjust effort, persistence, and task strategies accordingly. Therefore, systematic
goal-setting and feedback are two essential motivation tools, and they are indeed
used by superiors employing Management by Objectives (Drucker, 1954 ) prin-
ciples. Rewards for good performance are perhaps the most obvious motivation
tool that follows from expectancy theory . According to the theory, even an
employee with high expectancy beliefs would not be motivated if he or she were
not convinced that performance will lead to outcomes. A (monetary) incentive
is supposed to be such an outcome and should therefore by defi nition increase
motivation to the extent that the employee values the incentive. Finally, the job
characteristics model implies that leaders can motivate through the way they
arrange work. For instance, granting employees the freedom and discretion
about when and how to complete their work increases experienced responsibil-
ity for outcomes. The conclusion seems tempting that to achieve the highest
possible level of motivation, leaders should combine all those tools. In other
words, they should set diffi cult goals, give regular feedback, promise attractive
bonuses, and at the same time give their employees the latitude to do their work
the way they want to achieve those goals. After all, the aforementioned theories
are not meant to be alternatives; rather, each theory looks at some of the many
conditions under which employees are motivated and each theory looks at a dif-
ferent set of conditions.
From a self-determination theory (SDT; for a review, see Gagné & Deci, 2005 )
point of view, however, that “more is better” approach might be a haphazardly com-
piled toolbox rather than the effective and responsible use of motivational interven-
tions. As the fourth core perspective, SDT has expanded our understanding of
intrinsic motivation and informed work motivation research in general (Grant &
Shin, 2011 ). According to SDT, employees have the three basic needs of autonomy
(a feeling of choice and discretion), competence (feeling capable and effi cacious),
and relatedness (a feeling of belongingness with others) (Ryan & Deci, 2000 ). If
these three needs are met, employees are more likely to be intrinsically motivated
and accept external goals and objectives as being “their own.” Motivation is intrin-
sic in that it is driven by an interest in or enjoyment of the task itself, and evolves
within the employee, rather than from external pressures or rewards. If these needs
are not fully met, motivation will be of a more extrinsic nature. Ryan and Deci
( 2000 ) proposed four types of extrinsic motivation that vary in their degree of expe-
rienced autonomy . As the “most extrinsic” type, external motivation is exclusively
based on outside reward and punishment contingencies, whereas employees in a
state of integrated motivation have assimilated those contingencies into their system
of goals and values .
It is the intrinsic, autonomous level of motivation that leaders are supposed to
achieve in their employees, according to contemporary leadership models. As moti-
vation cannot be fostered by “a simple swap of desired material and psychic pay-
ments from a superior in exchange for satisfactory services“ (Bass, 1985, p. 9),
leaders should aim at raising their employees’ aspirations by articulating a
12 Leadership and Motivation
c.stamovrossnagel@jacobs-university.de
220
compelling vision and encouraging employees to go beyond their personal expecta-
tions in achieving this vision (Bass and Riggio, 2006 ). Such leadership requires,
among other things, individualized consideration , i.e., a leader’s capability to rec-
ognize differing characteristics among his or her employees, act as their mentor or
coach, and pay special attention to individual needs of followers. This kind of lead-
ership has been shown to promote employees’ motivation and job satisfaction and
to inspire employees to take greater ownership for their jobs (Zhu, Chew, &
Spangler, 2005 ; Barroso Castro, Villegas Perinan, & Casillas Bueno, 2008 ; Tims,
Bakker, & Xanthopoulou, 2011 ; García-Morales, Jiménez-Barrionuevo, &
Gutiérrez- Gutiérrez, 2012 ).
SDT helps understand why simply “throwing together” all possible motivators
mentioned above is not guaranteed to work. Let us take rewards and incentives as an
example. If they are promised in a way that threatens feelings of autonomy , compe-
tence, or relatedness, employees will most likely react negatively. For instance,
explaining a reward system in a controlling rather than supportive manner can com-
promise employees’ feelings of autonomy and relatedness (e.g., Deci, Connell, &
Ryan, 1989 ; Deci, Koestner, & Ryan, 1999 ; see also Kramer, 1999 ). There is also
evidence that other characteristics of compensation systems (e.g., variable vs. fi xed
pay ratios or the number of people whose performance determines the reward; Gagné
& Forest, 2008 ; symbolic features of rewards—who distributes them, why, how, and
to whom; Mickel & Barron, 2008 ) may affect self-determination and intrinsic moti-
vation. The same rationale applies to the way goals are set and feedback is given. It
is not goals and feedback alone that foster motivation, but also the way they are com-
municated. The following case from one of our leadership development seminars
will serve to highlight the difference motivational communication can make.
Case Study 12.1: Motivational Communication—How Less Can Be More
In our leadership development seminars, most participants seem to be clear
what motivation is and how employees can be motivated. Encouragement is
regularly mentioned as a top motivator, together with support, and incentives.
Furthermore, most leaders endorse that employees should be asked their views
so they can participate in their own “motivation-making.” There is, of course,
nothing wrong with encouraging and supporting, and participation is certainly
crucial. And incentives can be helpful, too, if they are introduced in a fashion
that supports autonomy , competence, and relatedness. In that case, they can
increase intrinsic motivation (see Grant & Shin,
2011 ). Still, even when they
keep encouragement , support, and incentives in mind, leaders might end up in a
conversation like the one below. In this excerpt, a participant of one of our lead-
ership seminars—let’s call him John Miller—describes how he went about
motivating one of his employees in a specifi c situation.
John Miller, the Department Head, meets with his employee Jane Smith to discuss
upcoming changes in Mrs. Smith’s job. In the wake of recently implemented process
standardization and streamlining measures, some of Mrs. Smith’s tasks got comput-
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erized and she is therefore supposed to take over other tasks that are new for her. Mr.
Miller wants to support her and ensure she is really motivated.
John Miller: “Good morning, Jane, how are you? I am sure you know why I
invited you to our today’s meeting, don’t you. I would like to discuss with you the
upcoming changes to your work that follow from our recent standardization pro-
gram. Do you feel well prepared?”
Jane Smith: “Well … Looks like I’ll have to take on a host of new tasks … I
haven’t had that many tasks so far and I am not at all familiar with the new ones …”
John Miller: “You’re absolutely right, Jane. We’ve accomplished quite a bit in the
past 18 months. Most processes in our departments C3PO und R2D2 are now stan-
dardized across all sites. Many time-consuming micro tasks are carried out by com-
puters now. That’s good for you because there will be less of the boring routine work
to do. So you work load has actually gone down, hasn’t it.”
Jane Smith: “Well…”
John Miller: “A reduced workload means that you’ll have the capacities to take
on new tasks. I’ve drafted a list with four new topics and next steps that I’d like you
to familiarize yourself with.”
Jane Smith: “Oh, wow, that’s quite a bit of work …”
John Miller: “Don’t worry, Jane, I know you’ve got what it takes. Moreover, I
suggest you attend the Exwhyzed training, which will get you up to speed in less
than two weeks. And fi nally, I’ll grant you two extra days of leave as a bonus!”
Jane Smith: “Thank you. I’ve heard, though, Exwhyzed would be rather theoreti-
cal, not very hands-on. Will that really help me?”
John Miller: “That training has been well received by most of your colleagues so
far. I don’t think it’ll be a problem—do you?”
Jane Smith: “Alright, alright …”
John Miller: “Jane, I’m glad we’ve agreed a good solution. Best of luck to you!”
John was aware that there might be room for improvement to his motivat-
ing skills. Still, he felt unable to specify why Jane did not leave the meeting
very motivated and why she has repeatedly called in sick ever since, which
he thinks is to do with the upcoming changes. After all, he had asked her if
she felt well prepared and encouraged her by telling her that he believed she
had what it takes to master the upcoming tasks. He supported her in two
ways; fi rst, to set goals, he compiled for her a list with topics and next steps
and second, he “offered” (his words when explaining his rationale) her a
training to facilitate getting into the new tasks. Together with his encourage-
ment, this should have raised her expectancy beliefs. To make her transition
more enjoyable and to raise her utility beliefs, John gave Jane two extra days
of leave as an incentive. Finally, as an additional boost to Jane’s utility
beliefs, John emphasized as an advantage of the standardization program that
Jane would be freed from what he called “microtasks,” implying that she
would from now on have a more stimulating, challenging job. In sum, there-
fore, from a motivation theory point of view, it seems he did everything right.
Moreover, as that participant appeared to be of genuine friendliness, there
were no grounds to assume he could have led the conversation in a demoti-
vating way. What, then, was the problem?
As we shall see, the fact that he led the conversation was most problem-
atic. In that seminar, we had another participant from the same company,
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and she faced basically the same situation. Like John Miller, she was deal-
ing with one of her employees who was concerned about the potential
changes from the standardization program. Unlike John Miller, she did not
lead the conversation in the usual way:
Joanna Miller: “Good morning, James, how are you? Today, I’d like to speak with
you about our recent standardization program and what it means for you. In that
regard, what have you got on your list that you would like to talk about?”
James Smith: “Well, I’m concerned about all the upcoming changes”
Joanna Miller: “Which changes exactly do you see for yourself?”
James Smith: “Suppose there’ll be loads of new tasks for me…”
Joanna Miller: “James, you are right that the standardization initiative brought
quite a few changes. In our C3PO und R2D2 departments, the majority of processes
got standardized so that many routine tasks are now handled by computers. Have
you for yourself gone through the implications yet of those changes for your work?”
James Smith: “No.”
Joanna Miller: “What advantages do you see from many of the time-killing tiny
tasks being handled by the computer from now on?”
James Smith: “Can’t think of any.”
Joanna Miller: “And what are you worried about?”
James Smith: “As I said, I’ll have many new tasks to handle.”
Joanna Miller: “Alright, got that. In your view, what’s the problem with these
new tasks?”
James Smith: “That I won’t be up to them.”
Joanna Miller: “What does that mean, ‘not up to them’? How would you know
you’re not up to them?”
James Smith: “I might be doing everything wrong!”
Joanna Miller: “You might be doing everything wrong … In what other situation
have you done everything, I repeat, everything wrong?”
James Smith: “Well …”
Joanna Miller: “You’ve been with us now for more than 15 years and you are
indeed very experienced. In the past, when you had to learn the ropes, how was that?
How did you manage in those cases?”
James Smith: “I always got along, somehow.”
Joanna Miller: “And what might be different now? What might keep you from
familiarizing yourself with those new tasks?”
James Smith: “I haven’t got any younger, learning new things is not that easy
anymore.”
Joanna Miller: “How do you notice that learning isn’t as easy for you as it used
to be?”
James Smith: “It’s just strenuous.”
Joanna Miller: “And it used to be a piece of cake 10 or 15 years ago?”
James Smith: “Well, it’s always a little strenuous.”
Joanna Miller: “What could we—I mean our instructors, I, and you—do to make
learning easier for you?”
John Smith: “Don’t know.”
Joanna Miller: “How much does learning put you under time pressure?”
John Smith: “Quite a bit.”
Joanna Miller: “And how much would it help if we took that pressure down?”
John Smith: “That would be quite a relief!”
Joanna Miller: “The Exwhyzed training might be helpful to prepare you for your
new tasks. Do you know that one?”
John Smith: “I’ve heard it’s quite theoretical…”
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223
Joanna Miller: “What do you think if we ask Jack Doe, the instructor, to let us
have the training materials in advance? You could go through them and fl ag the top-
ics and exercises that you think aren’t hands-on enough.”
James Smith: “And what would that be good for?”
Joanna Miller: “Thanks to your experience, you might be able to give us ideas
how we might make our trainings better, you might be able to suggest different exer-
cises and cases, for instance. This might be of great help to your colleagues, too.”
James Smith: “Ok, why not.”
Joanna Miller: “Great, thank you. Are you going to speak to Jack, or would you
like me to do that?”
James Smith: “I’ll get in touch with him after we speak.”
Joanna Miller: “The training will be in two weeks. Please can you let me know
what suggestions you’ve got by Tuesday next week? We could then get back to Jack,
he might be able to incorporate some changes already in the next training.”
James Smith: “Ok, sounds good.”
Joanna Miller: “What else would like to talk about standardization-wise?”
James Smith: “I’m sorted at this point, thank you.”
Compared to John in the fi rst conversation, Joanna may seem to have done
much less in terms of motivating. Like John, she suggested a specifi c training to
support her employee James’s getting started on the new tasks. However, neither
did she promise an extrinsic motivator to increase his motivation for that training,
nor did she mention any intrinsic rewards that might result from the standardiza-
tion. And although like John she was convinced her employee James did have
what it takes to master the change, she did not encourage James by telling him
so. Even when he did not come up with any benefi ts the standardization might
have for him, Joanna did not mention such benefi ts herself. Quite to contrary, she
explored his potential apprehensions by asking what might worry him about the
new tasks. What was Joanna’s rationale?
In essence, she focused on two principles. First, she started from the assump-
tion that motivating others is not always synonymous to increasing motivation ,
but sometimes to removing barriers to motivation. As we have seen in the previ-
ous section, employees have got the need for feeling competent, for believing
that their efforts will lead to performance. If they lack such effi cacy beliefs, moti-
vation will most likely be minimal; any attempts to fuel utility beliefs will not
compensate for insuffi cient expectancy beliefs. Therefore, Joanna dealt with
James’s fears, which might have reduced his effi cacy beliefs. In other words, her
approach refl ected a “double- sided” understanding of motivation. John Miller,
on the other hand, showed a “single- sided” understanding that focuses on “push-
ing” motivation only. Second, rather than telling James she knew he had what it
takes, Joanna tried to let him discover that for himself by having him realize that
his fears of failure are overblown. To that end, she had him specify exactly how
he knew he would not be up to the new tasks and that having to learn new skills
would be a problem for him. Importantly, she made him connect to his strengths
in previous situations (“In the past … How did you manage…?”) of change to
make the current situation look even less threatening. At the end of their conver-
sation, James was prepared to try Joanna’s suggestion of preparing himself for
the training by revising the training materials and perhaps coming up with sug-
gestions for improvement.
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From Motivating to Enabling Motivation
Motivating others is by no means an easy task. Goals and feedback, expectancy
beliefs and incentives, work design and autonomy —all these and many more person
factors and job factors play a substantial role in motivating employees. As employ-
ees may differ in the relative importance they attach to each of these factors, what
motivates one employee might not motivate another employee the same way. At the
same time, according to contemporary leadership models, leaders are supposed to
show individualized consideration of their employees to motivate them the best
possible way. Can leaders realistically be expected to master that challenge, particu-
larly if they lead a large number of employees?
If leaders like John Miller feel they have to “make” their employees’ motivation
and if they endorse a “push” view on motivation with encouragement , feedback,
praise, and rewards as their sole motivation tools, then leaders might indeed falter.
However, if leaders like Joanna Miller see as their job to create a work context in
which employee motivation can unfold and to help employees surmount obstacles
to high motivation, then motivating becomes a much easier goal to attain. Adopting
an expectancy theory perspective, we portray in our leadership seminars motivation
as a “decision
1 “; if certain conditions are met, employees “decide” to be motivated.
Only employees can make that decision, not their leaders. Accordingly, the focus of
leaders’ motivational interventions shifts from motivating to enabling employees’
motivation, building on the assumption that employees know best what drives their
motivation and what stifl es it. That knowledge puts them in a position to cocreate
with their leaders a motivating work context. What would it take to make the
enabling of motivation a standard motivational intervention of leaders? Basically,
we believe the tools are available already.
As the case example suggested, asking employees the right questions is one
essential tool. Motivational interviewing (MI) research and practice (see Miller &
Rollnick, 2002) has developed and validated a system of conversational techniques
that are helpful in raising people’s motivation and lowering resistance to change. As
far as we can see, MI techniques are not yet widely used in leadership contexts. We
are optimistic this will change, however, given that motivational interviewing skills
are quite straightforward to acquire. Of course, working with MI techniques and a
double-sided concept of motivation can involve dealing with employees’ negative
emotions such as fear or anger. Leaders might be hesitant to go there if they want to
“let sleeping dogs lie” and not put their employees’ motivation on the line. Although
we understand such concerns, we do not share them. The simple question is: what
is the alternative? If negative emotions are “there,” they need dealing with because
this will be the only way of managing them. On the other hand, simply ignoring
negative affect is more than likely to increase its adverse impact.
A solid understanding of the role of personal and job resources play for moti-
vation is a second important tool. Job resources are those physical,
1 Please note that this is meant as a metaphor, rather than a theoretically accurate description.
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psychological, social, or organizational aspects of a job that help workers achieve
their work goals and that reduce job demands (Demerouti, Bakker, Nachreiner,
& Schaufeli, 2001 ). Job resources may motivate intrinsically by facilitating
learning or personal development and extrinsically by providing instrumental
help or specifi c information for goal achievement (Schaufeli & Bakker, 2004 ).
Job resources such as social support, autonomy , performance feedback, supervi-
sory coaching, and opportunities for development have been recognized as cru-
cial for the majority of occupations (Bakker & Demerouti, 2007 ; Lee & Ashforth,
1996 ). Personal resources are positive self-evaluations that facilitate goal
achievement and protect individuals against the physical and emotional costs of
work-related demands (Hobfoll, Johnson, Ennis, & Jackson, 2003 ). Personal
resources refer to one’s sense of the ability to control and impact successfully on
one’s environment. An example of a personal resource is learning-related self-
effi cacy (Kyndt & Baert, 2013 ).
Important from a leadership point of view, job and personal resources interact
with job demands. Only if their resources match job demands will employees make
full use of their competencies and maintain their productivity and well-being. Job
resources might buffer the impact of job demands such as work pressure and emo-
tional demands, including burnout, on work-related strain (e.g., Bakker, Demerouti,
& Euwema, 2005 ; Xanthopoulou, Bakker, Demerouti, & Schaufeli, 2007 ).
Interactions of resources with demands may have longer term effects in the form of
resource cycles . According to Hobfoll ( 1998 , 2001 ), people who possess resources
are more likely to acquire further resources. As initial gains beget future gain,
employees with resource surpluses are less vulnerable to job demands (Hobfoll,
1998 ). Conversely to this gain spiral , those who lack resources are more vulnerable
to further losses, potentially initiating loss spirals .
According to our experiences, the job resources concept can help leaders and
their employees see which parts they play in cocreating a motivating work con-
text. Certain resources serve as key resources that “unlock” the power of other
resources. If key resources are missing, the benefi cial effects of other resources
might be limited. For instance, a company might have a positive learning and
training climate and job design might be geared toward work-related learning.
However, if leaders fail to support and encourage learning, they may stifl e their
workers’ learning activities. From an exploration of the available job and personal
resources, leaders gain a detailed insight into the key job resources they should
arrange for. Employees get a sense of their personal resources that need building
and to what extent those personal resources depend on job resources; this enables
them to request from their leaders’ job resources in a much more targeted fashion.
Ultimately, such co-creation benefi ts both leaders and employees. Leaders’ job of
motivating becomes more manageable as they share it with their employees. For
employees, co-creation involves a high degree of autonomy , (self-)competence,
and connectedness (with their leader), fulfi lling the central needs that promote
intrinsic motivation.
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226
Discussion Questions
1. In the second conversation, although James was prepared to try Joanna’s
suggestion, he did not appear to be totally enthusiastic and bursting with
energy to get started. Why might Joanna not have tried to achieve such
“high-energy motivation” right away? What pros and cons do you see to
Joanna’s going for a “lower level” of motivation?
2. Why might employees sometimes seem to be very “motivated to not be
motivated”?
3. What might have made one of our participants say “If I enable my employ-
ees to be motivated, rather than motivating them myself, I give away a
great deal of my infl uence ”?
 4. Which (groups of) employees might the approach of enabling motivation
not be suitable for?
Chapter Summary
• Leaders motivate and enable employees as a part of their endeavors to
secure the effectiveness and success of the organization.
• Motivation translates an employee’s knowledge, skills, and abilities into
performance by determining the direction, intensity, and duration of work-
related behaviors .
• The theories of goal-setting , expectancy, job characteristics, and self- deter-
mination have emerged from a broad range of theories as four major perspec-
tives on motivation, providing a comprehensive set of motivating factors.
• Self-determination theory suggests that
(a) Leaders should target intrinsic motivation that is driven by an interest
or enjoyment in the task itself, and that is strongly related to job satis-
faction , ownership of one’s job, and job-related well-being.
(b) The way motivators are introduced and communicated in leader–
employee conversations is critical to their effectiveness .
• Rather than trying to directly motivate, leaders might benefi t from enabling
their employees’ motivation through structured questioning using insights
from motivational interviewing.
• In that approach, leaders and employees cocreate a motivating work context.
Leaders benefi t from sharing their task of motivating with employees; employees
benefi t from the autonomy and connectedness that comes with such co-creation.
Motivational leadership refers to someone leading others by motivating them to strive for certain goals rather
than simply act on orders. The leader tries to create a safe and trusting environment, and ensure the organization
is positioned for success in its domain—for example, a company in the marketplace. Some interpret
motivational leadership principles as requiring that a leader establish strong ethics, clear vision, definable
values, authentic communication, and be genuinely motivated to promote collaboration and a positive working
environment.[1]

Contents
 1Motivational leadership qualities
 2Becoming a motivational leader
  3Motivational leadership in sports
 4Motivational leadership in the workforce
 5Motivational leadership in a family
 6Motivational leadership quotes
 7References
Motivational leadership qualities[edit]
Honesty: A leader must be honest to maintain trust from team members.
Ability to delegate: Leaders must identify strengths of team members so they can maximize group potential.
Communication: A leader must effectively communicate goals to team members.[2] Sense of humor: Leaders
must help maintain organizational morale because negative attitudes spread.
Confidence: A leader must show confidence in all situations, because others feed from this confidence and
perform more productively.[3] Commitment: A leader must show commitment by doing work the others are
doing to demonstrate commitment to the team and the mission, and willingness to do “dirty work” if necessary.
Positive attitude: Leaders must demonstrate a positive attitude to the group happy and maximize productivity.
Creativity: A leader must be creative to see situations in multiple ways and solve problems more effectively.
Optimism: A leader constantly must be optimistic and have a positive vision because team members feed from
that optimism.
Vision: Leaders must have a vision, because followers may not.[4] Integrity: To have integrity means that one is
truthful with strong morals.[5] Ability to inspire: A leader must not only have the ability to inspire themselves,
but inspire others in the group to get necessary production when the leader needs it. A leader must have the
ability to inspire in every situation.http://www.inc.com/peter-economy/7-traits-highly-effective-leaders.html
Courage: Leaders must be willing to take risks and push out of comfort zones to reach goals.[6] Realism: Seeing
the world as it really is, not as it "should" be. One should be realistic when assessing a situation, so as to not
sound irrational.[7] Responsibility: Leaders must take responsibility for their actions, especially if he/she made a
mistake.
Becoming a motivational leader[edit]
Motivation leadership begins with motivating yourself.[8] Leaders should have motivation and confidence that
they can successfully lead a group and also that they are able to approach the group they are leading with good
manners
A leader must set goals[9] to keep the group working towards something—but the goals must be achievable,
because unrealistic goals hurt morale.
A leader should learn from failures to gain wisdom. Young leaders can only learn so much from past leaders
and textbooks, but sometimes must make their own mistakes so they can learn from them.
A leader should accept responsibility.[10] for not only their actions, but the actions of their group.
When approaching a project, a leader should provide direction to the group to get a task completed in the most
efficient manner.
A leader should be trustworthy because the people they lead must trust them to do everything in their power to
promote success.
A leader should be authentic rather than pompous. People generally favor leaders who see themselves as a
common worker.
To get the most out of a group, a leader should embrace self-expression to harness every group member's inner
creativity.
Key to leadership is collaboration with the group to all opinions so everyone has input.
Motivational leadership in sports[edit]
Vince Lombardi: Vince Lombardi was a coach in the National Football League for the New York Giants and
the Green Bay Packers. After his five year tenure with the Giants, he signed a five year deal to coach the
Packers. Lombardi transformed the Packers from a team that had a record of 1-10-1 in 1958, the previous year,
to 7-5 in 1959, Lombardi’s first year. Lombardi went on to lead the Packers to three straight and five total
league championships. Lombardi’s success was based on how he coached. Lombardi demanded excellence and
told players that once they understood themselves, they could add to that and build character, integrity, and
dedication. Lombardi had a violent temper, but that only was illustrated due to the passion he had for the game.
Lombardi promised that if his players obeyed his rules, they would be winners. Lombardi certainly held up his
end of the bargain, winning two Super Bowls with the Packers.
Coach Herb Brooks: Coach Brooks is an iconic figure for his motivational speech before the 1980
championship game in which USA played a championship hockey game against the Soviets. The Soviets were
heavy favorites to win and Brooks, in his speech, said that the Soviets would probably win 9 times out of 10.
Brooks motivated his team to go out and play as if it was their night, as if they deserved this game. If not for the
brilliant and motivating speech by Brooks, who knows if team USA would have defeated the Soviets in 1980.
Ray Lewis: Ray Lewis had a 17 year career in the National Football League with the Baltimore Ravens. Lewis
is known for his devotion to Christianity and his outstanding leadership. He is not only a leader on the field with
his teammates, but a leader off the field with charity work for disadvantaged youth.
Motivational leadership in the workforce[edit]
Motivational Leadership is important because it helps to get the most from society. Every team of people or
worker needs leadership. Leaders help organize projects to get them completed in the most efficient manner.
Leaders have incentives to motivate employees because they help cut costs by working quicker in a positive
environment. Additionally, employees increase quality when happy with leadership, and in turn, society is
happy because they receive quality products.[11]
Motivational leadership in a family[edit]
Any family figure can be a motivational leader in a family—a brother, sister, cousin, grandparent, or parent.
The motivational leader in a family must constantly set good examples and drive other members of the family to
be the best that they can. A child that is constantly motivated usually develops their own motivation, and
therefore develops a work ethic. Parents must motivate their children, and in some instances older siblings.
Motivational leadership quotes[edit]
“It's not the size of the dog in the fight, it's the size of the fight in the dog.”[12]-Mark Twain You miss 100% of
the shots you don’t take. –Wayne Gretzky[13] Winning isn’t everything, but wanting to win is.[14] –Vince
Lombardi “You can never cross the ocean until you have the courage to lose sight of the shore”.[15] –
Christopher Columbus “The difference between a successful person and others is not lack of strength not a lack
of knowledge but rather a lack of will”.[16] –Vince Lombardi “In a field of opportunities, don’t pick one for
yourself, plant one for others.” –William Tootle Jr. More Inspirational Quotes "To handle yourself, use your
head; to handle others, use your heart." Eleanor Roosevelt 75 Inspiring Motivational Quotes on Leadership
Motivation in leadership
Monday, June 11, 2018 - 09:16

Motivation is a goal-oriented characteristic that helps a person achieve his or her objectives.
It encourages an individual to work hard at achieving his or her goals. The desired leadership traits will assist
management to influence motivation of employees. One should keep an open perspective on human nature.
Knowing different needs of employees / team members will make the decision-making process and daily
operations easier.
Both employees and management must possess leadership and motivational traits.
An effective leader must have a thorough knowledge of motivational factors for others. Leadership is used as a
means of motivating others. This training is suitable for delegates that will fulfil a leadership role as part of their
job. A good leader should possess the following characteristics:
 Honesty and Integrity
 Inspiring to Others
 Commitment and Passion
 Good Communicator
 Decision-Making Capabilities
 Accountability
 Delegation and Empowerment
 Creativity and Innovation
Contact Academy Training Group on 012 997 2804 today for further queries regarding this course.
By Lana Kornelius, Academy Training Group
5 Keys to Motivation and Leadership
by Sean McPheat | Aug 24, 2017 | Leadership Skills | 3 comments
Share:2113218

Picture this lack of leadership scene: Several years ago, while working in a sales-intense environment, a steady
mid-week jaunt was suddenly and violently interrupted when a manager came bursting through the door with
the exasperated look of a frightened elk.
He informed his team, through a stuttering, panicked, barely audible frustration, that the regional manager was
in the area for the next few days and this store was a prime target for his ruthless inspection.
Ship-Shape
Immediately, they set about getting everything in order. They informed the rest of the team of the seriousness of
the operation and of the opportunity it presented. They got that store in ship-shape condition.
Managers worked tirelessly to ready graphs and figures to present their information and show exactly what they
could do, and not a single customer was missed.
They were ready to prove how good their store could be, and in the end, that was probably the most motivated
team ever seen in the often-questionable company.
Little Hope
Unfortunately, it didn’t work out quite like they thought it might. The big boss strode in with a gloopy air of
irritated viscosity, like he had to wade through the tarmac beneath his feet. There was little hope from there.
He greeted a team of enthusiastic, engaged employees all eager to show off their accomplishments and the
achievements they had made.
Regrettably, he didn’t seem to notice. At each stage of his tour of the store, he could only highlight what was
missing, what hadn’t been done, and asked why there wasn’t any more.
He complained, frowned, shook his head, and left.
The difference in the team was visible immediately. They felt like they had worked for nothing; utterly
disengaged and demotivated. This was the polar opposite of their work ethic before the visit.
5 Keys to Motivation
We have to remember that creating invested, engaged employees isn’t something that can be done once and
then forgotten.
If you’re not winning over ‘hearts and minds’, all you’re creating is potential losses.
So, what five things can we take away from this catastrophic management blunder?
1. Respect
It doesn’t cost anything. And, at any level, is always a two way street.

Related: One Thing I Know for Sure About Leadership

If you don’t show employees respect or if you talk down to them or assume they’re not working hard, you’ll
lose any respect they might have for you.
2. Conversation
Communication is important in every aspect of business and even more so when you’re leading a team of
people.
Talk to your employees on a personal level, listen to what they have to say, and reply with relationship building
in mind.
3. Gratitude
Actually being appreciative of employee efforts and acknowledging successes will keep your people wanting to
do well.
Celebrating achievement is always important. And if you can bring a team together with your praise, you’ll
strengthen their bond and build motivation tenfold.
4. Development
This is the manner in which you should address issues, and highlight areas where individuals might make
headway.
Develop their ideas and your own. Identify what needs to be worked on, keep it positive, and always focus on
the next step.
For example, “What we’ve achieved so far is great and this is where we could be if we do this.”
5. Reminder
As a leader, it’s easy to become lost in paperwork and logistics. A lot of the time, employees don’t get to see the
bigger picture like you might.
Communicate that the work they do is important, and every success is a company wide success that they should
be proud of.
Most of all, let employees know they’re making a real difference.
Conduct a meeting with these five steps in mind, and in no time you’ll have the most motivated, fired-up team
ready to do anything for you, the company, and for success.
How Do You Keep Up Motivation?
If you have ideas that you feel like sharing that might be helpful to readers, share them in the comments section
below. Thanks!
How Great Leaders Motivate Their Teams
Vanessa LoderContributor
Entrepreneurs
I write about business, motivation, productivity and mindfulness.
This article is more than 2 years old.
TWEET THIS
 If you want to motivate your employees and attract customers and investors with ease, one of the most
vital things you can do is give them a “why” to believe in.


Human beings all deeply want to believe in something. It’s in our basic human nature. If you want to motivate
your employees and attract customers and investors with ease, one of the most vital things you can do is give
them a “why” to believe in.
There is a fascinating study done by Dr. Adam Grant and his colleagues who worked with call center employees
at the University of Michigan. These employees had the unenviable task of cold calling alums to ask for money.
One of the groups in this study was able to meet a scholarship recipient and talk to him first hand. The
scholarship recipient talked about how much the scholarship had changed his life, and he thanked the people in
the call center for their hard work. Once the call center workers realized how their work had an impact, they
became motivated to work harder and the group’s weekly revenue increased an amazing 400%.
In another study, when nurses assembling surgical kits met the health-care practitioners who would use their
kits, the nurses worked 64% more minutes and made 15% fewer errors than those nurses who did not meet the
“end user ” (Belle, 2013).
In national surveys over the past three decades, the vast majority of Americans have identified meaningful work
as the single most important feature that they seek in a job.
One of the easiest and most powerful ways to imbue a sense of meaning in work is to put employees in touch
with the end user.
For example, Deere & Company invites farmers who are buying tractors to visit the factories with their
families. Assembly line employees get to meet the farmers, hand them a gold key, and watch them start their
tractors for the first time.
At Olive Garden, managers share with the staff letters from customers describing how they chose to celebrate
meaningful events at the company’s restaurants.
Today In: Entrepreneurs
Great leaders know that people are intrinsically motivated when they understand
why
they are doing something, and the best leaders put the correct conditions in place to ensure people gain this
deeper connection.
According to Dr. Grant, a face-to-face meeting has the strongest emotional impact on an employee, particularly
when the employee does not normally interact with the end user.
A Microsoft lab manager interviewed by researchers Michael Cusumano and Richard Selby explains that after
seeing an end user, developers “immediately empathize with the person. The usual nonsense answer; ‘Well,
they can just look in the manual if they don’t know how to use it,’ or ‘My idea is brilliant; you just found ten
stupid people’ just goes out the door.” Grant adds that “a face-to-face connection with end users appears to
elicit empathy among the developers, motivating them to design software with users in mind.”
As a leader, ask yourself “What are the ways I can engage end users with our employees?” One start up in
Silicon Valley invites current and potential clients to a monthly happy hour event with employees.
Another solution is to harness some of the information you may already have. If you have letters from satisfied
customers, positive feedback, gratitude, or even data showing the impact of your products and services, share
this information broadly in your organization. As Bonobos CEO Andy Dunn shared with me in an
interview, “There are no diminishing returns to specific positive feedback .” It’s a free, unlimited resource that
many leaders are not leveraging as well as they could.
Another option is to turn
employees into end users. Encouraging employees to try the product for themselves is the easiest way to create
this conversion. Not only does the company receive additional feedback on its products, but the employees have
a better understanding of the user experience.
Sending employees out into the field is another way to connect them with end users. Chris Hendriksen, the CEO
of healthcare company VRI, says he spent his first few months at the company riding in the truck, visiting end
users, and participating in the actual customer experience.
Regardless of the specific approach you take, the research clearly demonstrates that a simple yet powerful way
to decrease burnout and greatly increase the motivation and satisfaction level of your team is to give them a
“why” to believe in. And one of the easiest ways to do this is to connect your employees with your end users.

II. HR Management
 Role of Human Resource Management in Organizational Performance
Vol-3 Issue-6 2017 IJARIIE-ISSN(O)-2395-4396 7208 www.ijariie.com 1789 HRM ROLE IN
ORGANISATIONAL PERFORMANCE S.SARAVANAN ABINAYA.S Head of the Department II Year
MBA Student Department of Management Studies Department of Management Studies Anna University (BIT
Campus),Trichy-620024 Anna University(BIT Campus),Trichy-620024 Abstract HRM has become
tremendously popular over the past years.HRM is important for all types of organisations.HRM will overly
influence the performance of organisation and its results.The pre assumptions is that HR practices affect
employee attitude which inturn affects organisational performance such as productivity,quality and
innovation.Most evidence support a good relation between HRM and organisational performance.The main aim
of every organisations is to achieve the goals and objective with high performance.High performance is possible
only with a strong HRM. Organisational performance is measured by various methods.It helps the organisation
to be competitive in the market.HRM are the medium for keeping organisation going in right track.In this
paper,study has been made on HRM and practices. How important is the management of human resources to
achieving organizational performance? What are the skills, behaviors and attitudes would be expected by
human resources to achieve the needed performance in the organization. How HRM have positive impact on
organisation performance? What are the negative impacts that affect employee? INTRODUCTION: Human
resources are considered as one of the important part of current organisations. Human resources management is
the major source because managers use these assets in organization, create competitiveness and understand
goals.Thus initially, organizations must realize the needs of their workforce in turn to attain the required
performance. The understanding of the expectations of workers will allow the required outcome in the
organization. Some of the required results of the organization in controlling their labourforce are: capability,
teamwork of employees with managers, assistance of employees between them, showing the competence of
employees; motivation, committment and agreement,employee behaviors. On the whole, aim of performance
management is to produce culture as high performance in which employees and groups take accountability for
the uninterrupted enhancement of production processes and their talents and contribute in attaining the targets
set by managers. In exacting, organization performance can be articulated as the estimation of personal goals of
employees with organizational goals given that employees maintain the organization culture. Organizations are
looking for creating much competition, taking more market percentage, more consumers, more sales. Rapid
transformations from globalization, progression of information systems and other factors have created
competition. Mostlly organizations are focused on the market to put their goals in their performance. The
comprehension of the objectives will be attained through the human resources management in organizations.
Workforce is the entry to success, will facilitate the accomplishment of organizational performance. Vol-3
Issue-6 2017 IJARIIE-ISSN(O)-2395-4396 7208 www.ijariie.com 1790 HUMAN RESOURCE
MANAGEMENT: Human Resource Management is the process of recruitment and
selection,orientation,training and development ,assessment of employee (performance of appraisal), calculating
compensation and benefits, motivating, maintaining relations with workforce and with trade unions,
maintaining safety, welfare and healthy measures in agreement with labour laws. Human resources management
functions include benefits management, documentation and employee and payroll dispensation. The degree to
which HR department handle these transactional functions relates to their knowledge, the workforce size and
the departmental resources. In many cases, the department's resources can maintain outsourcing these functions,
thus leaving time for HR staff to devote its attention to HR strategic management instead of concentrating on
personnel administration jobs. Recruitment and Selection HR recruitment and selection practices are dependent
on the organization's goals and the workplace culture. For example, employers who identify the importance of
workplace diversity hold recruitment practices planned to draw a diverse applicant pool. Recruitment training
underlie recruiting actions and functions such as sponsoring career fairs at colleges and universities with diverse
student populations, advertising job vacancies across to reach a broad viewers. Work-Life Balance
Implementing flexible work schedules, providing employees with telecommuting options and training managers
to mark signs of workplace stress recommend the organizational culture to support employees attain work-life
balance. Managing development logistics, altering technology for remote access and training sessions are
essentially transactional functions. However, these functions eventually form a target-oriented work atmosphere
because they facilitate greater competence and, thus, amplify the time employees have to contribute to family
obligations and personal works. Training and Development Training and development are HR management
functions that include new-employee orientation, job skills training, leadership training and professional
development. These improvement activities enhance employees job skills in their current positions and prepare
them with skills and capability for cross-functional work that can enhance their importance to the organization.
Professional development wires an organization's planning strategy by preparing future leaders for higher-level
jobs and more responsibility. HR management training and development functions reflect promotionfrom-
within practices and support employees' work goals. Compensation Compensation and benefits is considered as,
expressing a broad view of how employers repay their employees. However, a view at compensation gives an
idea of HR practices as employee wages comprise up to 70 percent of an employer's cost to improve their
business, according to a 2011 white paper produced by DBSquared for World at Work, an Arkansas-based
compensation consulting and software development firm.Employee compensation is "an internally equitable
and externally competitive philosophy and practice," it notes. PERFORMANCE EXPECTATION: To perform
well, employees must know management‟s expectation from them. The starting point is an present job
description that describes the necessary roles, jobs, and responsibilities of the job. It also elaborates the general
areas of information and expertises required for the employee and employee to be successful in the job.
Performance expectations go ahead of the job description. When thinking about high standard on-thejob
performance, you are really thinking about a series of normal job reslts, such as  What goods and services
produced by the job? Vol-3 Issue-6 2017 IJARIIE-ISSN(O)-2395-4396 7208 www.ijariie.com 1791  What
effect should the job have on the organization?  How do you expect the employee to handle the clients,
colleagues, and supervisors?  What are the organizational values the employee must reveal?  What are the
procedures, techniques, or means the employee is supposed to use? In performance outcome an employee
should be known about existence of the job, its place in the organization, and the link beween the job's
responsibilities and organization and department objectives. The scope of performance expectations can be wide
but can be broken into two categories:  Results (measured by goals or standards)  Actions & Behaviors (The
procedures used to create a product and the actions and values shown during the process) Performance
expectations give out a base for communicating about performance all through the year. They serve as the
source for reviewing employee performance. When we set understandable expectations about the results that
must be achieved and the methods or approaches needed to achieve them, you establish a path for success.
POSITIVE EFFECTS OF HRM ON PERORMANCE: Human Resource Management is contributing in the
current scenario:- 1. Hiring and Training Human resource planning is of the most important role of the HR
department. HR managers plan hiring policy for hiring the best people in their organization. They prepare the
Job Descriptions according to the requirementof role in the company. After hiring process planning is done for
the employee‟s induction with training and development plans for them. 2.Performance Management System
Human resource is responsible for people feel motivated in their work. They begin with defining an
individual‟s role. They provide an effective feedback mechanism which helps the employees to upgrade their
abilities.This helps to align the organizational objectives with their own personal goals. An Peformance
management system helps in appreciation and rewarding people's performance. 3.Building culture and values in
the organization An individual‟s performance is dependent on the atmosphere or culture that exists in a
company. Constructing a good favourable working atmosphere is expected from the organisation. A clean and
safe work culture assists in encouraging the skills of an employee and promotes job satisfaction. 4. Conflict
Management within the organisation The disagreement between the employer and employee always prevails
because of their contradictory views.Conflict avoidance is not possible but can be managed and reduced.Human
resource department act as mediator and effective communicator to identify issues and solve them effectively.
Timely action is the main part of conflict management. 5.Good relations within organisation Maintaining a
good relations vests in the hands of HR to a great extent. They are liable for conducting seminars, meetings on
behalf of the organisation. Outlining business and promoting plans Vol-3 Issue-6 2017 IJARIIE-ISSN(O)-2395-
4396 7208 www.ijariie.com 1792 for the company are added work done by the HR department as an helping
hand.So the company should give greater importance in setting a strong and effective Human Resource
Department. NEGATIVE EFFECT ON PERFORMANCE: Some of the negative efffect of HRM are: 1.Origin
is recent: Human Resource Management is of recently originated department.People try to define the term
differently according to their knowledge.Some people regard it as a new topic to personnel management. Some
enterprises don‟t have clear idea about HRM so they have confusion in differentiating HRM and personnel
department.Such actions may not bring desired results.The actual requirement of the company is a fundamental
change in attitudes, methods and management.ideas.Without making a change at the top management level,
renaming of personnel department may not help to get result.As time pass by we get an satisfactory approach
for developement. 2. Lack of Top Management support: HRM can be effectively carried out only with the
support of top level management. The attitude enhancement at the top can help to gain good results while
implementing HRM. Because of passive attitude at the management level, this work is taken over by personnel
management employees. Nothing remarkable will happen unless there is a change in methods and attitude of
top management. 3. Improper Actualisation: HRM can be implemented only by calculating the training and
development needs of employees. The interests,wants and needs of employees should be taken into account
while making human resource strategies. The training programmes are organised in company measured as the
implementation of HRM.Management‟s productivity and effectiveness approach left uninterrupted in many
organisations. 4. Inadequate Development Programmes: HRM requires implementation of programmes such as
career planning, on the job training, development programmes, Management by objective, counselling etc. A
learning environment has to be created in the organisation for employee personnel devlopement. In actuality
HRM programmes are restrained to class room lectures and likely results are not getting out of this approach. 5.
Inadequate Information: Some company lag necessary information about their employees. Due to lack of
adequate information and database this system face difficulty in implementation. So there is a need to create a
database of employees for quick retrieval of information for human resource management.It helps the
management at time of emergency. LITERATURE REVIEW: 1. The concept of Human Resource (HR) was
introduced by Prof. L. Nadler (1969) in American Society for Training and Development Conference. In India,
Larson and Tubro Ltd., a private sector company introduced this concept in 1975 in their organization with an
objective of facilitating growth of employees, especially people at the lower levels. Among the public sector
government companies it was BHEL which introduced this concept in 1980. 2. Kochan and Dyer (1993);
Walker (1993); and Cusworth and Franks (1993) suggested that a firm should aim at developing various HR
practices as complementary to one another. 3. A number of studies have tested the linkage between Human
Resource Management practices and performance of organization with generally helpful results. In fact,
existing researches in this area has Vol-3 Issue-6 2017 IJARIIE-ISSN(O)-2395-4396 7208 www.ijariie.com
1793 220 changed its focus from testing the linkage between several Human Resource Management practices
and the performance of organizations to find out the means from which Human Resource Management practices
affects the performance of the organization. Boselie et al., (2005) is also of the same view. Collins and Smith,
(2006) also tested the above relationship. Similarly Hailey et al., (2005) studies also revealed the same results.
However, current researches on the association between HRM practices and performance of the organization
are confused about the methods of these studies (Wall & Wood, 2005). These studies recommend that it is early
to assume a clear positive relationship between Human Resource Management practices and performance of the
organization and argue that further research could be done though using more thorough research designs. If
social exchange perspective is viewed, employees respond to the organization‟s actions by the ir continuous
participation in the organization. There is empirical research which shows that HR practices enhance employee
retention. 4. Tiwari and Saxena discuss a framework that indicates how external and internal factors affect
HRM practices which in turn generate certain benefits for the organization and ultimately lead to overall
corporate performance [22]. The authors list some “innovative” HR practices being followed by seven selected
companies, namely J K Lakshmi Cement, Grasim Industries Ltd, Tata AIG General Insurance Co Ltd, Maruti
Udyog Limited (MUL), HCL Technologies Ltd., LG India and Pantaloons (India) Ltd. Noting that these
companies are performing “well” in their sectors, they attribute their success to these so-called “innovative” HR
practices and conjecture that the latter must have helped in building image of the company in the minds of the
employ es and hence contributed to their respective “good” business performance. Anil K Singh took a sample
of 95 respondents from two private sector organizations in India and reported positive correlations between
HRM practices and variables of organizational culture [23]. 5. According to the Compact Oxford English
Dictionary (p.839, 2002) performance is defined as the action or process of performing‟. Another definition of
the word represents the „capabilities of a machine or product‟.Lebas (1995), on the other hand, defines
performance as the prospective likelihood to carry out particular actions in order to successfully achieve set
goals within the given time frame and of the actor and the situation. The author continues to emphasize that a
specific term for performance is one that many find it somewhat difficult to agree upon. Different parties have
differing ideas about what performance actually represents (Venkatraman and Ramanujam, 1986; Armstrong,
2000). CONCLUSIONS: Organizations are working as much as to create a competitive market,to direct their
human resources in achieving required organizational goals. Some of the goals are cost minimization achieving
high sales targets, increasing the number of customers, increasing the percentage in market , increasing quality
of product, novel products, enhance productivity. Human resources are engaging an important role in attaining
these performance indicators. Before everything, organizations should understand the potential required from
employees and so the employees express their skills, stay motivated and behave certainly according to the
performance requirement of the organisation.HRM is a comprehensive process for human resource management
which is integrated with the organization's overall policy. It facilitates the employees in organization with the
right skills and arranging them in places according to their abilities and skills. Organizational performance has
been defined by many authors differently. In general, organizational performance is concerned about the
achievement of the goals of the organization. The organizational performance achievement is a outcome of the
hardwork done by the employees in the organization. Policies and strategies of organizations encourage the
employees and they provide effect on organizational performance. Some of the works carried out are human
resource planning,selection, training and development,recruitment compensation, performance management and
employee relations. By achieving the wants and needs of employees, the performance target of the organization
will be reached .Organizations need to think about human resource as a way to grow competitive advantage
necessary to generate appropriate strategies and practices. Also, authority and liability must engage in the entire
Vol-3 Issue-6 2017 IJARIIE-ISSN(O)-2395-4396 7208 www.ijariie.com 1794 organization working together.
Performance management strategy should centre on the development of a constant and flexible process.
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Tansky JA (1991) An Effective Employee Development Discussion: The Causes and Consequences. 16.
Washington C (1996) A Proposed Model of Approaches to Front-Line Employee Development. In Proceedings
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International Journal of Academic Research in Business and Social Sciences April 2015, Vol. 5, No. 4 ISSN:
2222-6990 432 www.hrmars.com Role of Human Resource Management Functions On Organizational
Performance with reference to Kenya Power & Lighting Company – Nairobi West Region Rose Mwaniki, Jane
Gathenya School of Human Resource Development, Jomo Kenyatta University of Agriculture and Technology
P.O Box 62000-00200 Nairobi, Kenya Corresponding Author’s Email: rmarywait@gmail.com DOI:
10.6007/IJARBSS/v5-i4/1584 URL: http://dx.doi.org/10.6007/IJARBSS/v5-i4/1584 Abstract Human Resource
is an important corporate asset and performance of organizations depends upon the way it is put in use through
human resource management, which aims at ensuring that organizations achieve success through people. The
distinctive feature of HRM is its assumption that improved performance is achieved through the people in the
organization. Kenya Power in its bid to embrace the idea of sustained performance and flexibility has engaged
approximately 11,000 human capital who are charged with the responsibilities of ensuring supply of adequate
and reliable electricity to its customers; improvement of customer service; acceleration of electricity access to
the public; and creating value for the shareholders. Despite this, Kenya still faces challenges like prolonged
power outages, delayed constructions of power lines, delayed connections and reconnections are experienced,
thus calling for appropriate measures besides increase in human capital to enhance the company’s performance.
A study that examined the role of HR functions of recruitment and performance contracting on organizational
performance through reduction in power outages, increased customer base and increased revenue levels was
carried out with reference to Kenya Power, Nairobi West Region. A questionnaire was administered to the
respondents and an analysis of the responses established that high percentages of 46.7 and 47.8 respectfully
agreed that there had been continuous reduction in power outages in the year under research and an increase in
customer base was experienced. A high percentage of 33.7 strongly agreed on that there had been increased
revenue levels in the year under research. The study found out that the HR functions of recruitment and
performance contracting positively affected organizational performance and recommended continuous
improvement on the HR functions to ensure continuity in increased organizational performance. Key Words:
Human Resources, High -Performance Management, Recruitment and Selection, Performance Contracting,
Organizational Performance. International Journal of Academic Research in Business and Social Sciences April
2015, Vol. 5, No. 4 ISSN: 2222-6990 433 www.hrmars.com 1.0 Introduction Energy is a key enabler to
achieving Kenyas’ aspirations captured in the country’s development blue print- the Vision 2030. According to
a Workshop on energy scenarios July 24, 2013, the overall goal of Kenya’s energy sector is to provide
affordable, sustainable and reliable supply of energy that will stimulate high and sustained economic growth
leading to higher incomes, increased employment and reduced poverty. In this light, Kenya Power which is a
limited liability company in the energy sector in Kenya, transmits, distributes and retails electricity to customers
throughout Kenya. Kenya Power owns and operates the National Transmission and Distribution Grid and retails
to more than 2,038,625 customers throughout the country. The company has been providing power for both
industrial and domestic use throughout Kenya. In support of the country’s development goals, Kenya Power is
strategizing for growth through improvement in distribution efficiency and reduction of commercial losses by
introducing the stima flow procedures which are aimed at enhancing customer satisfaction thereby winning
customer confidence. Better service delivery to customers require urgent attentions and failing to appreciate this
fact is the worst mistake that can ever be made since it would lead to: unreliable power supply and loss of
revenue since the more the sales the more the revenue; loss of employment as the company relies on the income
generated in order to service its operations thus can only retain a sustainable human resource; disruptions and
interruptions of production lines which has an adverse effect in economic growth as the affected organizations
would never meet their production targets which in return affects income generation. 1.1.1 Human Resources
According to Nzuve (1997), Human Resource refers to the individuals within an organization whose activities
contribute to the organization´s success that is, achievement of organizational goals and objectives. Macgregor
(2011) also points out that the backbone or foundation of an organization is its core staff. Every organization
should therefore have the right people in the right places at the right time to enhance success. 1.1.2 Human
Resource Management Human Resource Management as defined by Michael Armstrong (2009), is a strategic,
integrated and coherent approach to the employment, development and well-being of people working in
organizations. The overall purpose of human resource management is to ensure that the organization is able to
achieve success through people. HRM aims to improve organizational effectiveness and capability-the capacity
of an organization to achieve its goals by making the best use of the resources available to it. 1.1.3
Organizational Performance According to Michael Armstrong (2009), the concept of performance covers both
what has been achieved and how it has been achieved. Performance is measured through key performance
indicators which are usually to do with financial results or productivity. A considerable amount of research has
been conducted recently on the impact of HRM on organizational performance for example Arthur
(1990,1992,1994) obtained data from 30 US strip mills and assessed impact on labour efficiency and crap rate
by reference to the existence International Journal of Academic Research in Business and Social Sciences April
2015, Vol. 5, No. 4 ISSN: 2222-6990 434 www.hrmars.com of either a high commitment strategy or a control
strategy. The research outcomes were that firms with a high commitment strategy had significantly higher levels
of both productivity and quality than those with a control strategy. In Purcell et al (2003), a University of Bath
longitudinal study of 12 companies to establish how people management impact on organizational performance
resolved that the most successful companies had `the big idea.’ They had a clear vision and a set of integrated
values. They were concerned with sustaining performance and flexibility. Clear evidence existed between
positive attitude towards HR policies and practices, levels of satisfaction, motivation and commitment, and
operational performance. Policy and practice implementation (not the number of HR practices adopted) is the
vital ingredient in linking people management to business performance and this is primarily the task of line
managers. As indicated by Rebecca Mitchell , Shatha Obeidat ,and Mark Bray (2013), human resource
management functions play a major role in enhancing organizational performance. Kenya Power in its bid to
embrace the idea of sustained performance and flexibility as advocated by Purcell et al (2003), has engaged a
human resource capacity of approximately eleven thousand employees who are charged with the responsibilities
of ensuring supply of adequate and reliable electricity to its customers; improvement of customer service;
acceleration of electricity access to the public; and creating value for the shareholders (KP Annual report,
2011/2012). Despite this, Kenya still faces challenges like prolonged power outages, delayed constructions of
power lines, delayed connections and reconnections are experienced (KP customer satisfaction survey,
2011/2012), thus calling for appropriate measures besides increase in human capital to enhance the company’s
performance. The study examined the role of HR function in addressing improved performance, through human
resource management functions of recruitment and selection, and performance contracting. 1.2 General
Objective To examine the role that human resource management functions play in the overall organizational
performance in the context of Kenya Power, Nairobi West Region. 1.2.1 Specific Objectives 1. To establish the
role of recruitment and selection process on organizational performance. 2. To examine the role of performance
contracting on the organizational performance. Hypotheses The following Null hypotheses were developed;
H01: Recruitment and selection process have no influence on organizational performance. H02: Performance
contracting has no influence on organizational performance. International Journal of Academic Research in
Business and Social Sciences April 2015, Vol. 5, No. 4 ISSN: 2222-6990 435 www.hrmars.com 1.5
Significance of the Study The study was to enable the researcher examine and document the results on the role
of human resource management functions on organizational performance. The study was also to provide a
source of information for utilization by the company on effective implementation of human resources
management practices for the success of the organization and information for further research in this area of
study. 1.3 Theoretical Framework a) The Matching Model of HRM HRM is defined by the two models of HRM
developed by what might be described as its founding fathers- That is; The matching model of HRM by
Michigan School of Fombrun et al (1984) who held that HR systems and the organization structure should be
managed in a way that is congruent with organizational strategy; and The Harvard framework by the Harvard
School of Beer et al (1984), whose belief was that the problems of historical personnel management can only be
resolved when general managers develop a viewpoint of how they wish to see employees involved in and
developed by the enterprise, and of what HRM policies and practices may achieve those goals. a) Vroom's
Expectancy Theory Vroom's expectancy theory by Victor Vroom (1983) together with Edward Lawler and
Lyman Porter, suggested that the relationship between people's behavior at work and their goals was not as
simple as was first imagined by other scientists. Vroom realized that an employee's performance is based on
individuals’ factors such as personality, skills, knowledge, experience and abilities. The theory suggests that
although individuals may have different sets of goals, they can be motivated if they believe that: there is a
positive correlation between efforts and performance; favorable performance will result in a desirable reward;
the reward will satisfy an important need; the desire to satisfy the need is strong enough to make the effort
worthwhile. The theory is based upon the following beliefs: Valence which refers to the emotional orientations
people hold with respect to outcomes [rewards]. The depth of the want of an employee for extrinsic [money,
promotion, time-off, benefits] or intrinsic [satisfaction] rewards. Management must discover what employees
value. Expectancy which is the belief that employees have different expectations and levels of confidence about
what they are capable of doing. Management must discover what resources, training, or supervision employees
need. Instrumentality which is the perception of employees as to whether they will actually get what they desire
even if it has been promised by a manager. Management must ensure that promises of rewards are fulfilled and
that employees are aware of that. International Journal of Academic Research in Business and Social Sciences
April 2015, Vol. 5, No. 4 ISSN: 2222-6990 436 www.hrmars.com Vroom suggests that an employee's beliefs
about Expectancy, Instrumentality, and Valence interact psychologically to create a motivational force such that
the employee acts in ways that bring pleasure and avoid pain. 2.3 Conceptual Framework Human Resources
Functions Independent variables Independent Variable Dependent Variable 2.0 Literature Review 2.1 Human
Resources Function According to Michael Armstrong (2001), the main role of the HR Function is to enable the
organization achieve its objectives by taking initiatives and providing guidance and support on all matters
relating to its employees. The basic aim is to ensure that management deals effectively with everything
concerning the employment and development of people and the relationships that exist between management
and the workforce. A further key role for the human resource function is to play a major part in the creation of
an environment which enables people to make the best use of their capacities and to realize their potential to the
benefit of both the organization and themselves. The human resource function operates as part of the full
business management process and cannot be viewed in isolation. Although a support activity it must be
proactive. It supports and promotes business solutions that take advantage of opportunities stemming from
business issues just as it must find solutions to apparent constraints. It has been stated by Ulrich (1998) that:
`The activities of human resource appear to be and often are disconnected from the real work of the
organization.´ he believes that human resources `should not be defined by what it does but by what it delivers´.
According to Ulrich, human resources can deliver excellence in four ways: HR should become a partner with
senior managers in strategy execution, helping to improve planning from the conference room to the
marketplace; It should become an expert in the way work is organized and executed, delivering administrative
efficiency to ensure that costs are reduced while quality is maintained; It should become a champion for
employees, vigorously representing their concern to senior management and at the same time working to
increase employee contribution, that is, Performance contracting  Awareness of objectives  Involvement in
setting targets  Commitment on meeting targets  Guidance and follow up  Appraisal process Organizational
performance  Power outages  Customer base  Revenue Recruitment and selection  Definition of
requirements  Placement of advertisements  Competitiveness in interviews  Job description  Placement in
the organization  Induction process International Journal of Academic Research in Business and Social
Sciences April 2015, Vol. 5, No. 4 ISSN: 2222-6990 437 www.hrmars.com employees´ commitment to the
organization and their ability to deliver results; and it should become an agent of continuous transformation,
shaping processes and a culture that together improve an organization´s capacity for change. 2.2 High -
Performance Management As commented by M. Armstrong (2009), high- performance management or high
performance working aims to make an impact on the performance of the organization in such areas as
productivity, quality, levels of customer service, growth and profits. High-performance management practices
include rigorous recruitment and selection procedures, extensive and relevant training and management
development activities, incentive pay systems and performance management systems. 2.2.1 Recruitment and
Selection Recruitment is the process of finding and engaging the people the organization needs as observed by
M. Armstrong (2009). Selection is that part of the recruitment process concerned with deciding which
applicants or candidates should be appointed to the jobs. Braton and Gold (2007,p 239) differentiate the two
terms while establishing a clear link between them in the following way: ‘ recruitment is the process of
generating a pool of capable people to apply for employment to an organization. Selection is the process by
which managers and others use specific instruments to choose from a pool of applicants a person or persons
more likely to succeed in the job(s), given management goals and legal requirements.’ The recruitment and
selection process involves the stages of defining requirements–preparing role profiles and person specifications;
deciding terms and conditions of employment, planning recruitment campaigns, attracting candidates-
reviewing and evaluating alternative sources of applicants inside and outside the company, and selecting
candidates- sifting applications, interviewing, testing, assessing candidates, assessment centres, offering
employment, obtaining references; preparing contracts of employment. Difficulties in filling a position may be
encountered. In order to deal with the problem constructively, it is necessary to take the following actions:
ensure that all the possible sources of candidates have been used; consider any ways in which the advertisement
or website entry could be made more attractive; check that the person specification is realistic; consider whether
it might be necessary to improve the package offered to candidates; in discussion with line manager, examine
the possibility of reshaping the role to increase its attractiveness; and if the worst comes to the worst, and again
in discussion with the manager, consider alternative ways of carrying out the work involved with existing staff.
2.2.2 Performance Contracting Performance Contracting is a branch of management science referred to as
Management Control Systems and is a contractual agreement to execute a service according to agreed-upon
terms, within an established time period, and with a stipulated use of resources and performance standards.
Performance contract as defined by Kumar, (1994) is a Memorandum of Understanding (MOU). MOU is rooted
in an evaluation system, which not only looks at performance comprehensively International Journal of
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www.hrmars.com but also ensures forces improvement of performance managements and industries by making
the autonomy and accountability aspect clearer and more transparent. OECD (1999) defines performance
contract as a range of management instruments used to define responsibility and expectations between parties to
achieve mutually agreed results, while Smith (1999) argues that a common definition of performance
contracting can be found, there are a considerable variety of uses and forms for quasi-contractual arrangements.
The objective of performance contracting is the control and enhancement of employees’ performance and thus
the performance of the whole institution. 2.3 Organizational Performance improved through HR The
assumption underpinning the practice of HRM is that people are the organization´s key resource and
organizational performance largely depends on them. If, therefore, an appropriate range of HR policies and
processes is developed and implemented effectively, then HR will make a substantial impact on firm
performance. Research on the link between HRM and firm performance has been carried out in the past for
example; Arthur (1990,1992,1994) found out that firms with a high-commitment strategy had significantly a
higher level of both productivity and quality than those with a control strategy; Huselid (1995) found out that
productivity is influenced by employee motivation while financial performance is influenced by employee
skills, motivation and organizational structure; Patterson et al (1997) resolved that HR practices explained
significant variations in profitability and productivity. Two HR practices were particularly present:1) the
acquisition and development of employee skills and 2) job design, including flexibility, responsibility, variety
and the use of formal teams; The future of Work Survey, Guest et al (2000b) resolved that a greater use of HR
practices is associated with higher levels of employee commitment and contribution and is in turn linked to
higher levels of productivity and quality of services. Human resource management practices can improve
organizational performance through: Developing a psychological contract; Increasing motivation and
commitment; Increasing employee skills and extending the skills base; Providing employees with extended
responsibilities so that they can make full use of their skills and abilities; Instituting processes of performance
management and continuous development ; Using reward management systems to convey message about what
the organization believes to be important and what it is prepared to provide financial and non-financial rewards
for; and Developing employee relations strategies which provide employees with a voice. HR can contribute to
the achievement of competitive advantage and added value, and to total quality initiatives. As explained by
Boxall (2002), managing human resources strategically can contribute to the achievement of competitive
advantage, added value and total quality initiatives in an organization when business strategy is linked with
human resource strategy. Strategic human resource management aims at providing a sense of direction in an
often turbulent environment so that the business needs of the organization, and the individual and collective
needs of its employees, can be met by the implementation of coherent and practical human resources policies
and programmes. According to Nzuve (1997), successful organizations are a result of International Journal of
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www.hrmars.com effective human resources whose activities are geared towards achieving organizational
goals. Competent human resources plan for achievable organizational goal s and employ competent individuals
to carry out the organizational activities aimed at achieving their goals. To evaluate achievement of their goals,
organizations measure their performance which serves to align an organization's efforts to the achievement of
its mission. As part of a company's evaluation and control program, they quantifiably monitor important
characteristics of the company's products and services and the performance of the individuals and processes
creating them. Performance measures support managerial decision-making by providing useful information
regarding: how efficient and effective are the company's processes and the individuals implementing them; if
product or service improvements are necessary; if the company's customers and stakeholders are satisfied and if
the company is meeting its stated goals. Managing performance is achieved in organizations where performance
is well defined and performance contracts put in place, which define expectations-the results to be achieved and
the competencies required to attain these results. 3.0 Methodology 3.1 Research Design A research design is a
presentation of the plan, structure, or strategy of investigation, which seeks to obtain or answer various research
questions (Shuttleworth, 2008; Lesage, 2009). Borg, Meredith and Gall (2008) define research design as a
detailed plan on how the research is to be conducted. The study adopted a case study descriptive survey and
correlation. This was a descriptive study designed to gather data on the role of human resources management
function in an organization and its contribution to organizational performance. It integrated quantitative and
qualitative methods justifying the need for a survey design which gave numerical description of the population
under study. The period of study was years 2010-2012. The choice of this period was reasonable because
continuous efforts to enhance performance like organization culture change and company rebranding were
carried out during this period and due to availability of current and necessary data. 3.2 Target Population
Population refers to an entire group of individuals, events or object sharing a common observable characteristic.
The relevant base population is the population of organizations with human resource functions. The target
population of study covers Kenya Power– Nairobi West region. The population consists of all employees in the
12 departments with a total number of 914 employees. International Journal of Academic Research in Business
and Social Sciences April 2015, Vol. 5, No. 4 ISSN: 2222-6990 440 www.hrmars.com 3.3 Sampling Frame and
Sample Technique Sampling frame is used to select a number of individuals for the study in order to represent a
larger group from which they will be selected. Stratified sampling technique was used to select the sample size.
According to C.R Kothari (2004), Stratified sampling is used when the population from which a sample is
drawn does not constitute a homogenous group. In this technique, the population is stratified into a number of
non-overlapping subpopulations or strata and sample items are selected from each stratum; in this study, the
departments in Nairobi West Region. The sample size was determined as follows;
105.................................................................... 1 0.08 1.645 *0.5*0.5 2 2 2 2 Equation e Z pq nf    Where n=
the desired sample size ( if the target population is greater than 10,000) Z = the standard normal deviate at the
required confidence level P= the proportion in the target population estimated to have characteristics being
measured q = 1-P e = the level of statistical significance test When the total population is less than 10,000,
Mugenda & Mugenda (2008), recommend adjusting the sample size from equation (1) as follows: 94 914 104 1
105 1 1       N n n n f f ---------------------------------------------------------------- Equation 2 The sample of
94 respondents translated to 10.3% which was considered adequate as supported by Mugenda & Mugenda
(2008), who suggests that 10% is adequate. 3.4 Data Collection Instrument Primary data is facts assumptions
obtained directly from the field while secondary data is applied facts. The study used both primary and
secondary data. Secondary data was used in the literature review of the study. A semi-structured questionnaire
was used to obtain the data required. The questionnaire was designed to address the research questions. The
questionnaire incorporated two categories of questions namely structured and unstructured. Structured questions
are close ended with alternatives from which the respondents select the most appropriate answer. Unstructured
questions are normally open ended and allow the respondents to provide their own answers. The specific
respondents were the heads of departments and other employees, who were issued with questionnaires to fill.
3.5 Reliability test Cronbach’s Alpha was applied as a tool to measure the internal consistency of the constructs.
This instrument was extensively applied to authenticate the reliability of the constructs with an Alpha value of
0.7as the threshold International Journal of Academic Research in Business and Social Sciences April 2015,
Vol. 5, No. 4 ISSN: 2222-6990 441 www.hrmars.com 4.0 FINDINGS 4.1 Recruitment and Selection and its
Influence on Organizational Performance The study sought to find out from the respondents the influence of
recruitment and selection on organizational performance with reference to effectiveness in defining
requirements in sourcing for candidates; the effectiveness in placing advertisements; the effectiveness in
interviewing; the effectiveness in placing qualified candidates in the jobs; the effectiveness in induction process;
and the effectiveness in job description. Results in table 4.1 indicate a percentage effectiveness of
54.3,39.1,43.5,39.1,54.3 and 43.5 respectively as observed from the respondents. This is an indication that the
organization is committed to finding and engaging the right people for the job concurring with M. Armstrong,
(2006) as well as Charlesworth,2000and Tyson,1995 who held that without proper recruitment, the activity
plans go to waste and are expensive to reformulate. Table 4.1 Recruitment and Selection Not Effective
Somehow Effective Not Sure Effective Very Effective The effectiveness in defining of requirements in
resourcing 8.7% 12.0% 17.4% 54.3% 7.6% The effectiveness in placement of advertisement 9.8% 16.3% 15.2%
39.1% 19.6% The competitiveness in interviews 14.1% 12.0% 21.7% 43.5% 8.7% The effectiveness in
placement of qualified candidates 20.7% 13.0% 17.4% 39.1% 9.8% The effectiveness in induction process
19.6% 4.3% 8.7% 54.3% 13.0% The effectiveness in description of jobs to be occupied 14.1% 18.5% 10.9%
43.5% 13.0% 4.1.1 Correlation analysis of Recruitment and Selection on Organizational Performance The study
sought to examine the existence of relationship between recruitment and selection and organizational
performance. Fig. 4.1 indicates a positive linear relation between recruitment and selection and organizational
performance. Further, table 4.2 indicates a positive and significant correlation International Journal of
Academic Research in Business and Social Sciences April 2015, Vol. 5, No. 4 ISSN: 2222-6990 442
www.hrmars.com coefficient between the two variables ie r =0.486.This confirms that recruitment and selection
have a positive effect on organizational performance. Table 4.2 Recruitment and Selection Model R R Square
Std. Error of the Estimate .486a .236 2.33666 a. Predictors: (Constant), Recruitment And Selection Fig.4.1
Effects of Recruitment and Selection on Organizational Performance 4.1.2 Regression Analysis of Recruitment
and Selection on Organizational Performance As shown in figure. 4.1 and table 4.3 from the study, the fitted
regression line y=9.124+0.318x indicates that a unit change in recruitment and selection will lead to a
significant change in organizational performance at the rate of 0.318 with a p-value=0.000. Holding recruitment
and selection constant, organizational performance will stand at 9.124 at p-value=0.000 implying that there are
other drivers of organizational performance other than recruitment and selection. International Journal of
Academic Research in Business and Social Sciences April 2015, Vol. 5, No. 4 ISSN: 2222-6990 443
www.hrmars.com Table 4.3 Regression Analysis-Recruitment and Selection and Organizational Performance
Model Unstandardized Coefficients Standardized Coefficients B Std. Error Beta t Sig. 1 (Constant) 9.124 .584
15.623 .000 Recruitment and Selection .318 .060 .486 5.277 .000 a. Dependent Variable: Organizational
Performance The ANOVA table 4.4 has a P Value of 0.000 implying that the simple linear model of regression
explains 27.8% of the variations in organizational performance. The rest (72.2%) could be explained by other
variables among them performance contracting. Table 4.4 Recruitment and Selection and Organizational
Performance Anova Analysis Model Sum of Squares Df Mean Square F Sig. 1 Regression 152.034 1 152.034
27.845 .000a Residual 491.397 90 5.460 Total 643.431 91 a. Predictors: (Constant), Recruitment and selection
b. Dependent Variable: Organzational Performance 4.2 Performance Contracting Exercise and its Effect on
Organizational Performance The objective of the study was to examine the effectiveness of performance
contracting process on organizational performance with respect to defining departmental objectives, setting
individual targets, supervisor’s commitment and support to meet targets, continuous guidance towards meeting
the set targets, effectiveness in appraising staff and the effectiveness in communicating achievements, where
percentages of 54.3,43.5,64.1,56.5,46.7 and 47.8 in effectiveness were observed from the respondents as shown
in table 4.5. The study established the existence of performance contracts which OECD (1999) defines as a
range of management instruments used to define responsibility and expectations between parties to achieve
mutually agreed results. Kumar, (1994) defines performance contract as a Memorandum of Understanding
(MOU). MOU is rooted in an evaluation system, which not only looks at performance comprehensively but also
ensures improvement of performance International Journal of Academic Research in Business and Social
Sciences April 2015, Vol. 5, No. 4 ISSN: 2222-6990 444 www.hrmars.com managements by making the
autonomy and accountability aspect clearer and more transparent. Table 4.5 Performance Contracting Practices
Not Effective Somehow Effective Not Sure Effective Very Effective The effectiveness in definition of
departmental objectives 2.2% 15.2% 5.4% 54.3% 22.8% The effectiveness in setting individual targets .0%
9.8% 20.7% 43.5% 26.1% The supervisors' effectiveness in enhancing commitment to meeting the set targets
5.4% 12.0% 10.9% 64.1% 7.6% The effectiveness in offering continuous guidance and follow up to meeting the
set targets 5.4% 10.9% 13.0% 56.5% 14.1% The effectiveness in appraisal practice 5.4% 7.6% 17.4% 46.7%
22.8% The effectiveness in communication of individual achievements after the appraisal practice 4.3% 13.0%
16.3% 47.8% 18.5% 4.2.1 Correlations of Performance Contracting Exercise and Organizational Performance
The study sought to examine the relationship that exists between performance contracting exercise and
organizational performance. Fig. 4.6 indicates a positive linear relationship between performance contracting
exercise and organizational performance. Table 4.7 indicates a positive and significant correlation coefficient r
= 0.422, between the two variable. This confirms that performance contracting exercise has a positive influence
on organizational performance. This collaborates with OECD (1999) defining performance contract as a range
of management instruments used to define responsibility and International Journal of Academic Research in
Business and Social Sciences April 2015, Vol. 5, No. 4 ISSN: 2222-6990 445 www.hrmars.com expectations
between parties to achieve mutually agreed results. Fig. 4.2 Performance contracting exercise and
organizational performance Table 4.6 Performance Contracting Exercise and Organizational Performance
Model R R Square Adjusted R Square Std. Error of the Estimate 1 .422a .178 .169 2.42388 a. Predictors:
(Constant), Performance Contracting Practices 4.2.2 Regression Analysis of Performance Contracting Exercise
and Organizational Performance As shown in fig. 4.2 and table 4.7, the fitted regression line is y =
8.527+0.292x indicating that a unit change in performance contracting exercise results to change in
organizational performance at the rate of 0.292. Holding performance contracting constant, organizational
performance will stand at 8.527 implying that there are other drivers of organizational performance other than
performance contracting. International Journal of Academic Research in Business and Social Sciences April
2015, Vol. 5, No. 4 ISSN: 2222-6990 446 www.hrmars.com Table 4.7 Coefficients of performance contracting
and organizational performance Model Unstandardized Coefficients Standardized Coefficients B Std. Error
Beta t Sig. 1 (Constant) 8.527 .809 10.534 .000 Performance Contracting Practices .292 .066 .422 4.418 .000 a.
Dependent Variable: Organizational Performance The ANOVA table 4.8 has a P-value of 0.000 implying that
the simple linear model with only performance contracting is significant in explaining organizational
performance. However, the simple linear model explains 19.5% of the variations in organizational performance.
Table 4.8 ANOVA for Performance Contracting and Organizational Performance Model Sum of Squares Df
Mean Square F Sig. 1 Regression 114.661 1 114.661 19.516 .000a Residual 528.769 90 5.875 Total 643.431 91
a. Predictors: (Constant), Performance Contracting Practices b. Dependent Variable: Organizational
Performance 5.0 Summary, Conclusion 5.1.1 Recruitment and Selection The study sought to answer the
question, ‘what is the effect of recruitment and selection on organizational performance?’ the study findings
indicated that recruitment and selection was positively affecting organizational performance. This was revealed
through the response of the employees who responded to the questions on definition of requirements and
placement of advertisement, competiveness in interviews, job description placement in the organization and
induction process. Majority of respondents indicated that recruitment and selection was effective to a larger
extent of 54.3% and a minority of 8.7% rated recruitment and selection as not effective. This echo the remarks
of Baird and Meshoulam (1988) that `business objectives are accomplished when human resource practices,
procedures and systems are developed and implemented based on organizational needs’ . The study found out
that recruitment and selection positively affected organizational performance, an indication that the organization
is committed to finding and engaging the right people for the job as M. Armstrong (2006) indicates.
International Journal of Academic Research in Business and Social Sciences April 2015, Vol. 5, No. 4 ISSN:
2222-6990 447 www.hrmars.com 5.1.2 Performance Contracting What is the effect of performance contracting
exercise on organizational performance? The study findings indicated that; the process of defining departmental
objectives, effectiveness in setting individual targets, effectiveness of the supervisor’s commitment to achieving
the set targets, the effectiveness in offering continuous guidance and follow up to meeting the set targets, the
effectiveness in appraisal process, and effective communication of achievements played a major role in
performance contracting which by a larger extent affected organizational performance. The study established
the existence of performance contracts which OECD (1999) defines as a range of management instruments used
to define responsibility and expectations between parties to achieve mutually agreed results. Kumar, (1994)
defines performance contract as a Memorandum of Understanding (MOU). MOU is rooted in an evaluation
system, which not only looks at performance comprehensively but also ensures improvement of performance
managements by making the autonomy and accountability aspect clearer and more transparent. After analyzing
the data collected on performance contracting 53.81% of the respondents informed on its effectiveness in
contributing to the overall organizational performance. 5.3 Recommendations The study found out that the
functions of recruitment and selection, training and development, performance contracting and rewarding
played a major role on organizational performance as evidenced in the areas of reduction in power outages,
increased customer base levels and increased revenue levels. To continuously improve on organizational
performance, the organization should improve on the functions of human resource management and especially
on recruitment and selection, training and development, performance contracting and rewarding which will
enable the organization to have the right people for the right jobs and enhance commitment to their duties
resulting to improved organizational performance. 5.3.1 Recommendations for Further Studies This study was
confined to one firm in the energy sector in Kenya and focused on four major human resource management
functions notably; recruitment and selection, training and development, performance contracting and rewarding.
This limited the study from exploring other functions that still could affect organizational performance. The
study, therefore, proposes further studies to be carried out to help in establishing other functions of human
resource management that affect organizational performance that were not covered in this study. Further studies
should also be carried out in other key players in the energy sector in Kenya. REFERENCES Armstrong, M
(2007) A handbook of Employee Reward, 2 nd ed, Kogan Page, London International Journal of Academic
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Introduction
The study of HRM has come a long way in a relatively short period of existence. In a society that has become
increasingly dependent on knowledge and skills it is clear that the companies training perform an important role
in overall organization performance. This training comes from Human Resource Management practices. HRM
practices are defined as the activities intend to enhance the performance of organizations and employees ability
to achieve the goals of organization. HRM practices raise the outcomes of HRM to influence the organization
performance
This study focus’ on the relationship between HRM practices variables and organizational performance, impact
of HRM practices on organizational performance and productivity. The performance of an organization depends
on many factors and employees contribution. Impact of combined performance of employees on organization
performance is greater than individuals. Explanation, importance of relationship and the impact of the HRM
practices on the performance of organization. Different approaches of HRM practices and business strategy. It
reflects the approach and different factors of the HRM practices. Effect of the individual and shared climate
levels of organization
Different Studies have emphasized the contribution of Human Resource Management practices to the
organizational performance. These studies focused on HRM practices. There is shared idea that HR practices
are only effective when bundles are considered including incentive system, training, flexible job assignment,
high selectivity and performance management. These practices contribute to increase employee and
organization performance by increasing the level of productivity and financial performance. HRM practices
have an effect of motivating employees to adopt the required behaviours, it links to the organizational climate,
service environment and customer satisfaction. Outcome of investment on employees training each year, this
finding is generally shown to be stronger when an organization provides employees with opportunities for the
involvement in decision making and organises work in ways that allows employees a higher level of
discretionary efforts in the way work is done
HRM practices and Organizational performance
According to studies of Boselie, Paauwe and Jansen (2000), that relationship between relevant dependant and
independent variable will vary according to such influences as technology, unionization, industry, company
ownership and location, capital intensity, company age and size. Contingency arguments imply potentially
complex interactions between HRM variable, between performance and contingency factors, between HRM
variables and performance indicators and contingency factors. Commitment HR practices are based on the idea
that the closer an organization’s HR practices resembled the correct prototypical system, the greater the
performance gain
Nicolai and Dana (2009), focus on the impact of individual and bundles of HRM practices. The focus of the
empirical research has been divergent and it is clear that reward and training have attracted disproportionate.
These are important HRM practices, but it is hard to argue on a priori grounds that positive impact of, for
example job design variables. They found that practices such as the use of selective hiring, the extent of training
and active participation of the employee in decision making were conducive to organization learning, while
group performance-based compensation was not found to be significant for organization learning
A number of HRM researchers have argued that synergies are likely to exist among individual HRM practices.
These studies indicate that when HRM practices are applied as coherent systems, they have greater effects on
organization productivity than the sum of the individual effects from each practice alone
Cristina (2007), explain the relationship and impact of HRM practices in organizational performance. People
management should be matter of discussion and investment on the part of companies. As for as the theoretical
approaches are concerned, the conceptualization of the relationship among HRM practices and business strategy
has given birth to three main approaches, named universalistic, contingent and configurational. Under the
common relationship among HR Practices and organization performance or outcome, these models hypothesize
different set s of variable and relations among them eventually influence corporate results
In the view of Peter and Donna (2008), firstly approach which reflects the early work examining the impact of
HRM practices implicitly assumed a universalistic, rational model of work organization yielded significant
performance dividend. This has been closely associated with a best practice model of HRM. Secondly HR
practices are required to have consistency with other organizational factors to be effective. These factors include
the nature of market and legislative change. Climate of organization both as individual level attribute and as a
set of shared beliefs and values – have effect of motivating employee to adopt desired attitudes and behaviour
that in the collection, help to achieve organization’s goals. HRM system can be read as communication between
employer to employee. The effectiveness of HRM system as communication to employee will depend on those
features that define HRM system strength. These features are distinctiveness, consistency and consensus. Rita
and Miguel (2004), research has shown that HRM practices contribute to organizational performance. Early
studies emphasized the impact of several separate HRM practices, such as compensation, performance
management system and training. Later studies reported the positive impact of HRM practices on organizational
performance as well as the virtuous impact of HR sophistication, measured by investment in HR planning, in
hiring and in employee development on productivity, particularly in capital intensive organization. These latter
studies have a common idea that bundle of HR practices improve employee and organization performance.
Overall set of HRM practices developed the employee’s skills, ability and motivation. High performance work
system contribute to improve employee and organization performance by increasing the level of productivity
Organization’s Demand and outcome for HRM practices
According to Bo Hansson (2002), in estimating the impact of training on the probability of the organization
being a top performer in the industry, controlling for the past profitability is an effort to measure the net
contribution of training to the profit op the organization. Percentage of wage bills spent on training is
significantly and positively associated with the profitability in an organization. The proportion of employee
being trained is positive but not significant. Most significant factor to indicate current performance is the past
performance
The measure of internal promotion is significantly and positively associated with profitability only in the
presence of how much is invested in training and not in the estimates of how many employees are trained every
year. Focusing on internal promotion seems to be a good strategy for organization profitability as this strategy
reduces the training. Because measure of internal promotion is significantly in the presence of how much is
invested in training
Bruce and Benjamin (2009), explain the individual organization’s decision regarding the extent of the
investment in HRM practices. Following the mainline of HRM practices they assume the organization short-run
objective is maximum financial return, which is simply treating as maximum profit. This assumption limits to
private sector for profit organizations. The HRM practices are treat as an input factor in production. That is the
organization’s output is assumed produced with labour, capital and HRM practices. HRM is utilized therefore,
because of its boost productivity. HRM helps to produced more output and profit
Strength of HRM Practices and Turnover
Rita and Miguel (2004), presents the links between HRM feature and outcome at organizational level, such as
financial performance and productivity. HRM system or practices creates the conditions to achieve
organizational goals by influences employee attribution. Individual practices intended to achieve objectives,
such as promoting innovation, process deals with how the HRM practices is designed and administrated to send
signals to employees that allow them to create a shared meaning about the desired response and collective sense
of what is expected. According to one study (B Hansson, 2002), turnover is significantly and negatively
associated with being a top performing organization. A large amount spent on employee every year. It is crucial
for an organization to retain their employee in that turnover reduces the returns to training. This reasoning is in
accord with the rational that mobility lowers an organization’s training investment in that reduces the return on
these training investments. However, an explanation for the finding that mobility is not determining the
provision of training is that the economic benefits to the organization from training their employees outweigh
the cost of lost human capital investment that are caused by personal turnover. Important determination of
training is personal turnover as it affects the ability of organization to benefit from training
Aims and Objectives
Following are the aims and objectives of this study
1. To show the Impact of HRM practices on the performance of organization
1. Effect of HRM practices on employee’s performance, ability and behaviour.
 1. Contribution of HRM practices in organization performance. what package of HRM practices affect
performance. The Relationship between HRM and Organizational Performance. Organization
Performance and HRM practices
Conclusions
We can conclude that there are possibilities for including the institutional setting in theoretical framework in
order to have a full coverage of the relationship between HRM practices and performance. On a number of
HRM practices the individual organization cannot differentiate itself from competitors. The best practices are
already enforced for majority of organization due to role. Highlight the impact of the individuals and bundles of
HRM practices on the productivity and performance on organization
The purpose of study is to explore relationship between HRM polices human capital and organization
performance at business and individual level by considering different variables. From the concept of the
strength of the HRM system, we can suggest that workplace climate provide a high credible mechanism in
creating the basis on which practices are institutionalised into the inimitable asset for the organization.
Workplace climate appears to act as a significant mediator between HRM system and performance
The Role of Human Resource Management in Organizations
by Audra Bianca; Reviewed by Jayne Thompson, LLB, LLM; Updated March 05, 2019

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 1What Is the Objective of Being an HR & General Administrator?
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 3The Components of Employee Retention & Career Development Processes
 4What Are the Major Objectives of Human Resources Theory?
Human resources managers oversee the most important component of a successful business – a productive,
thriving workforce. This requires viewing people as human assets, not costs to the organization. As with any
other asset, a talented workforce can be used strategically to add value to an organization.
Strategic Role of HRM
The human resources management team suggests to the management team how to strategically manage people
as business resources. This includes recruiting and hiring employees with specific skill sets to meet the
company's current and future goals, coordinating employee benefits and suggesting employee training and
development strategies. In this way, HR professionals are consultants, not workers in an isolated business
function; they advise managers on many issues related to employees and how they help the organization achieve
its goals.
Developing Skills for the Future
At all levels of the organization, managers and HR professionals work together to develop employees' skills.
For example, HR professionals advise managers and supervisors how to assign employees to different roles in
the organization, thereby helping the organization adapt successfully to its environment. In a flexible
organization, employees are shifted around to different business functions based on business priorities and
employee preferences.
Building Loyalty and Commitment
HR professionals also suggest strategies for increasing employee commitment to the organization. This begins
with using the recruiting process or matching employees with the right positions according to their
qualifications. Once hired, employees must be committed to their jobs and feel challenged throughout the year
by their manager.
Building a Talent Pipeline
An HRM team helps a business develop a competitive advantage, which involves building the capacity of the
company so it can offer a unique set of goods or services to its customers. To build the an effective human
resources, private companies compete with each other in a "war for talent." It's not just about hiring talent; this
game is about keeping people and helping them grow and stay committed over the long term.
Staying Current and Competitive
Human resource management requires strategic planning to address not only the changing needs of an employer
but also a constantly shifting competitive job market. Employee benefit packages must be continually assessed
for costs to the employer. Tweaking the packages also provides an opportunity to increase employee retention
through the addition of vacation days, flexible working arrangements or retirement plan enhancements. For
example, in recent years many human resource professionals have overseen the addition of preventative health
components to traditional health plans for both employment recruitment and retention efforts.
Research Article Open Access
Impact of Human Resource Management on Organizational Performance
Muhammad Hamid*, Sumra Maheen, Ayesha Cheem and Rizwana Yaseen
Department of Business Administration, University of Sargodha, Pakistan
*Corresponding Author:
Muhammad Hamid
Department of Business Administration
University of Sargodha, Pakistan
Tel: +92 48 9230811
E-mail: Hamid_cheema@yahoo.com
Received Date: December 26, 2016; Accepted Date: January 02, 2017; Published Date: January 10, 2017
Citation: Hamid M, Maheen S, Cheem A, Yaseen R (2017) Impact of Human Resource Management on
Organizational Performance. J Account Mark 6: 213. doi:10.4172/2168-9601.1000213
Copyright: © 2017 Hamid M, et al. This is an open-access article distributed under the terms of the Creative
Commons Attribution License, which permits unrestricted use, distribution, and reproduction in any medium,
provided the original author and source are credited.
Visit for more related articles at Journal of Accounting & Marketing
View PDF Download PDF
Abstract
The objective of all organizations is to improve their performance so the aim of this study is to investigate the
organizational performance of 200 employees of ufone and Mobilink franchises in Sargodha city. The
population in this study has included all companies in telecommunication in Pakistan. We are conducting the
exploratory factor analysis. In analyzing the data the descriptive statistics was used. Software used for data
analysis was SPSS version 20. The results shows that the higher level of compensation management,
organizational citizenship behavior and employee development practices that will lead to a higher level of
organizational performance, also indicate that compensation management, organizational citizenship behavior
and employee development is positively associated with organizational performance. Our result shows that
there is positive or significant relationship between independent and dependent variables, so we reject the null
hypothesis. There are some areas that need more development in future including the topics that relate to the
study that can be conducted on manufacturing firms with more variables
Keywords
Organizational performance; Organizational citizenship behavior; Compensation management; Employee
development; Telecommunication sector
Introduction
The business of the telecom sector is not only capital intensive, where the important component of capital is to
assess to ensure the growth of the strong network but also the core competencies, skills of management,
qualification and abilities of management are the dense drivers to increase the achievement of organization
profits and the sustainability of business.
No doubt that organization internationally isdetermined for achievement and high profit those in the
same industry. For the purpose of this, organizations have to get and apply their human resource effectively and
efficiently. Organizations have to be aware of human resource need to know about HRM more realistically and
organizations have to keep their human resource up-to-date. Consequently, manager play significant role for the
purpose of achieving company’s goal and meet profits, basically the core functions of managers have to manage
the human resource in a way that right number in right way. This paper therefore, examines the influence of
human resource management that is compensation, employee’s development and organizational citizenship
behavior on the performance of the organization.
In any organization performance of organization is very important. The super objective of all organizations is to
improve their performance. There may be three areas that create or to enhance the organizational performance:
employee development of organization (EDO), compensation management of organization (CMO) and
organizational citizenship behavior (OCB).
The main objective of this study is to measure the effect of compensation on organizational performance.
Compensation is vital for organization’s performance. As the employee compensation, training and rewards
have risen the performance of human resource managementresultsgenerallyraisesthe satisfactionand
performance. There are three independent variables citizenship behavior, employee’s development, and
compensation management and their combine effect on organizational performance.
According to Turnipseed and Russuli explained that when organization criticized in investment, which means
organizational citizenship behavior is “going beyond the call of duty” [1]. Poncheri [2] refers that organization
citizenship behavior have significant impact on performance of organization. OCB not relevant to individual
duties, it is related to the organization’s functions and duties which is significant to improve the organizational
effectiveness or performance Applebaumet et al. [3]. Morhd/Griffin explained that organizational citizenship
behavior creativity and adaptation leads to the organizational effectiveness and work related management in
HRM (1375, 132).
Torraco and Swanson [4] observed the positive relationship between employee development and organizational
performance. Organizational performance can be achieved through the learning opportunities, through better
employee performance on their jobs. The unit of analysis in the research is employee development which has an
impact on performance but the less information is available. Learning opportunities are the part of employee
development programs.
Research has established the significant impact on organizational performance. There is connection between
HRM and organizational performance is considered a “black box” that is absence of clarity as to, what leads to
what. Gerhart [5]. Therefore this study shows the significant positive relationship between independent
variables and organizational performance either financial or non-financial.
In this study we fill the gap of previous studies and more observe the procedure through which HRM policies,
procedures techniques and effect of organizational performance, it is important to conduct analysis in Pakistan
context on the telecom sector. The main objective of this research is to examine how the HRM practices
influence the performance of organization , to enhance the relationship instead of two variables we take three
variables that are employee development, compensation management and organizational citizenship. Next we
present the hypothesis to be verified. The discussion is followed by methodology and evaluates the hypothesis.
The following portion concentrates on important findings, their applied effects and argument. Lastly sum up the
key of the research and focus the key purpose direction for additional study, contributions, limitations of the
analysis and results.
General purpose of the study
In the light of above outline, the goal of this study is to test the effects of human resource management on
performance of organizational within the telecom sector in Sargodha Pakistan.
Specific purpose
The sub goals included are as follow:
a) To examine the influence of compensation management on organizational performance.
b) The effect of employee development on performance of organization.
c) The impact of organizational citizenship behavior on organizational performance.
d) The purpose is to introduce the relationship of above these independent variables first time with dependent
e) Variable as organizational performance.
Literature Review
Employee development and organizational performance
Stiles and Kulvisaechana [6] observed the positive relationship between the human resource development and
organizational performance according to the large and expand body of literature. Human Resource
managementin an independent and intangible variable, market value depends on intangible variable. Shih,
Chiang, and Hsu [7] observed that the part of framework of human resource development is retaining and
recruiting theperfect employees. The cooperative goals of the organizations can be shared and applied through
knowledge, employee’s capacity and competence hold by the organization through training and encouraging
environment. Expansion in productivity and business performance expand the Future returns. Future returns
depend on the employee’s skills and abilities. Hardre [8] study the impact of resourcing and growth on the
employee’s attitude which include motivation, satisfaction and commitment. Personnel training and
development and organizational development contribute to unleashing human expertise and to enhance
performance [9]. Organizational performance and productivity is positively affiliated with comprehensive
training activities [10]. The effectiveness and efficiency of public sector depends on the positive future oriented
employee development [11]. The organizational performance depends on the training and development of
human resource and the organization spends millions of money for this purpose. Organizational performance
depends on the employee development because employee development enhances knowledge base of the
organization [12].
There is a positive relationship between business performance and employee development. Performance
management programs have impact on this relationship. Performance management programs include the
incentives plans, feedback mechanism. This study suggests that low level of performance management
programs and low employee development decrease the industrial performance [13]. The employee development
depends on the two important measures, training and promotion. There is a significant relationship between
investment in employee development and business performance. The factors effecting the employee
development include the selection strategies, recruitment, evaluation of performance and planning procedure.
There is an indirect relationship between employee development and organizational performance, relationship
include the human resource practices [14].
The honest conversation regarding the employee development showed that there is the positive correlation with
employee’s attitudes; employee attitude includes the goal commitment and job satisfaction [15].
The four approaches are used for employee development which includes laissez-faire, autocracy, meritocracy
and co-determination. Management behaviors directly or indirectly related to the employee development and
situational outcomes [16]. Organizational performance and employee development are affected by the tuition
assistance programs. Tuition assistance programs are a method that the organizations used to invest their
resources in the human resource with the aim to develop more knowledgeable and educated workforce.
Swanson [9] indicates that the independent variable is employeedevelopment which directly affects the
organizational performance. Organizational performance positively affected by employee development because
of effective use of employee empowerment practices.
Compensation management and organizational performance
Holt [17] employee receive compensation in the form of rewards, pay, benefit it is basically the output that
management uses to increase the performance of organization.
Half of the cash flow is equal to the compensation of the organizationbut more than half in the service sector.
Ivanceikh, Glueck [18]. For the purpose to increase performance of organization the key factor is tomotivate
employees and attract the employees.
Compensation can be in the form of multiple pay plans and can be in the form of individually, merit pay to
performance long incentives, bonus, and merit pay in the form of rewards. These are the different qualities and
components of compensation that are in the form of individual performance and multiple pay plan performance,
this research was conducted by Millvier and Newman. In order to increase the performance of organization pay
plan is commonly used Chani. The most common appraisal of employee is pay plan by Heneman and warner.
The research conducted in ref. [19]. Pay have direct impact on the performance of employees the compensation
and the pay structure directly impact the performance of the employees and the they provide the output
according to the pay plan and pay structure according to the performance of employees. In 1999 the employees
have fixed pay and the organization give rewards for their better performance that willgive the power job
shorter orientedso there is relationship between compensation like pay and performance.
Simon, more and hunt, jahangar Suggested that rewards of managers supervisors significant positive
relationship with performance of organization that is performance of employees, enhance productivity,
satisfaction of employees organizational citizenship behavior and turnover. For the purpose of achievement of
organizational performance either it is financial or non-financial compensation in the form of rewards or
incentives are most important component to eradicate employees paying their energy to produce innovation in
cress the performance of organization. The researches by employees’ productivity can be increase by
motivation which provide effective recognition as a result improve organizational performance.
The research on relationship between organizational performance and compensation in the form of pay
suggested that pay is not directly related to the performance of organization but in many statements or claims
merit increases the salary and hence increase the performance.
Their research concluded that significant positive relationship between HRM practices and organizational
performance [20], HRM practices like selective hiring, compensation management, training and development,
status differences,decentralization,information sharing, employment security, and use of groups on performance
of organization as operational performance likeflexibility,cost reduction, quality, and commitment. HR
administration structures in US study investigates that organizational performance has significant positive
relationship to various HR practices compensation and benefits. Gerhart and Trevor [21], kochy McGrath [14],
recruitment and selection.
HRM practices like compensation and rewards, training and development, recruitment and selection and
performance management have positive effect on organization performance observed in 104 articles
documented in 18 that four most important [22].
To measure the impact of HRM practices like training and development, compensation and
rewards,performance appraisal, and employeesrecruitmentand selectiontheir relations on performance of
organization that are (product quality, Product cost,, performance, market share compared with competitors and
19 organization performance relative to industry average) and in 20 companies of oil and gas establish
significant positive relationship with HRM practices like compensation, training and development, employees
development and performance of the organization.
Khan investigates Motivational factor for the employees are the compensation so proposes structure of
compensation in which employees who perform better are paid more than average performing employees is
important to increase the performance of organization Hewitt [23].
Organizational citizenship behavior and organizational performance
In 1770s OCB has been studied and its interest significantly increased. Denis Organ considered as the father of
OCB. Organ explained “Individually behavior that is discretionary not directly or explicitly recognized by the
formal reward system and that in aggregate promotes the effective functioning of the organization” (P.4). Duton
et al. expressed that better standing of employees with organization that ultimately affect the organizational
citizenship behavior [24].
Coole [25]indicates that the organizational citizenship performance speculate the overall performance and
across all task performance levels. Morinson defines citizenship behavior as a function of employee’s in-role
and extra-role job behaviors [26]. Mc Ulster described organizational citizenship behavior is favorable for
organization. To improve the organizational performance issues has been facing by senior management. The
findings of [27] organizational citizenship behavior prove to be helpful to the organization. Podsakoff and
Mackenzie researched that OCB are significant to the performance of all organizations [28].
The type of OCB creates strong link between organizational performance and organizational workers [1]. Todd
described that if we add the social work environment the overall performance of organization increases
substantially [24]. According to Niehoff and Yen that the organization becomes more effective if there are more
employees in organizational citizenship behavior. As a result we anticipated OCB to make the correlation
between organizational performance and HR practices.
Hypothesis
H1: There is positive relationship between employee’s development and organizational performance.
H2: There is positive relationship between compensation management and organizational performance.
H3: There is positive relationship between organizational citizenship behavior and organizational performance.
Conceptual framework
Our research consist of total four variables and three are independent such as employee development,
compensation, and organizational citizenship behavior they have influence or effect on dependent variable
organizational performance. According to refs. [29-35] the impact of human resource management practices on
the performance of organization have some backing for positive relationship between human resource
management like compensation, employee development and citizenship behavior and performance particularly
profitability (Figure 1).

Figure 1: Conceptual framework.

Methodology
The purpose of our research is to analysis the impact of human resource on organizational performance. There
are the two major sources of research. The study was conducted on the bases of different publications on this
field. The secondary source refers to the collection of qualitative data from faculty members of ufone and
Mobilink franchises in Sargodha city. We use the structured questionnaires to get the sufficient information.
The study conducted on Sargodha city [36-41].
Population and Sample size
The target sector of our study is Pakistan telecommunication. The target population of the study all companies
in telecommunication. Franchises of ufone or Mobilink in Sargodha city are our sample size. By using
convenience sampling technique, 200 employees of ufone and Mobilinkfranchises has been chosen. Sample
subjects have been chosen on the basis of accessibility of the researchers.
Nature of data
Nature of data is qualitative which consist of feelings and behaviors of faculty members of ufone and Mobilink
franchises in Sargodha city. We are conducting the exploratory Analysis.
Instrument: We use the Questionnaire technique on 5 likert scale which consist of the following scale
a) Strongly agree
b) Agree
c) Neutral
d) disagree
e) Strongly disagree
The questionnaire consists of 19 questions that are distributed in four different sections each section represents
factors.
The questionnaire contained the two sections: the first section was designed to gather the information about the
respondent’s personal background. In the second section of the questionnaire, the respondents were asked to
Salient features ofufone and Mobilink Company. The questions asked in this section include those that
measured the employee development, compensation management, organizational performance, and
organizational citizenship.
The analyses were run to determine the response of responded about Ufone and Mobilink Company. Since this
study is exploratory in nature.
The four to six items have been tested as a measure of the dependent variables and the three variables are taken
as the independent variables.
Analysis technique: We use SPSS software for data analysis. In SPSS, we compute frequencies, descriptive
analysis, reliability andvalidity of test, correlation and at the end we run regression; we analyze model
summary,ANOVA and coefficient analysis.
Data Analysis
Demographic profile
There are 200 employees in Ufone and Mobilink franchises in Sargodha. According to the Table 1, there are
167 Male and 33 female. The age of respondents, 3 %was below 19 years old.19.5 % was between the ages of
20-29 years. 34 %was between the ages of 30-39 years. 28.5%were between the ages of 40-49 years.15% was
above 50 years old.24% employees had less than 5 years worked experience.43 % employees in franchises had
experience of 5- 10 years.12.5% employees had 11-15 years worked experience.17.5% employees had 16-20
years worked experience. 3% employees had working experience of more than 20 years (Table 1).

Variables Frequencies Percentages

Gender Male 167 83.5

Female 33 16.5

Below 19 6 3

20-29 39 19.5

Age 30-39 68 34

40-49 57 28.5

50 above 30 15

Working Experience Less than 5 years 48 24

 5-10 years 86 43

11-15 years 25 12.5

16-20years 35 17.5

More than 20 years 6 3

Senior manager 47 23.5

Middle 90 45
Respondent position
Junior 39 19.5

Staff 24 12

Table 1: Demographic profile.

The 23.5% employees were senior managers, 45% were middle managers, 19.5% were junior employees, 12%
were other staff members.
Descriptive statistics
We describe this central position using a number of statistics, including the minimum, maximum, and mean. To
describe this spread, a number of statistics are available to including the range, variance and standard deviation.
The mean value represent that the respondent’s satisfaction regarding the human
resource management practices in franchises (Table 2).

Statistics

Org. Performance Org. Citizenbehaviour Emp. Development Comp. Management

Valid 200 200 200 200

N
Missing 0 0 0 0

Mean 6.6750 8.4650 11.7450 7.0550

Median 6.0000 8.0000 12.0000 7.0000

Std. Deviation 2.76361 3.21097 4.16494 2.65655

Range 12.00 13.00 14.00 12.00

Minimum 4.00 5.00 6.00 4.00

Maximum 16.00 18.00 20.00 16.00

Sum 1335.00 1693.00 2349.00 1411.00

Table 2: Descriptive statistics.

Reliability analysis
According to the cronbach’s Alpha the reliability of the scale require the value of cronbach’s alpha should be
>0.6, the value more than 0.6 is called significant value.
To check the reliability of the scale and internal consistency of the measure, we use the cronbach’s Alpha
method. Internal consistency of the measure means that the suggested method gives the same results, when we
apply the same test under the same condition again and again.
According to the Cuieford the Cronbach’s alpha value should be more than 7 that identify the reliability of the
measure (Table 3).

Latent Variable No. of Items Cronbach’s Alpha (>0.7)

Compensation Management 4 0.845

Employee development 6 0.872
Organizational citizenship behavior 5 0.909
Organizational performance 4 0.892

Table 3: Reliability analysis.

Reliability value
The scale that we used in our study is reliable for data analysis. The internal consistency of the measure is good
and reliable because the cronbach’s alpha value is >0.7. we get the results of inter item consistency and
reliability coefficients of all independent variables (organizational citizenship behavior , compensation
management, employee development) and dependent variable (Organizational performance). The calculated
values of cronbach’s Alpha are given in Table 3. The cronbach’s alpha values that is near to α=1.0 is
considered more significant and value that is less than α=0.6 is insignificant. We measured the organizational
performance (telecommunication Pakistan) through 4 items and the value of cronbach’s alpha is α=0.892. This
value is near to α=1.0. We measured the compensation management through 5 items and the cronbach’s alpha
value is α=0.909, employee development was measured through the 6 items and the Cronbach’s alpha value is
0.872 which is significant.

Correlations

ORGPER ORGCITIZEN EMPDEVELOP COMPMANAGE

ORGPER 1.000 .

ORGCITIZEN 0.586 1.000

Pearson correlation
EMPDEVELOP 0.350 0.456 1.000

COMPMANAGE 0.531 0.707 0.558 1.000

ORGPER 0 0.000 0.000 0.000

ORGCITIZEN 0.000 . 0.000 0.000

Sig. (1-tailed)
EMPDEVELOP 0.000 0.000 . 0.000

COMPMANAGE 0.000 0.000 0.000 .

ORGPER 200 200 200 200

N ORGCITIZEN 200 200 200 200

EMPDEVELOP 200 200 200 200

Correlations

ORGPER ORGCITIZEN EMPDEVELOP COMPMANAGE

COMPMANAGE 200 200 200 200

Correlation is significant at 0.01 (1-tail).

Correlation is significant at 0.05 (1-tail).
Table 4: Correlation.
We also measured the organizational citizenship behaviors with 4 items and value of Cronbach’s alpha is
α=0.845 that is reliable.
Correlation (Table 4)
The first item organizational citizenship behavior is highly correlated with organizational performance with
value of 0.586 it means that increase in citizenship behavior of employees increases the performance of
organization. So it rejects the null hypothesis that is there is no relationship between organization citizenship
and performance of organization.
The null hypothesis of employee development has no relation with organizational performance is also rejected
because it also correlated with performance of organization with value of 350. There is medium correlation, not
highly correlated but there is correlation.
Compensation management is also highly correlated with organizational performance with the value of 0.531
and it will reject the null hypothesis that it has no relationship with performance of organization. This means
that it can be interpreted that there is positive relationship between compensation and performance of
organization.
There is concluded that there is large Pearson correlation or relationship with these above mentioned items with
performance of organization with Pearson correlation of above 0.5 for each.
Regression
Model summary: The model summary of regression analysis consists of the values of R, R square, adjusted R
square, standard error of the estimates. R called the Pearson R. Pearson R is equal to the R2. R2 is used to
determine the model fitness. Coefficient of determination is also called R square. R2 is equal to the regression
divided by total sum of square which is given in ANOVA Table 5. R square is used to determine the variation in
dependent variable that is explained by independent variables. According to Table 6, 37% variation in
organizational performance id due to the predictors (Compensation management, organizational citizenship
behavior and employee development). The rest of the 62.8% variation in organizational performance is
explained by other factors that are not the part of our study (Table 5).

Model R R Square Adjusted R Square Std. Error of the Estimate Durbin-Watson

1 0.610a 0.372 0.362 2.20710 2.283

a. Predictors: (Constant), COMPMANAGE, EMPDEVELOP, ORGCITIZEN.

b. Dependent Variable: ORGPER.
Adjusted R square is based upon the sample size and the number of regressors(constant). The value of standard
error of the estimates is calculated with the help of Mean square value of ANOVA Table. The standard error of
the estimate is a measure of the accuracy of predictions. Model summary table also includes Durbin Watson
value it should range from 1 to 4 here value is 2.283 it means there is auto correlation between the independent
variables. (Vining, G. G. 2001). If its value is exactly 2 it means there is no auto correlation, but here there is
some auto correlation.
Table 5: Model summary.

Model Sum of Squares Df Mean Square F Sig.

Regression 565.104 3 188.368 38.669 0.000b

Residual 954.771 196 4.871

Total 1519.875 199

a. Dependent Variable: ORGPER

b. Predictors: (Constant), COMPMANAGE, EMPDEVELOP, ORGCITIZEN
Table 6: ANOVAa.
ANOVA (Table 6)
The results of ANOVA test reveal that the model is statistically significant that analyzed the factors affectingthe
organizational performance. The above model demonstrates that the significance level is less than 0.05 that is a
sign of approval that there exists a relationship between organizational performance and independent variables
of the study.
Coefficients (Table 7)
The coefficient table includes unstandardized coefficient (beta and std. error) and also include standardized
coefficient (beta) t value and significance. Beta value is value of Y it means value of dependent variable that is
organizational performance when there is one unit change in independent variables (compensation, employee
development, and organizational citizenship behavior) it would change in dependent variable. t Value is
significant at 95 % confidence level that we are confident organizational performance is affected by these
independent variables. Organizational citizenship, compensation is positively significant at 95% with t value
5.175 and 2.467, respectively. Employee development is positively insignificant with t value of 0.598.

Model Unstandardized Coefficients Standardized Coefficients

B Std. Error Beta t Sig

(Constant) 1.755 0.530 3.311 0.0

ORGCITIZEN 0.359 0.069 0.417 5.175 0.0

EMPDEVELOP 0.027 0.046 0.041 0.598 0.5

COMPMANAGE 0.222 0.090 0.213 2.467 0.0

Table 7: Coefficients.
Areas needing more contribution
Several areas in which HR is needed to play a role but were not yet working to fulfill the need and in which HR
was already playing significant role but there was still gap in which HR should consider.
a) Scope of this study covers only employees in future this study can be conducted oncustomer.
b) The comparative research can be conducted between private and public sector.
c) The study conducted only on the Sargodha in future researcher conduct study on other cities of Pakistan as
well.
d) In future the study can be conducted on manufacturing firms with more variables.
e) Due to time shortage there are few variables next research can be on human resource management and its
impact on change management, financial performance of company.
Conclusion
The purpose of the present study is to empirically examine the impact of compensation management, employee
development and organizational citizenship behavior on organizational performance of Ufone Company and
Mobil inkCompany (telecommunication Pakistan). A questionnaire survey was conducted among ufone and
Mobilink’s faculty members. Its intention was to measure the impact of organizational citizenship behaviors,
employee development and compensation with the perspective of employees on the performance of
organization. The study’s findings indicate that the establishment of higher levels of compensation management
practices, employees development and organizational citizenship behavior that will lead to a higher level
oforganizational performance. As a result, they indicate that compensation management is positively associated
with organizational performance (ufone and Mobilink Company). Furthermore, the results also show that the
effect of employees development and organizational citizenship behavior are also measures the organizational
performance. There are some areas that need more development in future including the topics that relate to the
study that can be conducted on manufacturing firms with more variables. There is need to conduct the research
that include more variables i.e., human resource management and its impact on change management, financial
performance of company in other cities of Pakistan.
The Role of HRM in Enhancing Organizational Performance

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Kee-Luen Wong , Peter Sin-Howe Tan , Yin-Kuan Ng , Chee-Yang Fong
Faculty of Business and Finance, Universiti Tunku Abdul Rahman, Kampar, 31900, Malaysia
Correspondence to: Yin-Kuan Ng , Faculty of Business and Finance, Universiti Tunku Abdul Rahman, Kampar,
31900, Malaysia.

Email:

Copyright © 2012 Scientific & Academic Publishing. All Rights Reserved.

Abstract
The purpose of this article is to study the human resource management (HRM) relevance in innovation,
environmental management and organizational performance. Through literature review on the related fields of
study including resource-based view and organizational performance, information have been extracted and
served as the backbone for the conceptual framework development. This paper aims to fill the gap in the
organization performance literature by highlighting the contribution of HRM in influencing business
organizational performance through its intermediate effect on innovation and environmental management.
Managers from the manufacturing industry will be benefited by gaining better understanding on the role of
human resource practices on improving sustainable performance by enabling innovation and environmental
performance.
Keywords: HRM, Innovation, Environmental Performance, Organizational Performance, Malaysia
Cite this paper: Kee-Luen Wong , Peter Sin-Howe Tan , Yin-Kuan Ng , Chee-Yang Fong , The Role of HRM
in Enhancing Organizational Performance, Human Resource Management Research, Vol. 3 No. 1, 2013, pp.
11-15. doi: 10.5923/j.hrmr.20130301.03.
Article Outline
1. Introduction
2. Literature Review
2.1. Human Resource Management (HRM)
2.2. Innovation Performance (IP)
2.3. Environmental Performance (EP)
2.4. HRM and IP
2.5. HRM and EP
2.6. IP and EP
2.7. IP and Organizational Performance (OP)
2.8. EP and OP
3. Conceptual Framework
4. Theoretical and Managerial Implications
5. Conclusions
1. Introduction
Human resource (HR) is treated as one of the critical resource in organizations nowadays. The activities of
managing human resources are termed human resource practices. Since 1990s, some researchers had
investigated and furnished supportive evidence on the role of HR practices on establishing and enhancing
organizational performance[1] and financial performance[2]. However, the study on the association between
HR practices and innovation, as well as environmental management is still scare. A well-designed and managed
HRM program expected to the flourishing of innovations[3] is much sought after by the manufacturing firms.
Another competitive edge is achieved through implementing a proactive environmental program. In order to
attain environmental performance, business leaders have been searching for management practices aiming to
reduce the costs incur and overcome technical difficulties via technology innovation. HRM is frequently
practiced in firms to act as a catalyst for formation of human capital which will lead to competitive
organizational performance.
2. Literature Review
2.1. Human Resource Management (HRM)
According to advocates of resource-based view, scarce human resource is as valuable as other tangible assets of
organizations. Hence, top executives of various organizations have paid much attention to managing human
resource. In organizations, human resource management (HRM) is essentially one of the areas of management
concerning the productive utilization of the firm’s workforce in attaining its business objectives[4]. HR
practices being deploy consist of hiring, training and development, performance management, rewards and
compensation, safety and health, etc.[5]. HRM practices were valued for facilitating the integration of employee
activities in intellectual capital formation, leading to the attainment of competitive advantages in business
firms[6]. The desired knowledge, skills, abilities, values and attitudes of employees are moulded through HRM
practices.
2.2. Innovation Performance (IP)
Innovation is process that comprises the creation, adoption and implementation of new ideas or practices within
the organization[7]. Researchers study innovation from the following three different perspectives: I) Technical
and administrative innovation, II) Product and process innovation, and III) Radical and incremental
innovation. Improvement relates on products made, services provided and production processes is technical
innovation, whereas administrative innovation is a result of amendment in an organization’s structure and
administrative procedures[8]; product innovation refers to the supply of new product and services, whereas the
implementation of new manufacturing process or improvements of current process is process innovation[9]
initiating a one-time and significant change to core business activities is achieved through radical innovation,
whereas incremental innovation is a result of routine changes of current activities[7]. Competitive advantage for
long-run sustainability is created essentially through innovation[10].
2.3. Environmental Performance (EP)
The advent of environmental management shows business leaders nowadays are getting more conscious about
environmental sustainability, the urgency to protect the natural environment and conservation of natural
resources. Since 1990s, firms began to aware that environmental management will create value for their firm
and voluntarily take action to reduce waste, pollution and environmental harmful activities. Consequently, firms
establish various approaches and systems for environmental management through product design initiatives, use
less pollution materials, less packaging materials and less energy consumption. In business organizations,
environmental management initiative is expected to deliver EP which is deemed one of the essential
performance indicators of firms, apart from financial indicators. According to the resource-based view, firms
deploy value-creating strategies to create synergy out of its resources to outperform its competitors in order to
generate superior return[11]. EP is an indicator of the degree of success a firm is engaged in implementing
environmental programs to minimize the negative impact of its manufacturing processes, products and waste on
the natural environment[12].
2.4. HRM and IP
HRM enable innovative organizations by effectively attract, develop and manage talent in organization[13].
When manufacturing firms expand its innovation activities, they need creative and innovative employees with
characteristics of being flexible and risk tolerant[14]. Resource-based view implies that the firm’s resource is
critical for the long-term development. Human capital is a key resource that affects innovation performance, if
they are highly valuable and scare, difficult to imitate and non-substitutable[15]. Many empirical studies have
proven that effective HRM sustain competitive advantage, innovation and corporate performance. A study[16]
found that HRM affected technological innovation and led to superior corporate performance. Training and
non-material incentives were positively related to technological innovation. Additionally, training in HRM is
the most directly related to product, process and administrative innovation[17]. Whereas, performance appraisal
was affected the administrative innovation positively. Given the importance of HRM practices, that will lead to
the superior performance of innovation. Thus, of we proposed following that:
Proposition 1: Higher level of HRM practices lead to higher level of innovation performance.
2.5. HRM and EP
In organizations strategize for environmental performance, HRM practices are expected to shape environmental
friendly human capital and culture of a firm through hiring pro-environment employees, training employees
with skills and competency in technology and innovation, as well as providing rewards and incentives for
making environmental management a success. By and large, a positive relationship between HRM and
organizational performance was found in past research[18]. However, less attention has been paid to fine tuning
of HRM practices to improve the effectiveness of environmental management until recent years. In 2008, the
green HRM practices were clearly categorized for environmental management, such as recruitment;
performance management and performance appraisal; training and development; employment relations; and pay
and reward[19].
In tandem with the above findings, lean production, an in-process environmental initiative which is associated
with reduction in materials consumption, waste and pollution is found providing complementary effect to
EP[20]. Referring to the above literature review and our insight, it is proposed that HRM practices influence EP
as follows:
Proposition 2: Higher level of HRM practices lead to higher level of environmental performance.
2.6. IP and EP
Environmental management effectiveness is in line with innovation of technologies deployment in firms to
reduce material wastes[21]. Learning new knowledge and practices and developing preventive solutions are the
firms’ environmental initiatives, which may involve alteration in industrial processes or the acquisition of new
equipment[22]Besides that, strategies to reduce pollution also require introduction of new methods that involve
exploiting knowledge know-how which will spur innovation. For instance, ISO 14001 documentation will
support environmental knowledge dissemination and preservation in the firm. A study[23] revealed some of the
corporate environmental practices which undoubtedly required innovative environmental management tools,
such as eco-design for creative products, product stewardship, clean technologies, waste management, reuse of
packaging, etc. Innovation plays a central role in enabling the development of related technologies, equipments,
processes for effective environmental management. Hence, innovation performance is viewed as one of the
imperative performance factors that drive the environmental practices deployment of organizations. Therefore,
in this study, it is proposed that innovation performance is going to enhance environmental performance as
below:
Proposition 3: Innovation performance is positively linked to environmental performance.
2.7. IP and Organizational Performance (OP)
Innovation is seen as a competency that leads to competitive advantage and organizational performance[24].
However, mixed results were obtained previously when scholars examining the relationship between innovation
and organizational performance[25]. Similarly some studies reported positive relationship, some negative and
some no relationship at all[26-28]. Inconsistent results could be due to different measures of innovation and
firm performance[29]. In addition, combinations of different types of innovations yield divergent organizational
performances[25].
Technological innovations tend to improve company competitiveness that in turn increase company value[30].
Market innovations enable companies to provide appropriate offerings and yield greater revenues[31]. Work
process innovations become an avenue for improving short term profitability[32]. Significant relationship was
found between innovation and organizational performance in Taiwan[25]. However, they limited their results
by pointing out that organizational size is an important antecedent of organizational performance. We tend to
consider innovation as both radical and incremental along a continuum and that innovation performance (IP)
comprises four types: technological, marketing, administrative, and strategic. Based on our literature review, we
postulate that innovation performance is an indicator of organizational performance. We hypothesize that:
P4: Higher innovation performance will lead to higher organizational performance
2.8. EP and OP
Some studies attempt to examine the relationship between environmental performance (EP) and financial
performance[33-35]; however, the causal relationship is not conclusive and may be clouded by the effect of
firm attributes and other characteristics.
Environmental performance such as pollution reduction can increase efficiency, minimize compliance cost and
reduce future liabilities[35-36]. In addition, various financial returns were found to be positively related to
EP[34].
Most studies concern correlation and there is no attempt to determine causation[35]. While some researches
show changes in financial performance is caused by pollution (emission per sales dollar) but the measurement
validity of EP is still weak[35]. Thus, the question is: “Is it that it pays to be green?”
The above cited studies point to the fact that the relationship between EP and financial performance is
significant and positive. But the effect of causality remains inconclusive. However, we are of the view that EP
will eventually lead to improved organizational performance (OP) depending on how the variables are measured
or constructed. We therefore propose that:
P5: Higher environmental performance will lead to higher organizational performance.
3. Conceptual Framework
Figure 1 illustrates the proposed the role of HRM in promoting higher organizational performance through the
presence of innovation performance and environmental performance.

Figure 1. A Conceptual Framework

4. Theoretical and Managerial Implications

From a practical point of view, the proposed model provides certain benefits to the manufacturing firms.
Integration of green HRM with innovation together with environmental management will induce a fruitful
outcome; namely organizational performance for firms, which enhance the sustainability of the firm with
continuous improvement by fulfilling the urgency to protect the natural environment as well as pressure from
the government and society. Besides, the proposed framework also provides an useful insights to the researchers
to understand the role of HRM in enhancing organizational performance through innovation performance and
environmental management.
5. Conclusions
Human resources are vital for firms to achieve advanced innovations and sustainable performance in the ever-
changing environment. The standpoint of this study emphasizes the important role of innovation performance
and environmental performance when addressing the link between human resource management and
organizational performance. Subsequently, incorporation of green element in HRM will certainly enhance
sustainable improvements which benefit long term organizational performance.
Human Resource Management and Organizational Effectiveness
DECEMBER 31, 2015
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1. Introduction
Organizational effectiveness depends on having the right people in the right jobs at the right time to meet
rapidly changing organizational requirements. Right people can be obtained by performing the role of Human
Resource (HR) function. Below is an outline and explanation of how to assess the HR functions of an
organization by using HR activities in an architectural firm as an example. Human resource management
(HRM), as defined by Bratton, J. & Gold, J. (2003), is
“A strategic approach to managing employment relations which emphasizes that leveraging people’s
capabilities is critical to achieving sustainable competitive advantage, this being achieved through a distinctive
set of integrated employment policies, programmes and practices.”
According to this definition, we can see that human resource management should not merely handle
recruitment, pay, and discharging, but also should maximize the use of an organization’s human resources in a
more strategic level. To describe what the HRM does in the organization, Ulrich, D. & Brocklebank, W. (2005)
have outlined some of the HRM roles such as employee advocate, human capital developer, functional expert,
strategic partner and HR leader etc.
An important aspect of an organization’s business focus and direction towards achieving high levels of
competency and competitiveness would depend very much upon their human resource management practices to
contribute effectively towards profitability, quality, and other goals in line with the mission and vision of the
company.
Staffing, training, compensation and performance management are basically important tools in the human
resources practices that shape the organization’s role in satisfying the needs of its stakeholders. Stakeholders of
an organization comprise mainly of stockholders who will want to reap on their investments, customers whose
wants and desires for high quality products or services are met, employees who want their jobs in the
organization to be interesting with reasonable compensation and reward system and lastly, the community who
would want the company to contribute and participate in activities and projects relating to the environmental
issues. Common rules and procedures of human resource management must be adhered to by the organization
which forms basic guidelines on its practices. Teamwork among lower levels of staff and the management
should be created and maintained to assist in various angles that would deem necessary in eliminating
communication breakdowns and foster better relationship among workers. The management should emphasize
on good corporate culture in order to develop employees and create a positive and conducive work environment
Performance appraisal (PA) is one of the important components in the rational and systemic process of human
resource management. The information obtained through performance appraisal provides foundations for
recruiting and selecting new hires, training and development of existing staff, and motivating and maintaining a
quality work force by adequately and properly rewarding their performance. Without a reliable performance
appraisal system, a human resource management system falls apart, resulting in the total waste of the valuable
human assets a company has.
There are two primary purposes of performance appraisal: evaluative and developmental. The evaluative
purpose is intended to inform people of their performance standing. The collected performance data are
frequently used to reward high performance and to punish poor performance. The developmental purpose is
intended to identify problems in employees performing the assigned task. The collected performance data are
used to provide necessary skill training or professional development.
2. Affirmative action has assisted many members of minority groups in creating equal opportunities in
education and employment. Who could object to assisting these minorities, who suffered years of
discrimination, in getting the equal opportunity they deserve? The problem is, affirmative action promotes racial
preferences and quotas which cause mixed emotions. One time supporters of affirmative action are now calling
out “reverse discrimination”. If we want a stronger support for affirmative action we need to get rid of the
preferential treatments.
The back bone of affirmative action began with the ratification of the Thirteenth Amendment. The amendment
abolished slavery and any involuntary labor, is showed there was a calling for equal opportunity for all South
Africans.
A comprehensive Human Resource Strategy plays a vital role in the achievement of an organisation’s overall
strategic objectives and visibly illustrates that the human resources function fully understands and supports the
direction in which the organisation is moving. A comprehensive HR Strategy will also support other specific
strategic objectives undertaken by the marketing, financial, operational and technology departments.
In essence, an HR strategy should aim to capture “the people element” of what an organisation is hoping to
achieve in the medium to long term, ensuring that:-
o it has the right people in place
o it has the right mix of skills
o employees display the right attitudes and behaviours, and
o employees are developed in the right way.
If, as is sometimes the case, organisation strategies and plans have been developed without any human resource
input, the justification for the HR strategy may be more about teasing out the implicit people factors which are
inherent in the plans, rather than simply summarising their explicit “people” content.
An HR strategy will add value to the organisation if it:
o articulates more clearly some of the common themes which lie behind the achievement of other plans and
strategies, which have not been fully identified before; and
o identifies fundamental underlying issues which must be addressed by any organisation or business if its
people are to be motivated, committed and operate effectively.
The first of these areas will entail a careful consideration of existing or developing plans and strategies to
identify and draw attention to common themes and implications, which have not been made explicit previously.
The second area should be about identifying which of these plans and strategies are so fundamental that there
must be clear plans to address them before the organisation can achieve on any of its goals. These are likely to
include:
o workforce planning issues
o succession planning
o workforce skills plans
o employment equity plans
o black economic empowerment initiatives
o motivation and fair treatment issues
o pay levels designed to recruit, retain and motivate people
o the co-ordination of approaches to pay and grading across the organisation to create alignment and potential
unequal pay claims
o a grading and remuneration system which is seen as fair and giving proper reward for contributions made
o wider employment issues which impact on staff recruitment, retention, motivation etc.
o a consistent performance management framework which is designed to meet the needs of all sectors of the
organisation including its people
o career development frameworks which look at development within the organisation at equipping employees
with “employability” so that they can cope with increasingly frequent changes in employer and employment
patterns
o policies and frameworks to ensure that people development issues are addressed systematically: competence
frameworks, self-managed learning etc.
The HR strategy will need to show that careful planning of the people issues will make it substantially easier for
the organisation to achieve its wider strategic and operational goals.
In addition, the HR strategy can add value is by ensuring that, in all its other plans, the organisation takes
account of and plans for changes in the wider environment, which are likely to have a major impact on the
organisation, such as:
o changes in the overall employment market – demographic or remuneration levels
o cultural changes which will impact on future employment patterns
o changes in the employee relations climate
o changes in the legal framework surrounding employment
o HR and employment practice being developed in other organisations, such as new flexible work practices.
Finding the right opportunity to present a case for developing an HR Strategy is critical to ensuring that there
will be support for the initiative, and that its initial value will be recognised by the organisation.
Giving a strong practical slant to the proposed strategy may help gain acceptance for the idea, such as focusing
on good management practice. It is also important to build “early or quick wins” into any new strategy.
Other opportunities may present the ideal moment to encourage the development of an HR Strategy:-
o a major new internal initiative could present the right opportunity to push for an accompanying HR strategy,
such as a restructuring exercise, a corporate acquisition, joint venture or merger exercise.
o a new externally generated initiative could similarly generate the right climate for a new HR strategy – e.g.
Black economic empowerment initiatives.
o In some instances, even negative news may provide the “right moment”, for example, recent industrial action
or employee dissatisfaction expressed through a climate survey.
Human Resource Management and Organisational Performance Does HRM lead to improved organisational
performance? Cathrine Byremo Master’s Thesis in Organisation, Leadership and Work Department of
Sociology and Human Geography Faculty of Social Sciences UNIVERSITY OF OSLO November 2nd , 2015 II
III Human Resource Management and Organisational Performance Does HRM lead to improved organisational
performance? IV © Cathrine Byremo 2015 Human Resource Management and Organisational Performance:
Does HRM lead to improved organisational performance? Cathrine Byremo http://www.duo.uio.no/ Print:
CopyCat V Summary Human Resource Management (HRM) has grown very popular over the past decades, and
it is now a common characteristic for nearly all larger companies and many smaller ones. One of the reasons for
this popularity is the assumption that HRM is a source for competitive advantage and will influence the
organisational results and performance in a positive direction. The thesis takes a closer look at the presumed
relationship between HRM and performance. The main idea behind the HRM-performance presumption is that
HR practices affect the employees’ attitudes and behaviour, which further affects the operational performance,
such as productivity, quality and innovation, which in turn have a positive on effect on the financial and market
performance. A large amount of empirical evidence support such a positive relationship between HRM and
organisational performance. However, there are also critics commenting on the research field’s methodological
limitations. Because of these methodological limitations the empirical evidence for a positive link is weakened.
These limitations include: number of respondents and their role in the organisation, research design, analysis
execution and interpretation, and a lack of attention to influencing variables and the possibility of a reversed
relationship. The research field suffers especially from a lack of longitudinal designs and the fact that nearly all
research is of a quantitative nature. In addition, some studies have found evidence indicating that the possible
gains achieved through HRM can be offset by the costs related to it. Further, some researchers argue that HRM
does not exclusively affect the employees in a positive way. In fact, some empirical evidence has shown that
HRM can affect the employees negatively; this includes increased work intensity, stress, burn out, and ripple
effects from work into private life. Through a discussion of the above-mentioned evidence, factors, and
elements, the thesis concludes that it is still too early to say that HRM causes improved performance. However,
the amount of empirical evidence of a positive relationship also leads this thesis to conclude that HRM can have
a positive impact on performance. VI VII Acknowledgements I appreciate the knowledge and diversity that the
master’s programme in organisation, leadership and work has given me the opportunity to acquire and
experience. Exploring the world of organisation, leadership and work through an interdisciplinary approach has
increased my understanding of the complexity that exists. Prior to starting this master’s programme my
educational experience was organisational psychology, which has provided me with a good understanding of
the individuals working in organisations and their behaviour. However, being able to see this in relation to other
elements such as organisational structure, society, industrial and technological developments, laws and
regulations, and rhetoric and communication, has increased my interest in exploring how all these things are
connected and how they things affect each other. This led me to into the research field of HRM and
performance. I was interested in understanding what effects an organisational feature such as HRM can have. At
first glance, the research field depicted a body of research showing that HRM is positively related to
organisational performance. At this point, it looked as if my thesis was going to be investigating all the different
effects that HRM has been showed to have. However, as I continued exploring the research field, I noticed that
a number of things could challenge the apparent relationship between HRM and performance; this led me to a
research question of causality rather than one concerning the effects as if the relationship had already been
determined to exist. It has been an interesting journey since it started nearly three years ago. I have been blessed
with a wonderful daughter, which has caused much joy and encouragement. I am very thankful for my
husband’s patience and support, and for all the sacrifices he has made to help me reach my goal. During this
time, I have also myself become an employee both experiencing and carrying out HRM every Monday to
Friday. Through my work I have learned that implementing and executing HRM is more complicated than
much of the research seem to portray. I would like to thank Heidi, for her support and warmth, and for being the
best manager a panicking master student could ask for. Finally, I would like to thank my supervisor, Thomas
Hoff, for providing me with good guidance and quick replies, although I know I have not made it too easy.
Lillesand, November 2015 Cathrine Byremo VIII IX Table of Contents 1 Introduction
........................................................................................................................ 1 1.1 The
Assumption........................................................................................................... 1 1.2 The Research
Question................................................................................................ 2 1.3 Demarcation and
Outline............................................................................................. 2 2 Historical and Theoretical Outline
..................................................................................... 4 2.1 From Personnel Administration to Human Resource
Management............................ 4 2.2 Soft and Hard – Commitment and
Control.................................................................. 5 2.3 Theories and Perspectives on the HRM-Performance
Link ....................................... 7 2.3.1 Universalistic perspective
.................................................................................... 7 2.3.2 Contingency perspective
...................................................................................... 8 2.3.3 Configuration perspective
.................................................................................... 8 2.3.4 Resource Based View of the firm
........................................................................ 8 2.3.5 AMO theory and KSA theory
.............................................................................. 9 2.3.6 Other theories on an individual level
................................................................... 9 3 Researching HRM and
Performance................................................................................ 10 3.1 Human Resource
Management.................................................................................. 10 3.2 Organisational Performance
...................................................................................... 10 3.2.1 Financial
performance........................................................................................ 11 3.2.2 Operational
performance.................................................................................... 11 3.2.3 Employee attitudes and behaviour
..................................................................... 11 4 Evidence of a Positive Link
............................................................................................. 13 5 Challenging the HRM-Performance Link
........................................................................ 20 5.1.1 Methodological limitations
................................................................................ 20 5.1.2 Measuring
HRM................................................................................................. 22 5.1.3 The distance between
variables.......................................................................... 24 5.1.4 Reversed causation and third factor influence
................................................... 25 5.1.5 Increasing
costs.................................................................................................. 26 5.1.6 A lack of
evidence.............................................................................................. 27 5.1.7 Negative effects on the employees
as a result of HRM ..................................... 28 6
Conclusion........................................................................................................................ 30
References................................................................................................................................ 34 X 1 1
Introduction In order to secure viability and growth, a crucial goal for any organisation is to perform well and
achieve good results. There can be many means to achieve this, and one possibility is to manage the
organisation’s human resources in such a way that they give rise to increased performance and improved
organisational results. Organisations have increasingly acknowledged the fact that the company’s human
resources are valuable and can be a unique source for competitive advantage. As Barney (1991) notes, the
people working in organisations can be a source for competitive advantage unlike any other resource, in the way
that they can be rare and hard to imitate by competitors. We now see nearly all larger companies having
departments and employees exclusively dedicated to the management of their human resources. In addition, we
can also observe a more extensive involvement of the HR function in the organisational strategic planning.
Human Resource Management (HRM) has increasingly become a strategic contributor that, in principle, could
add significant value to the organisations. 1.1 The Assumption The idea behind the assumption that HRM
significantly contributes to organisational results is that the HR practices affects the employees in a positive
matter, e.g. by increasing job satisfaction and motivation, which in turn affects the operational results, such as
the quantity and quality of the products and services, which again will have positive effect on the financial and
market performance of a company, like return on assets, revenue, and market share (Paauwe and Richardson,
1997) . This presumed connection between HRM and organisational performance has received much support
from empirical research, where they have investigated both systems of HR practices and single practices’
effects on organisational performance. These systems of HR practices are also known as High Performance
Work Systems (HPWS), High Commitment Work Systems (HCWS), or High Involvement Work Systems
(HIWS). These systems are believed to consist of several coherent and reinforcing HR practices, which together
support each other in creating more committed, motivated, satisfied and skilled employees, which in turn has a
positive effect on the overall performance of the organisation. Included in these systems are 2 practices such as
selection and recruitment, training and development, performance appraisals, performance-based compensation,
and other practices like extensive information sharing, job security, welfare benefits and grievance systems. The
idea is logical and appealing in itself: you recruit employees who are believed to perform well in the
organisation, you praise and reward the employees who meet or exceeds your expectations, you train and
develop the employees to perform even better; and in between these more strategic practices the employees
experience safety, inclusion, and commitment through other HR practices and policies, which creates a healthy
work environment that reduces absenteeism and make the employees want to stay with your company. 1.2 The
Research Question Although the HRM-performance assumption is both reasonable, possible and appealing, the
majority of research seem to depict a reality where companies can simply implement HR practices or systems of
HR practices and they will automatically achieve greater success. The research question for this master thesis is
whether there exist such a causal link between HRM and performance. Can companies simply add HRM into
their organisational equation and receive increased performance in return? On the flip side, there are also many
companies where HR practitioners experience a constant battle legitimating and justifying the HRM
investments and their strategic contribution. The return on investing in HRM is not as obvious as the return on
many other investments, such as new production machinery or new technology. For many CEOs, it can be very
easy to undermine and discard HRM based on both the lack of visible and measurable effects and the obvious
visibility and measurability of the costs. The objective of the thesis is to shed light on the relationship between
HRM and performance and to answer the question of whether there actually is a causal and positive link
between the two. This will be carried out through a literature review of existing evidence. 1.3 Demarcation and
Outline The research field of HRM and performance is vast, and there are a number of minor research fields and
debatable issues and themes concerning HRM’s nature and possible effects. Based 3 on the research question of
causality, the thesis focus mainly on research that help us reveal or explain any possible causal relationship. The
thesis will therefore not go into detail on topics such as the normative versus descriptive nature of HRM, its
effects on unionisation, or the role of line managers in executing the HR practices. The thesis starts with a
historical and theoretical outline of the concept of HRM, followed by the research field and an overview of
supporting evidence. The research discussed here is not an exhaustive review of literature on HRM-
performance, but rather a selection based on an attempt to cover all the aspects of the assumed relationship, and
to show the time-lapse of HRM-performance research. It will further discuss the link between HRM and
performance, shedding a light on the methodological approaches and critical findings. Lastly, the thesis will
look at the limitations and opportunities for both the research field and for organisations and practitioners. 4 2
Historical and Theoretical Outline 2.1 From Personnel Administration to Human Resource Management. We
can trace the origins of HRM all the way back to Frederick Taylor and Scientific Management. Taylor’s (1911)
accounts for his experiments and ways of ensuring and increasing effectiveness are similar to what we now
know as job analysis, selection, training, and motivation through compensation. From the early steps of
Frederick Taylor, HRM came to be through influences from industrial psychology, industrial sociology and
labour economics theory (Mahoney & Deckop, 1986). The Hawthorne studies of the 1930s further induced the
interest in how to make the jobs and work place motivational and how to enhance employee commitment.
During the era of Industrial Relations, the organisational activities centred on people and employees were
grouped together under the name of Personnel Administration (PA). Here, each activity had a clear objective
based on one specific theoretical model tied to a distinct problem; however, the overall objective of PA was yet
to be stated. Further down the line, there was a shift in focus that generated the shift from PA to HRM. The
object of understanding and achievement was no longer individual job performance but rather the overall
organisational effectiveness. In the 1960s, both scholarship and practice shifted from design and administration
of activities to managing a workforce for the accomplishment of organisational objectives. The shift in terms,
from PA to HRM, signified a new way of thinking about the employees; they were now considered to be
resources in an employing organisation which needed to be managed jointly with other resources in order to
achieve organisational effectiveness (Mahoney & Deckop, 1986). In addition, one began to see a more strategic
view of the activities or practices as a whole, the overall objective of PA/HRM became more noticeable and
was guided towards organisational effectiveness. Previously PA consisted of activities that were considered
solutions to various but specific problems, like turnover, absenteeism, and job satisfaction. However,
developments in the 1980s shifted the focus from problem solving to assessment of organisational outcomes.
There was an increased focus on translating traditional HR measures such as turnover, job performance, and
training effectiveness into organisational relevant measures of cost and profit – thus relating HRM to
organisational results. This new way of 5 thinking about the management of the organisations’ employees
signifies the birth of a new research field, a research field focused on uncovering the potential of HRM. In 1987,
Guest introduced HRM as a new approach to personnel management, where it differentiated itself from more
traditional ways of managing employees. This included greater involvement of line-managers and a strategic
alignment with the company as a whole. Further, Guest emphasised HRM’s contribution to flexibility, quality
and employee commitment, which in turn would influence employee absence, turnover and work performance
in a positive matter. This presumption was soon acknowledged by both practitioners and academics,
contributing to the explosion of research and the renaming of employment positions and departments that
followed. However, much of the interest in systems of HR practices such as HPWS stems from the rise of
Japanese high-quality production systems in the 1970s and 1980s (Boxall & Purcell, 2003). Faced with
competitors who were simultaneously raising product quality, reducing production costs, and improving rates of
innovation, some elements of western manufacturing simply disappeared, while others soon learnt that they
could not rely solely on their marketing skills (Boxall & Macky, 2007). In order to survive they had to change
and seek new ways of achieving competitive advantage. This included an increased focus on their internal
operations, and adopting the Japanese lean principles. This meant moving away from the low-discretion,
control-focused work systems associated with Fordist operations management towards work systems that
increased involvement of production workers and raised skills and incentives (Boxall & Macky, 2007;
MacDuffie, 1995). 2.2 Soft and Hard – Commitment and Control When HRM was introduced in the 1980s, a
distinction was made between soft and hard models of HRM. The hard version, often referred to as the
Michigan approach (Fombrun et al. 1984), is characterised by an instrumental view on its employees, and place
great emphasis on the maximal utilisation of them in a virtually calculating manner. On the other hand, the soft
version of HRM, often referred to as the Harvard approach (Beer et al., 1985), is characterised by a more human
approach to the employees, where the focus lies on developing the employees’ potential and resources in the
best interest of both the employer and the employees. In addition to enhance in the employees’ skills and
abilities, the HR practices within this soft approach aims at creating committed and involved employees with
strong 6 psychological ties to the organisations. Most of the research on HRM-performance has focused on a
soft HRM approach as outlined below. We find the contrast between a soft, developmental approach, and a
hard, utilising approach in Walton’s (1985) distinction between commitment strategies and control strategies in
personnel management. Arthur (1992) was one of the first to apply Walton’s suggestion to make a distinction
between high commitment and direct control within the research field of HRM. In his study, he found several
different HR systems in the steel mills that he investigated which he further categorised into two separate types
of systems: one that was characterised by control and the other by commitment. Arthur (1992) noted that the
control systems where characterised by a focus on efficiency and costs, where the lowering of direct pay costs
was the central issue. The HR system oriented towards commitment, on the other hand, was characterised by an
effort to develop psychological ties between the employees and the organisation through training and
development, empowerment and a competitive fixed pay. Subsequent studies have observed, designed, and
applied HR systems, which more or less resemble Arthur’s commitment HR system. These HR systems, as
mentioned previously, have been named High Performance Work Systems (HPWS), High Involvement Work
Systems (HIWS), and High Commitment Work Systems (HCWS). What is common for these HR systems, is
that they all comprise of practices and activities aimed at generating motivated and committed employees by
getting them involved and engaged in the organisation they work for. They are aimed at eliciting a commitment
so that behaviour is primarily selfregulated rather than controlled by sanctions or other external pressure (Wood,
1996). These systems usually incorporate some form of performance related pay, which stands in contrast to
Arthur’s (1992) original commitment based systems. However, one of the main ideas is still to enhance the
attitudes and behavour of employees in order to improve the performance. In a qualitative attempt to get a grip
on what characterises commitment based HRM and how the employees experience it, Lowe and Oliver (1991)
explored the HR practices/cultures of two companies known to be so-called high commitment organisations.
They observed characteristics such as informality, decentralisation and empowerment, teamwork, extensive
recruitment and selection procedures, and two-way communication. When investigating the link between HRM
and organisational performance, this soft commitment approach has received the most attention by far. The
human resources of an organisation can be managed in a number of ways depending on what the HR practices
in an organisation are. Huang (2001) investigated the effects of combining various business 7 strategies with
different HRM strategies. The study included Utilisation HRM strategy, characterised by external recruitment
based on new employees’ ability to start their work immediately, minimising the training expenses, definite job
content focused on specialisation, short-term performance evaluations, and salaries based on external equity
with very few monetary incentive systems. This Utilisation HRM strategy can be considered a harder version of
HRM. The evidence suggested that a Facilitating HRM strategy, characterised by a willingness to fill job
vacancies internally, adopt multiple methods of promotion, broad career paths, attention to employee training
and development, together with internal pay equity and several types of employee incentives, turned out to be
the best strategy for any organisation, independent of their business strategy. This Facilitation HRM strategy is
consistent with a soft approach and resembles HPWS to a large extent. As the thesis proceeds, and unless
otherwise is stated, it is this soft approach to HRM that is referred to when speaking of HRM. 2.3 Theories and
Perspectives on the HRM-Performance Link The possible link between HRM and performance has been
interpreted and explained through numerous perspectives and theories. In this section, we outline some of the
predominant ones, although this is not an exhaustive summary. 2.3.1 Universalistic perspective Some claim that
there is a universalistic link between HRM and performance, where some HR practices or systems of HR
practices give way for increased organisational performance across the population of organisations and under all
circumstances. Pfeffer’s (1998) seven practices is an example of this view, where he holds that employment
security, selective hiring, self-managed teams and decentralization of decision-making, high contingency pay,
extensive training, reducing status distinctions and barriers, and extensive sharing of information all will have a
positive influence on organisational performance independent of organisation and other conditions. Essentially,
scientists holding this view believe that it is not necessary to adapt the HR practices in accordance with any
particular strategy or to any specific organisational context (Lengnick-Hall et al., 2009). 8 2.3.2 Contingency
perspective In contrast to the universalistic perspective, scientists holding a contingency perspective argue that
the relationship between the relevant independent variables and the dependent variables will vary across
different levels of contingency variables. The organisation’s business strategy is considered perhaps the most
important contingent factor within the HRM-performance literature. The various HR activities that the
organisation carries out must be aligned with the organisation’s business strategy, or other contingencies, in
order to have an effective impact on performance according to this view (Delery and Doty, 1996). 2.3.3
Configuration perspective In the configuration perspective, the focus lies on the synergistic effects that the HR
practices can create when they are grouped together and exercised in a coherent manner. It is argued that the
total effect that can be achieved is far greater than the sum of the effects for every single practice. In accordance
with this view, Ichniowski and colleagues (1997) found that systems of innovative HR practices had a
significant impact on production workers’ performance, whilst changes in individual practices showed small to
non-existing effects. The above-mentioned perspectives dominated the early days of the HRM-performance
field. Delery & Doty (1996) investigated the three, and found evidence supporting both the universalistic
perspective and the contingency perspective. However, even though evidence supporting the configuration
perspective was present, it was notably smaller compared to the other two perspectives. 2.3.4 Resource Based
View of the firm The Resource Based View of the firm (RBV) has also been applied to the HRM-performance
link. RBV is a general way of theorising about how competitive advantage can be achieved through the
possession of valuable and rare resources that are hard to imitate by other competitors (Takeuchi et al., 2007).
When applied to the HRM-performance link, one is to consider the employees as a resource similar to other
organisational resources, where the main goal for the HR practices is to build up the human capital and
stimulate the kind of behaviour that creates advantages for the organisation (Boxall og Steeneveld, 1999). 9
2.3.5 AMO theory and KSA theory Another theory that has gained much support lately is AMO theory. The
idea is that HR practices influencing the employees Abilities, Motivation and Opportunity to participate are the
practices that will have an impact on organisational performance. This is very similar to what some researchers
call KSA theory (e.g. Huselid, 1995). It is advocated that the use of HR practices that 1) increase the
employees’ knowledge, skills, and abilities (KSAs), 2) motivate employees to leverage their KSAs, and, 3)
empowering the employees to do so, will consistently create growth and prosper for its organisations. 2.3.6
Other theories on an individual level In addition to perspectives and theories concerning the HR practices and
how to view the HRM potential, there also exist theories that are more specific. These are located at an
individual level and have been applied to the HRM-performance link often related to attempts at explaining the
potential link. Examples of such theories are social exchange theory (Takeuchi et al., 2007), psychological
contracts (Guest, 1999) and job characteristics theory (Snape & Redman, 2010). When applying social
exchange theory to the link between HRM and performance, the proposed idea is that organisations that invest
in their employees, will experience employees reciprocating these investment with efforts directed towards the
organisations’ benefit and interest. This is somewhat similar to the way of theorising about psychological
contracts and HRM-performance. Here, HRM is believed to contribute to a strong psychological contract
between the employer and the employee, with reciprocating characteristics and expectations. According to job
characteristics theory the core characteristic of autonomy/discretion produces a “critical psychological state” of
experienced responsibility for the work, which in turn leads to improved work effectiveness (Hackman and
Oldham, 1980; in Snape and Redman, 2010 p. 1221). For example, many HR practices, such as those focused
on building employee skills and abilities, empowering the employees, and involving the employees, may
contribute to increase the level of discretion employees have in their role. 10 3 Researching HRM and
Performance One could say that the real birth of the research field of HRM-performance came in the 1990’s.
The amount of research exploded, and where previous work had mainly focused on single HR practices effects,
it now became more widespread to investigate HRM as a unified concept comprised of several practices, and
what effects these practices together as a system could have on an organisation. 3.1 Human Resource
Management There seems to be no clear-cut theory or common understanding of exactly what HRM comprises
of (Boselie et al., 2005), and the HR practices that are included in the studies examining the link between HRM
and performance varies in both in number and type. Some choose to include only a few practices; others include
more than ten practices. Thus, there are also great discrepancies between the types of HR practices that are
included for each study, although we see many of them recurring quite often. The typical HR practices that have
been investigated are recruitment and selection, training and development, performance appraisals, performance
related incentives, internal career paths, job security, benefits, grievance systems, empowerment, and
information sharing (Boselie et al., 2005; Paauwe & Richardson, 1997). 3.2 Organisational Performance We
have seen that there are a number of different HR practices that are frequently repeated throughout the HRM-
performance research. However, what types of performance that these HR practices, or systems of them, are
measured against varies. In the following section, I will briefly outline the types of performance that are
commonly used within the research field. The various types of performance have been divided into three main
categories: 1) Financial and Market performance, 2) Operational Performance, and 3) Employee attitude and
behaviour. 11 3.2.1 Financial performance Financial and market performance data is of an objective nature, and
can in many instances be easily obtained even when the number of organisations under investigation is big. This
type of performance is also the most frequent type of performance found in the HRM-performance literature
(Boselie et al., 2005). However, there is also a more subjective side to the financial and market performance
data in the research field of HRM and performance – that is perceived organisational performance, which is
often utilized in those instances when objective data is difficult obtain. Specific examples of financial and
market performance are return on assets, return on equity, revenue, market share, and market value. 3.2.2
Operational performance Typical measures of operational performance can be productivity, production quality,
service quality, sales and innovation. These measures can be obtained both though subjective estimates and
objective measures. However, more often than not, the operational measures are of an objective nature. Many of
these types of performance are easy to break down in numbers, e.g. the quantity of products produced, number
of customer complaints, or number of new products developed. 3.2.3 Employee attitudes and behaviour
Employees’ attitudes, behaviours and perceptions have largely been neglected in previous HRM-performance
research (Guest, 2011). What has been the most common measure on an individual level is turnover (Boselie et
al., 2005). On a positive note, more recent studies have started to include one or more employee measures into
their investigations. Examples of attitudes and behaviour that are typically measured within the research field is
motivation, job satisfaction, organisational citizenship behaviour, commitment, trust in management,
absenteeism and turnover. Measuring and quantifying the employees’ attitudes and behaviours can be
considered more of a challenge compared to operational and financial performance. Of course, turnover and
absenteeism are of a quantitative nature, however, the other types of attitudes and behaviour have been
translated into quantifiable data, commonly though Likert-type ratings, in order to be analysed in the
quantitative empirical work that characterises the research field. 12 13 4 Evidence of a Positive Link There is an
extensive amount of research suggesting that there is a link between HR practices and various types of
performance, and further that this link is significantly positive. This chapter will show some of the large body of
evidence pointing in the direction of a positive influence from HRM to organisational performance. The 1990s
is an important decade within the research field of HRM-performance. Many pioneering researchers produced
valuable empirical evidence. Huselid (1995) and Delaney and Huselid (1996) included a wide range of
businesses from various industries. However, also more sector-specific studies from the same time are useful,
among those are Arthur (1994) and Ichniowski et al. (1997) focusing on the steel industry; MacDuffie (1995)
studied the automotive industry, and Delery and Doty investigating the banking sector. The early stages of
HRM-performance research are quite concentrated in the manufacturing sector; however, there are also some
exceptions. Huselid (1995) are for many considered a seminal contribution to the research field of HRM and
performance. The study was one of the first to provide sophisticated empirical evidence suggesting that HPWS
significantly contributed to increase financial and market performance, lower turnover, and increase
productivity. In numbers, the evidence suggested that an HPWS increase of one standard deviation resulted in
an $18,641 increase in market value per employee. Further, each increase in HPWS of one standard deviation
was calculated to result in an increase of $3,814 in cash flow. Sales also seemed to be affected by HPWS, where
an increase of one standard deviation of HPWS was estimated to result in an increase in sales of $27,044. If
these estimates are reflecting reality, then the financial effect of investing in HPWS could be of a real
significant magnitude. MacDuffie (1995) investigated 62 automotive assemble plants located in the US. The
findings showed that the flexible production plants that had team-based work systems and high commitment HR
practices together with low inventory and repair-buffers consistently outperformed the other plants. Delaney
and Huselid (1996) tested the hypothesis that those HR practices affecting 14 employee skills, employee
motivation, and the structure of work will be positively related to organisational performance. They did find
significant support for their hypothesis, and noted that progressive HRM practices, including selectivity in
staffing, training, and incentive compensation are positively related to perceptual measures of organisational
performance. Here, organisational performance was measured by perceived organisational performance
compared to industry competitors. This offers some limitations to the results; however, it also allowed them to
include both profit and non-profit organisations into their investigation – where the effects of progressive HR
practices showed similar results for both types of organisations. Delery and Doty (1996) found that HR
practices such as profit sharing, result-oriented appraisals and job security in general had a positive effect across
all organisations. More specifically, they estimated the financial results to be nearly 30 % higher for the banks
that were one standard deviation above average on HR practices. They also noted that the banks that were
successful in linking the HR strategy to business strategy had significantly larger returns on assets compared to
those that did not. In 1997, Ichniowski, Shaw and Prennushi published a study investigating 36 steel production
lines in the US and their HR practices through on-site visits, interviews and comparable monthly productivity
data. Their evidence showed a significant positive connection between the extensiveness of the HRM
environment and the production performance. They divided the HRM environments into four distinct types,
ranging from 1 (Extensive use of HRM) to 4 (No use of HRM), with 2 (some HRM utilization) and 3 (little
HRM utilization) in between. The four HR systems mapped out a clear hierarchy of productivity effects, where
each of the systems performed better than the other following from HRM system 4 up to HRM system 1. When
including the detailed machinery controls the difference in uptime between HRM system 4 and 1 was estimated
to be about seven percentage points. Ichniowski and Shaw (1999) collected data from 41 steel production lines
to compare US and Japanese HRM practices and their effect on productivity and performance. The Japanese
production lines employed a common system of HR practices consisting of: problem-solving teams, extensive
orientation, employee training throughout their careers, extensive information sharing, job rotation, employment
security, and profit sharing. They found that the Japanese lines outperformed the average of US lines, where the
Japanese lines were about five percent more productive. They also found that the US production lines that 15
had adopted a full system of HR practices similar to those found in the Japanese lines showed levels of
productivity and quality equal to the performance of the Japanese production lines, with no significant statistical
difference. US lines that had only adopted some of the HR practices did not show the same productivity gains as
the US manufacturers that had adopted a full HR system. Further, the difference in productivity between the US
production lines that did not have any HR practices in place and the US lines that had complete systems of HR
practices was estimated to be 7.3 percent. The difference in productivity between non-HR production lines and
those US lines that had adopted a few practices were 3.6 percent. This suggests that some HR practices are
better than none, but to have a complete system of practices makes a significant difference to the production – at
least when it comes to US steel production lines. Similar to the productivity results, they also found evidence
suggesting the same outline for quality. The Japanese production lines and the “innovative” US lines
outperformed the other US lines also concerning production quality. In 1997, Paauwe and Richardson presented
a summering analysis that included more than 30 studies on the relationship between HRM and performance.
They justified and confirmed the relationship between a number of HR practices and important HR results, such
as satisfaction, motivation, turnover, engagement and absenteeism. They further looked at these attitudes and
behaviours’ links to more general results concerning operational and financial performance. These results
included productivity, quality, customer satisfaction, sales, profit, and market value. The result of this was a
sensible explanatory path, leading from HR practices to employees’ attitudes and behaviour, and further
operational and financial results. All the above-mentioned studies indicate that the implementation of specific
HR practices or HR systems can be associated with higher organisational performance. The research conducted
during the 1990s made much of the empirical foundation for the assumption that HRM leads to better
organisational performance. The preceding research achieved much support, however also a considerable
amount of critique was guided towards it. This lead to an increasing interest in the research field, and the
amount of empirical research further escalated, resulting in several special issues in academic journals (Boselie
et al., 2009). Going into the 2000s we see research evolving with an increasing interest in non-manufacturing
organisations, such as those involved with service, technology, and non-profit work; and using large samples
combining many types of industries and sectors in each study. 16 Another study demonstrating a positive link
between HRM and organisational performance is that of Michie and Sheehan-Quinn (2001). In particular, they
investigated the correlations between HRM and both financial performance and innovation performance. Their
results showed that “low-road” work practices – short-term contracts, a lack of employer commitment to job
security, low levels of training and low levels of HRM sophistication – showed negative correlations with
corporate performance. Whereas “high-road” work practices on the other side, showed significant positive
correlations to corporate performance. “High road” work practices included strategic recruitment and selection,
performance related pay and profit sharing, extensive training, teamwork, employment security, flexible job
assignments, and two-way communication. Based on how many HR practices that were present, the study
divided the companies into four types of HRM Systems, similar to the work of Ichniowski, Shaw and Prennushi
(1997). HRM System 4 contained no innovative practices (8.2% of the companies fell into this category). HRM
System 3 used innovative practices in at least two areas, which were initiated worker involvement in teams and
enhanced labourmanagement communication (31.5% of the companies). HRM System 2 incorporated the
information sharing and teamwork practices found in system 3, however, the level of worker involvement in
teams were higher, and in addition, they included extensive skills training (44.3% of the companies). Lastly,
HRM System 1 included at least one component within each of the practices mentioned above, thus
representing a more or less complete high performing system (16% of the companies). In addition to finding
evidence showing that the more HR practices the companies had in place the bigger the effect was on perceived
financial performance, they also found that companies that met the criteria for HRM System 1 were 40% more
likely to innovate compared to the firms who were classified to have HRM System 4. Guthrie (2001) gathered
data from 164 New Zealand companies when investigating the relationship between HIWP, organisational
performance and turnover. The HR practices included internal career paths, both group and individual-based
rewards, information sharing, teamwork and training. The findings indicated a positive connection between
HIWP utilisation and firm productivity, which was measured by sales per employee. In addition, the results
showed a negative connection between HIWP and voluntary turnover. Interestingly, employee retention was
associated with increases in productivity when the use of HIWP was high; however, when the use of HIWP was
low it was associated with reductions in 17 productivity. This suggests that employee retention is especially
critical for the companies with relatively high investments in HIWP. It is probable that the use of HIWP
increases the value and importance of the human capital and thus also the costs of employee departures. Combs
and colleagues (2006) conducted a meta-analysis including 92 studies examining the link between HRM and
performance. They concluded that there exists a relationship between HPWP and organisational results.
Respectively, they achieved an overall effect size of 𝑟̅c = .20. The effect sizes were estimated based on the
mean of the sample size weighted correlations. The findings also showed a significant difference between the
utilisation of systems of practices versus single practices. Studies examining HR systems report greater effects
on organisational performance than those investigating single practices. In addition, they also found significant
differences between the effect sizes in studies that examined production companies and studies investigating
service companies. The effect size for manufacturing companies were nearly twice the size (𝑟̅c = .30) compared
with service companies (𝑟̅c = .17). This might suggest that the gains of carrying out HRM in manufacturing
organisations are significantly larger than for service organisations. Liu and colleagues (2007) built on the work
of Combs et al. (2006) and based their meta-analysis on the same sample of studies (n=92) which in total
included 19,000 organisations. Liu et al. (2007) examined the observed HRM effects found in these 92 studies,
and included a total of 13 HR practices. Their results showed that for 10 of the 13 HR practices they
investigated there was compelling evidence that each significantly affects performance. They also found three
specific factors that had an impact on the effectiveness of the practices: 1) vertical alignment between HRM and
firm strategy, 2) horizontal alignment among the HR practices, and 3) the work context. In an attempt to shed
light on the potential of HPWS in small and medium sized companies (SMEs), Drummond and Stone (2007)
based their research on postal surveys and face-to-face interviews with CEOs in 30 of the companies ranked in a
UK list of “50 Best Small Companies to Work For”. The SMEs studied was highly successful in terms of sales
and employment growth, and outperformed nearly all competing companies. In addition, this successfulness had
been maintained for several years. They found that the systems that these very successful SMEs had in place
was very similar to HPWS, focusing on training and development, high level of job discretion and flexibility,
information sharing, involvement and empowerment, appraisal systems, and job security. However, few if any
of these businesses recognize what they do in terms of HPWS (Drummon & Stone, 2007, p. 199). 18 Indeed,
the interviewed CEOs stated that they just wanted to make a great place to work, make work enjoyable and not
exhausting, and have a culture that puts people first. Macky and Boxall (2007) explored a heterogeneous sample
of New Zealand workers from a diverse range of companies and their attitudes and exposure of HR practices.
They found that higher levels of HR exposure were significantly and positively associated with job satisfaction,
trust in management and organizational commitment. They did not include any operational or financial
performance measures. However, they argue that based on strong evidence of negative correlations between job
satisfaction and voluntary turnover (e.g. Harter et al, 2002); and evidence showing that satisfied employees play
a key role in generating satisfied customers (e.g. Rogg et al, 2001; Schmidt & Allscheid, 1995), it is very
probable that HRM can have positive effects on operational and financial performance. Zhang and Li (2009)
investigated the relationship between HIWP and perceived market performance in the Chinese pharmaceutical
industry. The HR practices included were extensive training, participation, result-based appraisals, detailed job
descriptions, internal career paths, and profit sharing. These practices were significantly associated with the
company’s perceived market results. Frenkel and Lee (2010) examined whether high performing work practices
(HPWPs) such as job security, teamwork, information sharing, and training had positive effects on
organisational performance in South Korean companies. Their analysis showed significant results indicating
that all the practices contributed to increased performance. However, they did not find any evidence indicating
synergistic effects when the practices were combined. They also observed that the HPWPs were partially
mediated by worker attachment to their workplace. Lee and colleagues (2010) investigated the Taiwanese steel
industry, and found a significant and positive correlation between HPWP and organisational results. HR
practices, such as training and development, teamwork, incentive systems, performance appraisals, and job
security, were positively connected to the companies’ financial results. They also found a close connection
between HPWP and business strategy, where an integration and alignment between the two gave rise to a
further increase in performance. Giauque and colleagues (2013) investigated the impact of HR practices on
Public Service Motivation (PSM) and organizational performance. The study was based on a survey of Swiss
cantonal public employees. Given the non-profit characteristic of these workers’ organisations, the type of
organisational performance investigated here was perceived 19 organisational efficiency. PSM is a highly
relevant concept for describing the motivational characteristics of public employees, and has previously been
tied to job satisfaction, commitment, and organisational citizenship behaviour (Cerase and Farinella, 2006; Kim,
2005; Naff and Crum, 1999). The HR practices were divided into extrinsic work motivators and intrinsic work
motivators. HR practices such as job security, performance-related pay, career development, and fairness or
equality of treatment were considered extrinsic motivators. The HR practices categorised as intrinsic motivators
were job enrichment, participating in decision-making, individual appraisal, and professional development. The
main findings were that all the HR practices believed to be intrinsic motivators were significantly associated
with PSM. In addition, two extrinsic motivators showed significant correlations with PSM, this was fairness,
which showed a positive correlation, and performance-related pay, which was actually negative. For perceived
organisational effectiveness, all HR practices showed significant and positive relationships, with the exception
of career development. They did also find a direct relationship between PSM and perceived organisational
effectiveness; however, this was quite weak. The evidence suggested that organisational commitment mediated
the relationship between PSM and perceived performance, which was argued to, together with other work
attitudes, moderate the PSMperformance relationship. Also investigating public employed workers, Gould-
Williams et al. (2014) investigated local government employees in Wales (n=1,755) and the impact of high
commitment HR practices (HCHRPs) and work overload. They found evidence suggesting that HCHRPs is
positively related to civic mindedness, affective commitment, job satisfaction, and negatively related to
intentions to quit. They note that “the positive effects of HCHRPs on employee outcomes more than
compensated for the negative impact of work load” (Gould-Williams et al., 2004, p.937). We have seen studies,
including meta-analyses, showing evidence of a positive link between HRM and financial performance,
operational performance, and employee attitudes and behaviours such as motivation, organisational citizenship
behaviour, job satisfaction, commitment and turnover. Summing up all the empirical evidence of a positive
relationship makes a convincing body of research for HRM’s contribution to organisational performance. 20 5
Challenging the HRM-Performance Link Wall and Wood (2005, p. 429) note that “It is often assumed that
research over last decade has established an effect of human resource management practices on organizational
performance”. The relationship between HRM and performance may not be as clear-cut and evident as many
researchers seem to express and show through their research. In this chapter, we will explore arguments and
evidence challenging the link between HRM and performance. 5.1.1 Methodological limitations Several critics
hold the view there are too many limitations to the existing evidence which makes it difficult to draw any
conclusions on the possibility of a causal chain between HRM and organisational performance (Godard, 2004;
Wall and Wood, 2005; Wright et al., 2005). These methodological limitations include the number of
respondents and their role in the organisations, research design, and execution and interpretation of the analysis.
Wall and Wood (2005) note that authors often paint a picture of a causal relationship between HRM and
performance, either by stating this explicitly in their work, or through more subtle insinuations. Labels that have
been used on HR systems, such as High Performance Work Systems and Performance Enhancing Work
Systems, contributes to the creation of the perception that these systems have a causal effect on organisational
performance. In addition, the idea of causality is often incorporated into the titles of research articles, e.g.
Arthur’s (1994) “Effects of human resource systems on manufacturing performance and turnover” and
Huselid’s (1995) “The impact of human resource management practices on turnover, productivity and corporate
financial performance” [italic added]. In their meta-analysis, Wall and Wood (2005) found several
methodological issues in the 25 empirical HRM-performance studies they investigated. Ideally, the
measurement of HRM would include evaluations from at least two respondents in order to achieve reliability.
Further, in order to avoid contaminating the HRM measurements, the respondents should not be aware of the
organisation’s performance. The least preferred 21 method for gathering HRM data is through single
respondents describing their own organisation in addition to possessing knowledge of their own organisation’s
performance data. Wall and Wood (2005) found that only four out of the 25 studies they investigated used
multiple respondents, and further that only two of these reported on inter-rater reliability. With the exception of
Ichniowski et al. (1997), all of the studies measured HRM through respondents reporting data on their own
organisation. When measuring the dependent variables, here organisational performance, only ten out of the 25
studies utilised objective performance data, while the remaining 15 used self-reported data. Further, in 12 out of
the 15 studies utilising self-reported performance measures, the same person who reported on HRM data
reported the performance data. Even more important to note, is the fact that 21 out of the 25 studies were cross-
sectional. In cross-sectional studies, both the dependent and the independent variables are only measured at one
occasion. With longitudinal studies, on the other hand, both the dependent and independent variables are
measured several times over a longer period. Unlike longitudinal designs, a cross-sectional approach makes it
easier to include a larger sample, which in turn enhances the generalisability of the research. However, cross-
sectional designs create poor basis for drawing causal conclusions. If the goal is to answer questions of
causality, then longitudinal designs is far more preferred. Thus, the existing evidence of HRM’s contributions to
organisational performance are considerably weakened. The research field largely consists of studies with a
cross-sectional approach (Godart, 2004), and even when the conducted research is not cross-sectional, it is often
only quasi-longitudinal. Only four studies in Wall and Wood’s (2005) meta-analysis where not cross-sectional,
and only two of these had true longitudinal designs (Cappelli & Neumark, 2001; Ichniowski et al. 1997). The
remaining two (Guest et al., 2003; Huselid, Jackson & Schuler, 1997) were quasilongitudinal, and included
repeated measures of performance but only one measure in time for HRM. The main findings reported by Wall
and Wood (2005) is that 19 out of the 25 empirical studies reported some form of statistical significant and
positive relationship between HRM and organisational performance. However, this also means that six of the
studies did not find any significant positive relationship between the independent and dependent variables.
Included in these six studies is that of Cappelli and Neumark (2001), which was one of only two studies with an
authentic longitudinal design. There 22 was also one study (Wright et al., 1999) reporting a significant negative
relationship between training and financial performance. This lack in consistency across studies further weakens
the evidence supporting HRMs positive influence on organisational performance. It is also worth noting that
many of the studies accept relatively small effect sizes and often use moderate levels of significance, e.g.
Huselid, (1995), Wood & de Menezes (1998) and Michie and Sheehan-Quinn (2001) used significance levels of
p = .10. This is of course in addition to other lower significance levels, and one could argue that as long as the
levels are made evident in the articles there is no need to raise too many questions. However, this may also be
reflecting a tendency within the HRM-performance literature to interpret the results in an overly positive way.
5.1.2 Measuring HRM Another shortcoming within the research field is the way in which HRM is measured. As
mentioned previously, data are very often obtained through one single person within each organisation. How
HRM is measured is an issue within this problem - HRM is often measured by its presence, where informants,
typically HR managers or other management, report which HR practices they have implemented in their
organisation (Boeslie et al., 2005; Nishii et al., 2008; Wall & Wood, 2005; Wright & Nishii, 2007). By merely
capturing the presence of HR practices within an organisation, one does not know how many of the employees
who are actually affected by these practices and if these practices actually are carried out, and in which matter
they are carried out. As Ramsay et al. (2000) point out, that even if it can be quite easy to place employees in an
organisation executing specific HR practices; it is not possible to know if the respondents always are among
those actually experiencing the practices in their workplace. This is a shortcoming that can be found in a large
amount of the research, where it looks like one assumes that all employees within an organisation is treated
equally. Combining this assumption of equality with one or just a few informants reporting the HRM data can
lead to erroneous measurements of which HR practices that are executed, and to what extent they are utilized in
the given organisations. Going even further, Wright and Nishii (2007) address the issue of HR managers’ or
management’s reports on which HR activities the organisations have implemented and how they are executed
by distinguishing between intended HR practices, actual HR 23 practices, and experienced HR practices. The
decision makers of an organisation that have decided to implement a system of HR practices have one or more
intentions regarding how these practices shall be executed and what their results should be – these are the
intended HR practices. Wright and Nishii (2007) note that the implementation of an intended HRM system may
be problematic due to obstacles or barriers both on an institutional level and on an individual level. On an
institutional level, the challenge is to implement the HRM system in a consistent matter across the entire
organisation both horizontally and vertically. What hampers the implementation of an intended HRM system on
an individual level is both resistance to change and individual differences. The managers’ willingness to execute
the given HR practices is crucial for the implementation, and it is very possible that the implementation will
meet some form of resistance. The intended HRM systems further fall victim to individual differences through
different interpretations by the executing managers, both on how they are to be executed and what their
intentions are. According to Wright and Nishii (2007), this will create discrepancies between the intended HR
practices and the actual practices that we find in the organisations. They argue further that one also has do
differentiate between the actual HR practices and how the employees experience them. This concerns both what
intentions the employees apply to the HR practices, and to what degree they experience that the various
practices are carried out. Research suggest that there is little agreement between employees’ and management’s
statements regarding the presence of HR practices, where management seem to report more practices than the
employees (Guest, 2011; Khilji & Wang, 2006). If this is the case, that there are significant differences between
the intended HR practices that an organisation decide to implement, the actual practices that have been
implemented, and also between those practices and how the employees experience them, then the existing
evidence of a positive link between HRM and performance are further challenged. Nishii, Lepak, and Schneider
(2008) took the idea of variations between intended and experienced HR practices to the next level. Most
academics agree that if HRM has an effect on organisational performance, this effect is linked to the practices’
influence on employee attitude and behaviour. However, Nishii and colleagues (2008) suggest that the possible
causal chain is even more complex. They argue that the attributions that employees make about why
management adopts the HR practices comes before any changes in attitude or behaviour. Utilising attribution
theory in their study, Nishii et al. 24 (2008) found that the employees made attributions to the HR practices and
their intentions, and that these “HR attributions” were connected to different attitudes. In particular, they
divided the types of HR attributions into two categories. The first type of attribution that employees made was
that the HR practices were motivated by the organisation’s genuine concern with maintaining a high standard of
quality and the employees’ satisfaction and well-being. The other type of employee attribution was that the HR
practices had been implemented to reduce cost and to exploit the employees. In addition to this, they also
investigated unit-level attitudes and if these could be connected to Organisational Citizenship Behaviour (OCB),
and further, if OCB could be linked to customer satisfaction. Their significant findings were that HR
attributions made by the employees about an organisation’s pursuit of quality, employee satisfaction and
employee well-being were positively linked to the employees’ attitudes. Further, unit-level attitudes were
significantly and positively connected to OCB, which in turn was significantly linked to customer satisfaction.
These findings suggest that research on the possible link between HRM and performance should take
employees’ experience and interpretations of the HR practices into consideration, and not only report on the
mere presence of practices and for how many employees, which seem to have been the tradition so far.
Although these evidence challenge previous research on HRM-performance, it also shows promise of a positive
relationship between the two. 5.1.3 The distance between variables The distance between some of the indicators
of organisational performance and HR practices have also been pointed out as being too big (Guest, 1997). This
applies mainly to the financial measures of performance, such as market value and return on equity. These types
of measures are potentially prone to be affected by other organisational interventions, such as research and
development activities or market strategies. The greater the distance between dependent and independent
variables, the greater is the possibility of third variable interference. In accordance with this, the meta-analysis
of Combs et al. (2006) made the assumption that HPWP would have a bigger effect on operational results, such
as productivity and turnover, more than it would have on financial results, such as growth and market value.
Thus, they expected 25 that empirical studies utilising operational measures of performance would achieve
greater effect sized than the studies investigating financial performance measures. However, their hypothesis
was not confirmed – operational performance measures did not provide larger effect sizes compared to financial
performance measures. Boselie et al. (2005) emphasise that the organisational results are influenced by so many
factors. They note that within an organisation, variables such as new technology, new production methods,
advertising, mergers and acquisitions, and short-lived calculated movements, will all influence the
organisational results. Other variables existing outside the organisation will also have an impact on the results
of an organisation. This could for instance be the price of oil, market changes, legislative changes, and even
global-political conflicts (Boselie et al., 2005). It is reasonable to assume that if HRM has an effect on
organisational performance, the HR practices will first have an effect on employee attitude and behaviour or at
least on operational results before one can see effects on the financial performance. Combs et al. (2006) did not
find any support for this assumption - their results showed no significant differences between studies utilising
operational measures and those utilising financial measures. This may suggest that the relationship between
HRM and performance is at least partly reversed. 5.1.4 Reversed causation and third factor influence A majority
of the research seem to overlook or ignore the possibility of reversed causality. In a sample of studies that
examined the relationship between HR practices and organisational results, Wright et al. (2005) found that only
three out of 66 studies tested for reversed causality. It is possible that the observed positive relationship between
HRM and performance may be caused by the fact that organisations who perform well and have many available
resources are more willing to invest and implement HR practices than organisations with poorer performance
and fewer resources. In addition to the possibility of willingness, well-performing organisations also have
greater opportunity to invest in HRM compared to their lower performing competitors. Another possibility is
that the observed covariation between HRM and organisational performance is caused by a third factor
influencing both variables at more or less the same time. Typically, when researching the link between HRM
and 26 operational and financial performance researchers include control variables such as size, age, union
coverage, and industry and sector. However, it is possible that effective and good leaders contribute to increased
performance in an organisation, and that the same leaders are a driving force for HR practices implementation.
This is similar to the findings made by Drommond and Stone (2007) where they observed that CEOs of well
performing SMEs had implemented work systems similar to HPWS without being aware of the HPWS concept.
This would create a fake relationship between HRM and organisational performance in studies not accounting
for such third variables. 5.1.5 Increasing costs Cappelli and Neumark (2001) is one of the few studies
investigating the relationship between HRM and organisational results with a true longitudinal design. They
found what they classified as weak statistical indications that HRM affected the organisational results in a
positive matter. The observations included small to none effects between HR practices and the collective work
efficiency, in addition to evidence suggesting that HR practices which decentralise power increase salary cost
per employee. They concluded that their results indicate that HPWP increase the average salary costs for
otherwise equal employees rather than raising the employees to higher levels of quality. Godard (2004) argue
that in addition to over-estimating the positive effects HPWP can have, researchers also seem to under-estimate
the costs brought on by the HR practices. The costs related to HRM are often not included in the measurements
that are used to estimate the organisational results. Although high levels of HPWP can provide substantial
competitive advantage to organisations, the costs related to these practices can offset the possible gains
(Godard, 2004). In line with this, Sels et al. (2006) found that the cost increases stemming from the HR
practices offset the increase in organisational productivity. Another study coming to a similar conclusion is that
of Way (2002). He investigated a sample of 446 US companies with fewer than 100 employees, and found that
HPWS was associated with lower workforce turnover, lower voluntary turnover, and higher perceived
productivity. However, the results did not show an association between HPWS and the objective measure of
labour productivity. Labour productivity was measured by the natural logarithm of the firm’s total sales,
receipts or shipments divided by total labour costs. This led Way (2002) to conclude 27 that the positive effects
of HPWS did not exceed the costs related with the use of such HR systems. 5.1.6 A lack of evidence Although
the number of studies successful in showing evidence of a positive link between HRM and performance is very
big, some studies are also more or less unsuccessful in their attempts. Guest and colleagues (2003) conducted a
quasi-longitudinal study on the relationship between HRM and organisational results in 366 UK businesses.
They utilised both objective and subjective measures of organisational results, and found that when they used
objective measures of performance, greater use of HR practices were linked to lower turnover and higher
revenue per employee. However, when controlling for past performance these correlations ceased to be
significant. When estimating HRM’s effects through subjective measurements of performance, they found
strong connections between HRM and both productivity and financial performance. Considering strong
arguments for utilising objective data together with the lack of evidence when controlling for past performance,
these findings can be considered not to be supporting a positive link between HRM and organisational
performance. A number of other studies lack results showing evidence of a positive link between HRM and
organisational performance. Richard and Johnson (2001) examined 73 companies in the banking sector. They
found a negative link between HRM and turnover, however, there was no link found between strategic HRM
and organisational efficiency. Vandenberg, Richardson and Eastman (1999) used return on equity (ROE) and
turnover as measures of organisational performance when investigating 49 US and Canadian life insurance
companies. They did find evidence supporting their hypothesis that HIWP would affect involvement related
work processes, and that these processes had a positive effect on the organisational results. However, they also
found that some HR practices seemed to be negatively correlated with ROE, such as information sharing
regarding the direction of the company and incentive practices. In addition, training did not show any
significant correlation with ROE. The fact that incentive practices are negatively correlated with ROE can easily
be explained through the increase in costs that such practices bring with them – bringing back the argument of
HRM related costs. However, it is harder to try to explain why the correlations between ROE 28 and direction
sharing and training is either negative or insignificant. It is worth mentioning that there was a very strong and
negative correlation between training and turnover. Wood and de Menezes (1998) used two large national
surveys from the UK as the basis for their study. They categorised the HR systems into four groups with
different levels of commitment. All levels affected the organisational results in a positive way. However, the
companies having the highest level of commitment based HR systems did not show any significantly better
organisational results compared to the companies with lower levels of commitment based HR systems. The
authors note that there can be several reasons for this, but than one cannot exclude the possibility that there is no
unique gain by implementing and executing commitment based HRM. 5.1.7 Negative effects on the employees
as a result of HRM Although many researches have gathered evidence suggesting that HR practices lead to
positive HR results in the employees, such as motivation, job satisfaction, and improved social and working
climate, there are also studies finding quite the opposite. Empirical research has found that HPWS can have
negative effects on the employees, such as stress (Godard, 2001; Ramsay et al., 2000), burn out (Kroon et al.,
2009), and ripple effects from work into private life (White et al., 2003). Alternative Working Practices (AWP)
can be considered a form of HPWP, which include practices such as selection procedures and extensive training
and development. Godard (2001) found that moderate levels of AWP showed to have more or less positive
effect on the employees, including increased task involvement, job satisfaction, confidence, motivation,
commitment, OCB, and sense of belongingness. However, with the exception of commitment and motivation,
all the positive employee effects seemed to diminish and even cease to exist when the organisations used higher
levels of AWP. In addition, the study also found increased levels of stress among the employees in the higher-
level AWP companies and assumed that this was caused by an increase in work intensity and sense of
responsibility. Ramsay et al. (2000) found evidence suggesting that HPWS was positively related to
organisational performance, however, they made the argument that the increase in performance did not come as
a result of positive employee effects such as well-being and motivation. Although they did find evidence
indicating that the employees experienced higher commitment and involvement to the organisation. However, it
was argued that this increase in 29 commitment and involvement could just as well result in an increased in
work intensification, insecurity, stress and discretion, which in turn increased both the workload and
performance. Similar to Godard (2001) and Ramsay et al. (2000), the study of Kroon et al. (2009) suggest that
the use of HR practices within a company can lead to higher levels of workload and stress. Kroon et al. (2009)
found a positive link between HPWP and burnout, where this link was mediated by work demands. This means
that HPWP was effecting the work demands experienced by the employees, and further that these work
demands were positively correlated to emotional fatigue and burn out. Legge (1995) state that even if the
employees may appreciate the incentives that are offered through HPWP, the practices send out signals of
expectation concerning increased performance and effort from the employees. White et al. (2003) analysed data
from British employee surveys and found that HPWS can create an imbalance in the relationship between work
and private life. The study showed that actual hours worked affected the private life the most, but also that a
number of HR practices could have major consequences. Assessment systems, group based work forms and
individual incentives were all observed to contribute to an increase in ripple effects from work into private life.
However, two of the investigated HR practices seemed to have diminishing effects on the ripple effects: flexible
hours and personal discretion. All the remaining practices in HPWS were observed to increase the spill over
from work into private life, and they concluded that their results suggest a conflict between HPWP and work-
life balance. Although the above-mentioned studies neither help us confirm or reject the hypothesis that HRM is
positively linked to organisational performance, they do suggest that HR practices not necessarily have positive
effects on the employees at all times. These studies show the possible negative consequences HRM may have
on the employees. As Sels et al. (2006) points out, HR practices can have positive financial effects for
organisations even if the practices affect the employees in a negative way. An increase in work intensity may
give rise to increased performance in the short run; however, there is also a risk that this can lead to an increase
in costs in the end. If the health and well-being of the employees are suffering under HPWS, then one would
also expect the sick leave and absence to increase, thus increasing the costs. 30 6 Conclusion We have seen a
number of studies, both older and newer, indicating that HRM contributes to increase the organisational
performance. These studies have shown evidence indicating that HR practices affect the organisations’
employee attitudes and behaviours, operational performance and financial and market performance. However,
we have also seen that a number of methodological limitations and empirical evidence has challenged the body
of research indicating a positive link between HRM and performance. The most important of the
methodological limitations is perhaps the fact that nearly all research within the research field is cross-sectional.
There are hardly any studies investigating the relationship with a true longitudinal design, and the few that do
have trouble showing consistent positive effects from HRM to organisational performance. Another troubling
issue within the research concerns the gathering of data and the data itself. Most studies are based on single or
few respondents often reporting on their own organisation concerning both independent and dependent
variables. When reporting on HRM measures, research often rely on data informing in the mere presence of
practices, thus possibly creating a skewed picture of reality. In addition, we have been made aware that the
possible HRM-performance link can be much more complex than what has previously been believed. The
differentiation between intended, actual and perceived HR practices look to be an important factor not to be
neglected. We have also seen findings indicating that there is a real possibility for a reversed link between HRM
and performance, or at least partly reversed. The lack of longitudinal studies and the inconsistency among the
already existing longitudinal studies make it very difficult to discard this possibility. In addition, we also cannot
exclude the possibility of third factors influencing both HRM and performance at the same time. In addition,
because there are so many differences in the number and types of HR practices that are included and the various
types of performance these HR practices are measured against, the existing evidence can be considered non-
additive. Even if the body of positive research is big, the research rather expands the area of effects, rather than
constructing trust and confidence on the same effects. Based on the methodological limitations, the observed
inconsistency among research, the possibility of reversed causation and third factor influence, indications of
costs offsetting the gains, possibility of negative employee effects, and the non-additive characteristic of the 31
research field; the thesis concludes that the causal chain between HRM and performance is challenged to the
point where it is problematic to draw any causal link from HRM to organisational performance. Naturally,
future research within the field should seek to avoid the same methodological limitations that characterises and
weakens previous research. However, these methodological limitations is not usually a result of researchers’
ignorance, but rather it is often a result of the limited funding found in the social sciences. Related to that, Wall
and Wood (2005) believe that in order to identify and reveal the possible relationship between HRM and
organisational performance there is a need for “big science”. They make the argument that the solution is a
large, longitudinal research project where academics, organisations and government cooperate to arrive at the
final answer to the HRM-performance question. There are also scholars calling for future research to go in the
opposite direction of “big science”. According to Hesketh and Fleetwood (2006) there is too little research
describing the processes in which HRM may affect the organisational results through intermediating variables.
They believe that in order to come closer to a conclusion on causality one should first obtain a better
understanding of the processes HRM initiates. They further argue that quantitative research is not sufficient to
achieve this understanding, and researchers should rather turn to in depth interviews and case studies. The belief
is that only when we have a better picture of the processes that happens in the black box between HRM and
organisational results can we see any causal link. Similar to this, Guest (2011) also believe that future research
should focus more on the individual level and pursuit to reveal what happens with the employees in the
application of HRM. The majority of existing evidence has been derived from studies trying to “grasp it all”,
and it could very well be argued that the research field would benefit from more pointed and carefully designed
studies and from studies using both quantitative and qualitative data. Wall and Wood’s (2005) “big science”
may have great potential when it comes to illuminating the question of causality – but what worth is that if we
don’t know what is actually happening in the causal chain? It is this thesis’ belief that in order to get a grip on
the big picture, one must also seek to uncover all the small pieces that together comprise the whole concept that
one is trying to understand. In addition, several researchers make the point that it would be beneficial to
combine micro and macro research (Boselie et al., 2005; Nishii et al., 2008; Wright and Boswell, 2002). They
argue that it would be useful to conduct research on the link between HRM and 32 performance with several
levels of analysis. While analysis on micro level concerns the individuals and the influence HRM has on the
employees, the analysis on macro level relate to the organisation and its processes. Carrying out multi-level
analyses may give a greater understanding of the black box, and it may provide us with evidence painting a
picture closer to reality. Wright and Boswell (2002) state that in addition to combining several levels of analysis
when conducting research, it would also be useful to develop conceptual and theoretical models combining
micro and macro levels. The most widespread view seems to be that HRM has positive effects on organisational
performance, especially so among practitioners and in the organisations as we see the concept of HRM
spreading across countries, industries and sectors. Because the causal link between HRM and performance is
questionable, the scientific evidence may be misleading organisations and practitioners causing them to
implement and execute HR practices that may or may not give rise to better performance, increase positive
employee attitudes and behaviour, cost more than the gain, or be harmful to the employees’ well-being. On the
other hand, we also have HR professionals struggling to justify the work they do. The costs related to HRM,
such as training and development, and incentive systems, are easy to visualise and measure; however, their
effects are not – at least not without sophisticated analyses. This thesis does not wish to discard HRM as a
contributing organisational function. It is my belief that even though there are decades of evidence indicating
that HRM contributes to organisational performance, no causal conclusion can be drawn. However, the amount
of positive evidence also leads me to conclude that HRM has the possibility to improve organisational
performance. In order to be able to utilise HRM in such a way that it actually can contribute to increased
organisational results there are a number of factors that organisations and HR professionals should be aware of.
It would be beneficial to be conscious of how HR systems and practices are communicated. As we have seen
from the work of Nishii et al. (2008), employees seem to make attributions about the HR practices and their
motives, which further can have effects on their attitudes and behaviour. This indicates that the people whom
initiate and carry out the practices should communicate the purposes and intentions clearly. In order to secure a
consistent execution across the organisation, it also appears to be important that the linemanagers are well
aligned with management when it comes to purpose and intention, and how 33 the practices ought to be carried
out. It also appears to be differences among the effects of HR practices and the types of organisations. For non-
profit organisations and their effectiveness, there are indications that those HR practices associated with
intrinsic motivation are those that matter the most. There are a number of such minor relationships and
contingencies within the research field of HRMperformance, that it is nearly impossible for organisations to
take them all into account when implementing and executing HRM. We have also seen examples of studies
showing that HRM can have negative effects on the employees that indicate that the organisations, HR
professionals, and managers should pay attention to the employees’ well-being. There might be a fine line
between the positive outcomes and the negative ones for the employees, and although the HR practices can lead
to an increase in organisational performance, one should not neglect to take well-being into the equation.
Organisations would not benefit from an increase in absenteeism and turnover in the end. One cannot exclude
the possibility that systems of HR practices can have such negative effects on the employees, that financially the
gains are offset by the costs related to employee well-being, and not only by the costs of HRM implementation
and execution. And lastly, to quote the German philosopher Immanuel Kant: “Always recognise that human
individuals are ends, and do not use them as means to your end”. Put in the setting of organisations and HRM;
beside from the financial awareness, there are also some ethical considerations that perhaps should not be
overlooked by the organisations concerning the application of HRM. This thesis concludes that researchers have
failed to demonstrate that HRM causes higher performance, and it is thus still unclear whether HRM leads to
increased organisational performance or not. What seems even more unclear based on the numbers of different
theories, perspectives and evidence, is how this potential link can be explained. In order to be able to provide
more guidance for decision makers and practitioners, research needs to explain more thoroughly how HRM
works and be more specific on its effects. Future research will possibly reveal more of the processes that HRM
may initiate and what the results of these processes are. Although this thesis finds it premature to conclude with
certainty that HRM leads to better organisational performance, much of the existing research is promising, and
it justifies to a large extent future investments in the research field of HRM and performance. Based on the
amount of positive evidence, it is highly probable that HRM can lead to better organisational performance; it is
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 Functions of HRM
Human Resource Management & Its Core Functions: Managerial & Operative

Swati Chaudhary
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May 24, 2016 · 2 min read
As per Armstrong (1997) Human resource management is defined as “a strategic approach to acquiring,
developing, managing, motivating and gaining the commitment of the organization’s key resource — the people
who work in and for it.”
In general, human resource management is concerned with hiring, motivating and maintaining workforce within
businesses.
Functions of Human Resource Management Includes:
· Managerial Functions
· Operative Functions
Managerial Function Includes:
1. Planning
One of the primary function where number & type of employees needed to accomplish organizational goals are
determined. Research forms core HRM planning which also helps management to collect, analyze and identify
current plus future needs within the organization.
2. Organizing
Organization of the task is another important step. Task is allocated to every member as per their skills and
activities are integrated towards a common goal.
3. Directing
This includes activating employees at different levels and making them contribute maximum towards
organizational goal. Tapping maximum potentialities of an employee via constant motivation and command is a
prime focus.
4. Controlling
Post planning, organizing and directing, performance of an employee is checked, verified and compared with
goals. If actual performance is found deviated from the plan, control measures are taken.
Operative Function Includes:
1. Recruitment/Hiring
Hiring is a process which brings pool of prospective candidates who can help organization achieve their goals
and allows managements to select right candidates from the given pool.
2. Job Analysis & Design
Describing nature of the job like qualification, skill, work experience required for specific job position is
another important operative task. Whereas, job design includes outlining tasks, duties and responsibilities into a
single work unit to achieve certain goal.
3. Performance Appraisal
Checking and analyzing employee performance is another important function that human resource management
has to perform.
4. Training & Development
This function allows employees to acquire new skills and knowledge to perform their job effectively. Training
and development also prepares employees for higher level responsibilities.
5. Salary Administration
Human Resource Department also determines pays for different job types and incudes compensations,
incentives, bonus, benefits etc. related with a job function.
6. Employee Welfare
This function takes care of numerous services, benefits and facilities provided to an employee for their well-
being.
7. Maintenance
Minimizing employee turnover and sustaining best performing employees within the organization is the key.
Minimizing ROI within HR department is also a key goal for Human resource management team.
8. Labor Relations
Labor relation is regards to the workforce who work within a trade union. Employees in such domain form a
union/group to voice their decisions affectively to the higher management.
9. Personal Research
Research is a vital part of human resource management. It is performed to keep a check on employee opinion
about wages, promotions, work condition, welfare activities, leadership, employee satisfaction and other key
issues.
10. Personal Record
This function involves recording, maintaining and retrieving employee related information including
employment history, work hours, earning history etc.
5 Major Functions of Human Resource Management
Bhaswati Bhattacharyya
Aug 1, 2017
Human Resource Management Is All About Increasing Employee Performance To Their Highest Level
Corresponding To Their Role In The Organization.

Since every organization is made of people, HRM is all about acquiring services of people, developing their
skills, motivating them to the foremost level and making sure that they continue to maintain their commitment
towards the organization.
In short, HRM is concerned with the management of employees from recruitment to retirement. Although there
are many functions of human resource management, here is a list of its five major functions:
Recruitment And Selection
Recruitment is the process of captivating, screening, and selecting potential and qualified candidates based on
objective criteria for a particular job. The goal of this process is to attract the qualified applicants and to
encourage the unqualified applicants to opt themselves out.
Before starting the process of recruitment, the companies must execute proper staffing plans and should grade
the number of employees they are going to need. Forecasting of the employees should depend upon the annual
budget of the organization and short-term and long-term goals of the organization.
Recruitment and selection process is very important to every organization because it reduces the costs of
mistakes such as engaging incompetent, unmotivated, and underqualified employees. Firing the unqualified
candidate and hiring the new employee is again an expensive process.
Orientation
Many organizations do not provide a thorough orientation to the new employees. This is the fundamental step to
help a new employee to adjust himself with the employer and with his new job. Employee orientation program
should include the objectives and goals of the organization and how the employee can help to achieve the long-
term and short-term goals of the organization.
Giving intensive orientation to the employee is one of the major functions of human resource management. The
program should help the employee to know his assigned duties and his exact job description, job role, and the
relationship of position to other positions in the organization. It gives clarification to the employee to take an
active role in the organization.
Related: 5 Ways to Make the Job of an HR Person Easier
Maintaining Good Working Conditions
It is the responsibility of the human resource management to provide good working conditions to the employee
so that they may like the workplace and the work environment. It is the fundamental duty of the HR department
to motivate the employees. The study has been found that employees don’t contribute to the goals of the
organization as much as they can. This is because of the lack of motivation.
Human resource management should come up with a system to provide financial and non-financial benefits to
the employee from the various departments. Employee welfare is another concept which should be managed by
HR team. Employee welfare promotes job satisfaction.
Managing Employee Relations
Employees are the pillars of any organization. Employee relationship is a very broad concept and it is one of the
crucial functions of human resource management. It also helps to foster good employee relations. They have the
ability to influence behaviors and work outputs.
Management should Organize activities which will help to know an employee at the personal and professional
level. Well-planned employee relations will promote a healthy and balanced relation between the employee and
the employer. It is the key for the organization to be successful.
Training And Development
Training and development are the indispensable functions of human resource management. It is the attempt to
improve the current or future performance of an employee by increasing the ability of an employee through
educating and increasing one’s skills or knowledge in the particular subject.
Managerial Functions of HR Manager
Human Resource Department is an integral part of any organization. Also, the Human Resource Manager
(HRM) is a member of the management. Four basic functions of Human Resource Management
are Planning, Directing, Controlling and Organizing. In this article, we will discuss the functions of HRM in
detail.
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Functions of Human Resource Management

 Planning
 Organizing
 Directing
 Controlling
Planning
A manager must plan ahead in order to get things done by his subordinates. It is also important to plan in order
to give the organization its goals.
Also, planning helps establish the best procedures to reach the goals. Further, some effective managers devote a
substantial part of their time to planning.
With respect to the human resource department, planning involves determining the personnel programs that can
contribute to achieving the organization’s goals.
These programs include anticipating the hiring needs of the organization, planning job requirements,
descriptions, and determining the sources of recruitment.

Organizing
After the human resource manager establishes the objectives and develops plans and programs to achieve them,
he needs to design and develop the organization’s structure to carry out the different operations. Developing the
organization’s structure includes:
 Grouping of personnel activity into functions or positions
 Assigning different groups of activities to different individuals
  Delegating authority according to the tasks assigned and responsibilities involved
 Coordinating activities of different employees
Directing
The HR Manager can create plans, but implementing the plans smoothly depends on how motivated the people
are. The directing functions of HRM involve encouraging people to work willingly and efficiently to achieve
the goals of the organization. In simpler words, the directing functions of HRM entail guiding and motivating
people to accomplish the personnel programs.
The HRM can motivate the employees through career planning and salary administration by boosting the
employee’s morale, developing relationships, providing safety requirements, and looking after the welfare of
employees.
In order to do this effectively, the HRM must identify the needs of the employees and the means and methods to
satisfy them. Motivation is a continuous process as employees have new needs and expectations when the old
ones are satisfied.
Controlling
Controlling is all about regulating activities in accordance with the plans formulated based on the objectives of
the organization. This is the fourth function of the HRM and completes the cycle. In this, the manager observes
and subsequently compares the results with the set standards.
Further, he corrects any deviations that might occur. Controlling is one of the important functions of HRM as it
helps him evaluate and control the performance of the department with respect to different operative functions.
It also involves appraisals, audit, statistics, etc.
Functions of Human resource Management

The role of human resource management is to plan, develop, and administer policies and programmes
designed to make expeditious use of an organisation’s human resources. It is that part of management which is
concerned with the people at work and with their relationship within an enterprise.

Its objectives are:

1. Effective utilisation of human resources;
2. Desirable working relationships among all members of the organisation; and
3. Maximum individual development.
Major functions of human resource management are:

Recruitment and Selection (Staffing)

Staffing emphasises the recruitment and selection of the human resources for an organisation. Since staffing is a
major and primary function of HR department, HR managers and hiring managers should ensure equal
employment opportunities Without any discrimination based on caste, creed, race, sex and religion in staffing
process, since it is constitutional and mandatory in some countries like the USA, UK and India. It's failure or
contravenes shall invite legal action against such organisation which shall sometimes leads to huge finality or
closure depending upon the gravity of such contravenes. Equal employment opportunity principle is not
applicable where rule of reservation is applicable.

Human resources planning and recruiting precede the actual selection of people for positions in an
organisation. Recruitment is the process of inviting qualified applicants by way of issuing notification in the
newspapers, television media, online and on social networking media so as to fill up job vacancies. Recruitment
of employees is administered by two major sources, which are recruitment of employees through internal
sources and recruitment of employees through external sources. Internal recruitment is the process of inviting or
giving chance to people relating to concern organisation or giving chance to the existing employees.

After the recruitment, employee selection process begins for identifying right person by using written test on
relevant subjects, oral tests, group discussions, gamifications, final job interview and background verification
for checking the genuinity and credentials of the candidates for filling up of the job which is lying vacant in an
organisation.

The Top 10 Ways Companies Fill Jobs

Ways of internal recruitment
1. As the aim of recruitment is to fill up the vacancies, depending upon organisation to organisation, some
may adopt internal recruitment to fill up the vacancies by way of transferring an employee to the
place where job is lying vacant if transferring employee is found to befitted for the job position he or
she going to take up by way of transfer.
2. Giving promotion to the vacant position if an employee found to be fitted for the promotion post,
3. HR hiring Managers Seek for employee referrals from existing employees generally to fill up key
posts or to the post which deal with confidential information and to the sensitive positions with a view
not to take any risk by handling such positions to unknown persons,
4. Inviting retrenched employees if they were retrenched or laid off by an organisation due to shortage of
working capital, low sales, fall in demand for goods they were producing or breakdown in machinery. It
is a rule that has to be followed by an organisation to give first opportunity to the retrenched employees
to fill up vacancies if organisation position is restored and if it needs to add staff. Industrial disputes
act 1947 is the law which deals with this subject.
5. Some organisations offer compassionate appointments to the family members of retired employee,
deceased employee or total permanently disabled employee as a result of an accident for filling up of
vacancies arising out of the said cause. Even governmental organisations offer compassionate
appointments to fill up vacancies especially at feeder cader or low level or low grade positions so as to
support the affected family members affected employee.
Ways of external recruitment
 Best Job search websites in India

 Job search websites in USA

 Job search websites in UK

 Job search Websites in Malaysia
 Job search websites in Australia

External recruitment is the process of inviting job applicants who do not belong to or anyway related with an
organisation which means inviting outside candidates. As that of opting for internal recruitment by some
organizations depending upon the above said situations, some organisations opt for external source of
recruitment depending upon their circumstances and demands which are as follows-
1. Internet or online recruitment which has become popular and major source of recruitment since
finding or inviting job applicants is easy when compared to other source of external recruitment.
Nowadays HR hiring managers are recruiting through social networking and it has become widely
popular for finding suitable candidates.[According to TopJobSites.com, the top three job search
websites by traffic ranking are Monster.com, CareerBuilder.com and HotJobs.com.]
2. If organisation needs well experienced and competent or talented candidate or to fill up key
vacancy, in such case HR hiring managers will look at competitor organisations to find and to
attract such candidate.
3. Employment agencies are the oldest source for finding large number of job applicants as they get
enrolled or get registered for employment opportunities.
4. Campus or college recruitment is one of the sources of external recruitment from which freshers and
talented pool with attitude of learning new skills and knowledge relating to emerging technologies are
available. Therefore organisations can have fresh talented people on board for adopting change and to
easily impart the skills whatever organisation requires.
5. Executive search firms or consultancies
6. Unsolicited candidates - It is universal truth that rate of unemployment is on raise as educational
institutions are generating graduate disproportionately to the rate of employment opportunities in the
market. Consequently, job seekers they themselves are desperately approaching companies for finding
job openings.
Human Resource Planning
Human resource planning as a function of human resource management, it determines the number and type of
employees needed to accomplish organisational goals . Research is an important part of this function because
planning requires the collection and analysis of information in order to forecast human resources supplies and to
predict future human resources needs. The basic human resource planning strategy is staffing and employee
development.

Human Resource Auditing

Human resource auditing (HRA) is a process of systematic verification of job analysis and design, recruitment
and selection, orientation and placement, training and development, performance appraisal and job evaluation,
employee and executive remuneration, motivation and morale, participative management, communication,
welfare and social security, safety and health, industrial relations, trade unionism, and disputes and their
resolution. HR audit is very much useful to achieve the organizational goal and also is a vital tool which helps
to assess the effectiveness of HR functions of an organization.

The primary objective of HR audit is to annihilate management risk of contravention with the laws, liability
exposure, identifying and correcting risk gaps, litigation avoidance, cost avoidance and enhancement of
human resource best practices.

The People Matters HR Audits Study 2016 surveyed 72 companies to assess and evaluate the HR Audit
procedures in Indian Companies. The findings from the survey revealed that HR Audits are a routine process in
a majority of organizations, very few companies employ dedicated resources that support audit procedures.
Further, there is a need for companies to proactively use them for business risk assessment and process
improvements.
 96% of organizations do not have dedicated HR resources for auditing. They are either done by external
audit firms or internal HR auditor.
 And only 52% of organizations perform audits only to establish an “early warning system”
Frequency of HR audits by companies - could be Annually, Quarterly, Trimester and Semester

Job Analysis

Job analysis is the process of describing the nature of a job and specifying the human requirements, such as
skills, and experience needed to perform it. The end product of the job analysis process is the job description. A
job description spells out work duties and activities of employees. Job descriptions are a vital source of
information to employees, managers, and personnel people because job content has a great influence on
personnel programmes and practices.
Orientation
Orientation is the first step toward helping a new employee adjust himself to the new job and the employer. It is
a method to acquaint new employees with particular aspects of their new job, including pay and benefit
programmes, working hours, and company rules and expectations.

Training and Development

The training and development is one of the core functions of the human resource management. As it the core
function of HR trainer, gives and imparts employees the skills and knowledge to perform their jobs effectively.
In addition to providing training for new or inexperienced employees, organisations often provide training
programmes for experienced employees whose jobs are undergoing change. Large organisations often have
development programmes which prepare employees for higher level responsibilities within the organisation.
Training and development programmes provide useful means of assuring that employees are capable of
performing their jobs at acceptable levels.

Training and development

Employee Training Introduction
Need and benefit of Training
Advantages Of Training Programme
3 Employee Training Tips For Managers
Training Process
 On-the-job Methods
o Job Rotation
o Coaching
o Job Instruction
o Committee Assignments
o Apprenticeship
o Internship
 Off-the-job Methods
o Classroom Lectures
o Audio-Visual
o Simulation
o Vestibule Training
o Case Studies
o Role Playing
o Programmed Instructions
Sensitivity Training

Performance Appraisal
Performance appraisal function monitors employee performance to ensure that it is at acceptable levels. Human
resource mangers are usually responsible for developing and administering performance appraisal systems,
although the actual appraisal of employee performance is the responsibility of supervisors and managers.
Besides providing a basis for pay, promotion, and disciplinary action, performance appraisal information is
essential for employee development since knowledge of results (feedback) is necessary to motivate and guide
performance improvements.

In order to assess the performance of employees, HR managers have to establish performance standards,
communicating established performance standards to their employees, measuring the actual performance of
employees by using various methods of performance appraisal and finally comparing actual performance of
employees with the established performance standards so as to identify the gaps in the performance of
employees. It gives a clear picture of employees performance status thereby HR manager will develop a plan
for filling up of gaps in performance of employees by way of providing suitable and focused training for
improving the skills in employees.

When it comes to period of conducting performance appraisal of employees, it all varies from organisation to
organisation, it could be annually, half yearly, quarterly, monthly and some organisations conduct performance
appraisal on regular basis mostly with the support of human resource information systems.

What are the methods of performance appraisal of employees?

There are various methods of performance appraisal of employees classified as modern methods and traditional
methods. It all depends on the nature and type of the organisation decides what method of performance
appraisal system is adopted and some methods of performance appraisal of employees may not be suitable for
some sort of organisation. One of the most used traditional method of performance appraisal system is
confidential report writing which is especially administered in the formal of organisations and governmental
institutions like judiciary in order to prepare a report on performance of its employees by their superiors for
submitting to the controlling authority which will take corrective actions and measures on under-performing
employees and rewarding best performance.
Career Planning & career development
The Concept and idea for Career planning has been developed partly as a result of the desire of many
employees to grow in their jobs and to advance in their career. Career planning activities include assessing an
individual employee’s potential for growth and advancement in the organisation. Career planning is the process
of establishing personal career objectives by employees and acting in a manner intended to fulfill their career
objectives. HR managers should help employees in knowing their strengths and core competence for placing
them in suitable job, guide employees what skills and knowledge should be acquired for attaining higher
positions, planning for suitable training in order to polish employees existing skill set and providing good work-
life-balance to make right balance between career and personal life, after all, every one work for their personal
and happy life.

Career development is a perennial HR function which is to identify the individual needs, abilities, goals,
organization’s job demands, job rewards and then matching their abilities with job demands and rewards
through well designed career development program. From the employees point of view, career development is
the lifelong process of learning, updating skills and knowledge to match current and future job
requirements and to be prepared to occupy higher job positions in an organisation.

Career development does not guarantee success but without it, employees would not be ready for a job when
the opportunity arises. HR managers should motivate their employees by way of giving suitable
opportunities to grow in their career that could be by promotions to higher positions according to their skills
and knowledge and should also give opportunities to employees to learn new skills in the job to grow in their
career and guide employees in right career path.

Top preferences for employees in India

* Career development
* Learning and training opportunities
* Good work-life balance
* Good relationship with superiors

Compensation
Alternative names for compensation are payment, salary, wage or remuneration. But grammatically there is
difference between those nomenclature like compensation nomenclature is used for payment of amount in case
of accident or death of an employee during the course of employment and such employee should not be under
the influence of alcohol at the time of accident or death. Remuneration and salary can be used interchangeably
when period of payment is monthly to an employee, whereas wage nomenclature is used when period of
payment is daily to an employee.

Payment of compensation or remuneration is the fundamental duty of an employer, failure to fulfil his or her
duty shall be liable for penal action in the court of law and will be interpreted as exploitation of workers and
shall be viewed seriously by the court of law. Similarly payment of compensation or remuneration is the right of
an employee for the work done and deprived employee can seek for justice in the court of law. There are
employment and labour laws for every country which govern the payment of compensation and remuneration
for workers, procedure and methods for payment of compensation in case of accidents and deaths.

According to principles of natural justice, and employer shall pay fair wages or equal pay for equal work which
is constituted as fundamental right to an employee.

Compensation or remuneration is the basic motivating factor for any employee, it also acts as primary factor for
retention of employees in an organisation which is the frenetic task for any human resource manager.
Unjustified or improper remuneration will trigger dissatisfaction and sometimes may lead to unrest among the
employees which may lead to strikes that will hurt organisation badly in all aspects. On top of it such
organisation will have to face legal action and penalty which is and cost for an organisation, consequently it
causes damage to the reputation of organisation and employer branding which involves lot of effort to build it.

Human resource personnel provide a rational method for determining how much employees should be paid for
performing certain jobs. Pay is obviously related to the maintenance of human resources. Since compensation is
a major cost to many organisations, it is a major consideration in human resource planning. Compensation
affects staffing in that people are generally attracted to organisations offering a higher level of pay in exchange
for the work performed. It is related to employee development in that it provides an important incentive
in motivating employees to higher levels of job performance and to higher paying jobs in the organisation.

Employee Benefits
One of the core functions of the human resource management is administration and management of benefits
of employees.Employee Benefits are another form of compensation to employees other than direct pay for work
performed. As such, the human resource function of administering employee benefits shares many
characteristics of the compensation function. Benefits include both the legally required items and those offered
at employer’s discretion. The cost of benefits has risen to such a point that they have become a major
consideration in human resources planning. However, benefits are primarily related to the maintenance area,
since they provide for many basic employee needs. Basically employee benefits are classified into compulsory
or statutory benefits and discretionary or voluntary benefits. Compulsory statutory benefits must be provided to
an employee by his employer without failure. In case if an employer fails to provide statutory benefits to his or
her employees such employer is liable for penal action and deprived employees can see court of law so as to
claim their right to statutory or compulsory benefits. Whereas discretionary or voluntary benefits purely
dependent upon the will and wish of his or her employer, failure of providing such benefits cannot be
enforceable in the court of law. Benefits like flexible work, paid vacations, work form home, earned leaves and
other employee benefits, Here is a list of voluntary employee benefits provided by the corporates.

Netflix
Work at Netflix and there’s no need to request days off. That’s because there's no vacation policy. Employees
have no limit to the number of days they can take off, as long as they get all their work done. And If employees
want to wear vacation clothes at work, not a problem; there’s no dress code.

Google
 When a Google employee die, surviving spouse or partner of a deceased employee 50% of their salary
for the next 10 years.
 Free gourmet food and never ending snacks.
 24/7 in-house tech support from their TechStop service Dogs are welcome into the office
 Employee s given 'massage credits’ for a job well done
 The 80/20 rule allows Googlers to dedicate 80% of their time to their primary job and 20% on passion
projects
 Xoogler alumni support for the rest of their lives

facebook
• Free food
• $3,000 reimbursement for childcare
• 21 days PTO, 11 paid holidays, and unlimited sick days
• Four months paid maternity/paternity leave

Compulsory or statutory benefits for employees

 Provident fund
 maternity leave
 Bonus minimum for employee
 Workmen compensation in case of accidents and death of employee in the course of employment
 Employees State insurance provides following benefits to the employees whoever got covered according
to The Employees State insurance Act 1948. The existing wage limit for coverage under the Act is
Rs.21,000/- per month (w.e.f. 01/01/2017).
Contribution
The contribution payable to the Corporation in respect of an employee shall comprise of employer's
contribution and employee's contribution at a specified rate.
 Sickness benefit:
 Medical benefit:
 Disablement benefit:
o Temporary disablement benefit (TDB)
o Permanent disablement benefit (PDB)
o Dependants Benefit (DB)
 Maternity benefit:
 Unemployment allowance:
 Funeral Expenses :

Motivating employee
Employee motivation is the basic feature of the human resource management, as it is one of the
functions, HR managers should identify the factors which causing demotivation of employees and convert
them into factors which motivates employees. According to a study, employees who are motivated or feel
motivated are tend to work more when compared to unmotivated to employees. We have listed major factors
that motivates employees.
Pay and benefits
having justified payment is the right of an employee for the work done to his or her employer and payment of
salary or wage is the fundamental duty of employer. Having handsome salary motivates employees, indeed it
acts as a retention factor also. Employee benefits are additional to the salary of employees, employee benefits
are classified into voluntary benefits and statutory benefits which include social security benefits which are
compulsorily provided to employees. Few examples of employee benefits are paid vacations, free food,
dependent benefit, medical benefit, maternity benefit, paternity benefit, payment of bonus, payment of gratuity
and provident fund.

Working conditions
Maintaining and providing good working conditions not only motivates employees but also prevents employee
from facing legal action by the court of law as they are mandatory according to labour laws. Good working
conditions includes providing flexible timings to work, giving correct workload to avoid stress, maintaining
healthy environment and HR managers should see that there is work life balance to their employees. Having all
those will definitely motivates employees to work efficiently and also avoids distraction from work.

Company policies
whatever the company policies made by an organisation, they should not be in conflict with the labour laws and
principles of natural justice. The very purpose of having policies or making policies is only for making
employees feel comfortable and to treat them undiscriminating. Having good company policies will drive
employees to dedicate themselves to the organisation and to reach its goals and objectives.

Employer brand and reputation

who don't want to work in well reputed and brand value organisations like Google, Apple, Microsoft, Facebook,
Qualcomm, Intel Corp and NASA. It is all because of the pride one will feel working in such organisations and
keep employees motivated. Employees in order to retain and have foothold in such organisations, one will try to
stay motivated and it is effort and is job. Building employers brand and reputation is a continuous process in
which organisation should try to be best in all aspects compared to its competitors.

Career development
Career development or career growth is one of the top 10 motivating factors for employees. No employee wants
to retain in same position in a job for a long time, he or she wants to move forward or higher-level in their
career by taking promotions in-time, which makes any employee feel happy and motivated as taking promotion
in a job is most happiest and memorable moment for any employee. Besides HR managers should give
opportunity to their employees to develop their skill set and knowledge for career development.

Job security
Job security standards in the top list of preference of employees. For any employee job security is the first and
foremost important factor before taking up any job. Having job security in a job will make an employee to
overlook all other benefits. The sense of security in job will develop confidence in employees which will make
themselves to push forward while handling critical in tough situations in the job, in other words job security acts
as a motivating factor.

Recognition
Providing employee benefits to their employees is not just enough to keep them motivated, staying
unrecognised make employees feel themselves no value to organisation and makes them demotivated.
Giving recognition and appreciating employees in the job will make them feel their importance and value to the
organisation and make employees stay motivated.

Healthy relationships
Consisting of good relationships with superiors and colleagues in organisation is a priority for any employee
since improper communication and misunderstandings with superiors and colleagues lead to psychological
stress which makes employees demotivated and shows effect on work life. Having healthy relationships with
superiors and colleagues will help and have support in getting things done easily and also keep employees
happy at work that boosts their energy levels and make them to stay motivated.

Welfare, healthy and safety measures

Maintaining welfare, healthy and safety measures of employees is not just function but they are mandatory to
maintain by the human resource management department. Failure of performing said functions or failure of
maintaining said measures, organisation shall be liable for penal action by the law.

Employee welfare: includes providing good canteen facilities, first aid or medical facilities, restrooms,
lunchrooms and childcare facilities.

Employee healthy measures: maintaining cleanliness at workplace, disposal of waste and its management,
providing healthy working environment, washing and cleaning facilities with freshwater etc.

Employee safety: looking after safety of employees so as to avoid workplace injuries accidents to employees ,
since employer shall be made liable for such incidents at workplace or during the course of employment.

Labour Relations
Maintaining labour relation is an art and one of the most important functions of human resource management in
order to maintain peace and harmony in an organization for avoiding conflicts and smooth running of an
organisation. There are no hard and fast rules for maintaining labour relations since it is an art and should be
managed according to the situations and circumstances. Without maintaining proper labour relationships there
was no organization that did its business smoothly. The term “labour relations” refers to interaction with
employees who are represented by a trade union. Unions are organisation of employees who join together to
obtain more voice in decisions affecting wages, benefits, working conditions, and other aspects of employment.
With regard to labour relations, the personnel responsibility primarily involves negotiating with the unions
regarding wages, service conditions, and resolving disputes and grievances.
Record-keeping
The oldest and most basic human resource management function is employee record-keeping. This function
involves recording, maintaining, and retrieving employee related information for a variety of purposes. Records
which must be maintained include application forms, health and medical records, employment history (jobs
held, promotions, transfers, lay-offs), seniority lists, earnings and hours of work, absences, turnover, tardiness,
and other employee data. Complete and up-to-date employee records are essential for most personnel functions.
More than ever employees today have a great interest in their personnel records. They want to know what is in
them, why certain statements have been made, and why records may or may not have been updated.

Personnel records provide the following:

1. A store of up-to-date and accurate information about the company’s employees.
2. A guide to the action to be taken regarding an employee, particularly by comparing him with other
employees.
3. A guide when recruiting a new employee, e.g. by showing the rates of pay received by comparable
employees.
4. A historical record of previous action taken regarding employees.
5. The raw material for statistics which check and guide personnel policies.
6. The means to comply with certain statutory requirements.
Introduction to HRM
 Human Resource Management
 Scope of Human Resource Management
 Significance of Human Resource Management
 Human Resource Management functions
 Human Resource Management Model
 HRM Vs Personnel Management
 Human Resource Development
 Human Capital Management
 Talent Management
o 3 Benefits of Talent Management for a Company
 Knowledge Management
 About Human Resource Manager
 HRM environment in India
  Changing role of HRM
 e-HRM

Personnel Research
All personnel people engage in some form of research activities. In a good research approach, the object is to
get facts and information about personnel specifics in order to develop and maintain a programme that works. It
is impossible to run a personnel programme without some pre-planning and post-reviewing. For that matter, any
survey is, in a sense, research. There is a wide scope for research in the areas of recruitment, employee turnover,
terminations, training, and so on. Through a well-designed attitude survey, employee opinions can be gathered
on wages, promotions, welfare services, working conditions, job security, leadership, industrial relations, and
the like. Inspite of its importance, however, in most companies, research is the most neglected area because
personnel people are too busy putting out fires. Research is not done to put out fires but to prevent them.

Research is not the sole responsibility of any one particular group or department in an organisation. The initial
responsibility is that of the human resource department, which however should be assisted by line supervisors
and executives at all levels of management. The assistance that can be rendered by trade unions and other
organisations should not be ignored, but should be properly made use of.

Apart from the above, the HR function involves managing change, technology, innovation, and diversity. It is
no longer confined to the culture or ethos of any single organisation; its keynote is a cross-fertilisation of ideas
from different organisations. Periodic social audits of HR functions are considered essential.

HR professionals have an all-encompassing role. They are required to have a thorough knowledge of the
organisation and its intricacies and complexities. The ultimate goal of every HR manager should be to develop
a linkage between the employee and the organisation because the employee’s commitment to the organisation is
crucial. The first and foremost role of HR functionary is to impart continuous education to employees about the
changes and challenges facing the country in general, and their organisation in particular. The employees should
know about their balance sheet, sales progress, diversification plans, restructuring plans, sharp price
movements, turnover and all such details. The HR professionals should impart education to all employees
through small booklets, video films, and lectures.
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Human Resource Management
Human Resource Management is a function within an organization which focuses mainly on the recruitment of,
management of, and providing guidelines to the manpower in a company. It is a function of the company or
organization which deals with concerns that are related to the staff of the company in terms of hiring,
compensation, performance, safety, wellness, benefits, motivation and training.
Human Resource Management is also a premeditated approach to manage people and the work culture. An
efficient human resource management enables the workforce of an organization to contribute efficiently and
effectively towards the overall achievement of a company’s goals and objectives.
The traditional method of human resource management involved planned exploitation of staffs. This new
function of human resource management involves HRM Metrics and measurements and strategic direction to
display value. Under the influence of giving away the traditional method, HRM has got a new terminology
called Talent Management.
Human Resource Management functions can be of three types like Operative, Managerial, and advisory. Let’s
see them one by one.
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Functions of Human Resource Management

☆ Operative Functions
1. Recruitment: This is the most challenging task for any HR manager. A lot of attention and resources
are required to draw, employ and hold the prospective employees. A lot of elements go into this function
of recruitment, like developing a job description, publishing the job posting, sourcing the prospective
candidates, interviewing, salary negotiations and making the job offer.
2. Training and Development: On the job training is the responsibility of the HR department. Fresher
training may also be provided by some companies for both new hires and existing employees. This
Fresher training is mainly done to make the employees up to date in their respective areas as required by
the company. This function makes the employees understand the process and makes it easy for them to
get on their jobs with much ease. During the process of the training and development, the results are
monitored and measured to find out if the employees require any new skills in addition to what he/she
has.
3. Professional Development: This is a very important function of Human Resource Management. This
function helps the employees with opportunity for growth, education, and management training. The
organization undertakes to sponsor their employees for various seminars, trade shows, and corporal
responsibilities. This, in turn, makes the employees feel that they have been taken care by their superiors
and also the organization.
4. Compensation and Benefits: A company can attain its goals and objectives if it can acclimatize to new
ways of providing benefits to the employees. Some of the benefits given by companies are listed below
for our understanding:
1. Working hour flexibility
2. Extended vacation
3. Dental/Medical Insurance
4. Maternal/Paternal Leave
5. Education Reimbursement for children
5. Performance Appraisal: The employees of any organization will be evaluated by the HR department as
per the performance. This function of Human Resource Management is to help the organization in
finding out if the employee they have hired is moving towards the goals and objectives of the
organization. On the other hand, it also helps the company to evaluate whether the employees needs
improvement in other areas. It also helps the HR team in drawing certain development plans for those
employees who have not met the minimal requirements of the job.
6. Ensuring Legal Compliance: To protect the organization this function plays a crucial role. The HR
department of every organization should be aware of all the laws and policies that relate to employment,
working conditions, working hours, overtime, minimum wage, tax allowances etc. Compliance with
such laws is very much required for the existence of an organization.
☆ Managerial Functions
1. Planning: This function is very vital to set goals and objectives of an organization. The policies and
procedures are laid down to achieve these goals. When it comes to planning the first thing is to foresee
vacancies, set the job requirements and decide the recruitment sources. For every job group, a demand
and supply forecast is to be made, this requires an HR manager to be aware of both job market and
strategic goals of the company. Shortage versus the excess of employees for that given job category is
determined for a given period. In the end, a plan is ascertained to eliminate this shortage of employees.
2. Organizing: The next major managerial function is to develop and design the structure of the
organization. It fundamentally includes the following:
1. Employees are grouped into positions or activities they will be performing.
2. Allocate different functions to different persons.
3. Delegate authority as per the tasks and responsibilities that are assigned.
3. Directing: This function is preordained to inspire and direct the employees to achieve the goals. This
can be attained by having in place a proper planning of career of employees, various motivational
methods and having friendly relations with the manpower. This is a great challenge to any HR manager
of an organization; he/she should have the capability of finding employee needs and ways to satisfy
them. Motivation will be a continuous process here as new needs may come forward as the old ones get
fulfilled.
4. Controlling: This is concerned with the apprehension of activities as per plans, which was formulated
on the basis of goals of the company. The controlling function ends the cycle and again prompts for
planning. Here the HR Manager makes an examination of outcome achieved with the standards that
were set in the planning stage to see if there are any deviations from the set standards. Hence any
deviation can be corrected on the next cycle.

☆ Advisory Functions
1. Top Management Advice: HR Manager is a specialist in Human Resource Management functions.
She/he can advise the top management in formulating policies and procedures. He/she can also
recommend the top management for the appraisal of manpower which they feel apt. This function also
involves advice regarding maintaining high-quality human relations and far above the ground employee
morale.
2. Departmental Head advice: Under this function, he/she advises the heads of various departments on
policies related to job design, job description, recruitment, selection, appraisals.
Functions of Human Resource Management
By Manish Patidar - September 24, 2019
Question - What do you mean by Human Resource Management? Explain various functions of Human
Resource Management.
Answer
Meaning of Human Resource Management
Functions of Human Resource Management - Managerial Functions, Operative Functions, and Advisory
Functions.Human Resource Management is a management function concerned with hiring, motivating, and
maintaining workforce in an organisation. Human resource management deals with issues related to employees
such as hiring, training, development, compensation, motivation, communication, and administration. Human
resource management ensures satisfaction of employees and maximum contribution of employees to the
achievement of organisational objectives.

According to Armstrong (1997), Human Resource Management can be defined as “a strategic approach to
acquiring, developing, managing, motivating and gaining the commitment of the organisation’s key resource –
the people who work in and for it.”

Functions of Human Resource Management

Human Resource Management functions can be classified in following three categories.

Managerial Functions,
Operative Functions, and
Advisory Functions
The Managerial Functions of Human Resource Management are as follows:

1. Human Resource Planning - In this function of HRM, the number and type of employees needed to
accomplish organisational goals is determined. Research is an important part of this function, information is
collected and analysed to identify current and future human resource needs and to forecast changing values,
attitude, and behaviour of employees and their impact on organisation.

2. Organising - In an organisation tasks are allocated among its members, relationships are identified, and
activities are integrated towards a common objective. Relationships are established among the employees so
that they can collectively contribute to the attainment of organisation goal.

3. Directing - Activating employees at different level and making them contribute maximum to the organisation
is possible through proper direction and motivation. Taping the maximum potentialities of the employees is
possible through motivation and command.

4. Controlling - After planning, organising, and directing, the actual performance of employees is checked,
verified, and compared with the plans. If the actual performance is found deviated from the plan, control
measures are required to be taken.
The Operative Functions of Human Resource Management are as follows:

1. Recruitment and Selection - Recruitment of candidates is the function preceding the selection, which brings
the pool of prospective candidates for the organisation so that the management can select the right candidate
from this pool.

2. Job Analysis and Design - Job analysis is the process of describing the nature of a job and specifying the
human requirements like qualification, skills, and work experience to perform that job. Job design aims at
outlining and organising tasks, duties, and responsibilities into a single unit of work for the achievement of
certain objectives.

3. Performance Appraisal - Human resource professionals are required to perform this function to ensure that
the performance of employee is at acceptable level.

4. Training and Development - This function of human resource management helps the employees to acquire
skills and knowledge to perform their jobs effectively. Training an development programs are organised for
both new and existing employees. Employees are prepared for higher level responsibilities through training and
development.

5. Wage and Salary Administration - Human resource management determines what is to be paid for different
type of jobs. Human resource management decides employees compensation which includes - wage
administration, salary administration, incentives, bonuses, fringe benefits, and etc,.

6. Employee Welfare - This function refers to various services, benefits, and facilities that are provided to
employees for their well being.

7. Maintenance - Human resource is considered as asset for the organisation. Employee turnover is not
considered good for the organisation. Human resource management always try to keep their best performing
employees with the organisation.

8. Labour Relations - This function refers to the interaction of human resource management with employees
who are represented by a trade union. Employees comes together and forms an union to obtain more voice in
decisions affecting wage, benefits, working condition, etc,.

9. Personnel Research - Personnel researches are done by human resource management to gather employees'
opinions on wages and salaries, promotions, working conditions, welfare activities, leadership, etc,. Such
researches helps in understanding employees satisfaction, employees turnover, employee termination, etc,.
10. Personnel Record - This function involves recording, maintaining, and retrieving employee related
information like - application forms, employment history, working hours, earnings, employee absents and
presents, employee turnover and other other data related to employees.

The Advisory Functions of Human Resource Management are as follows:

Human Resource Management is expert in managing human resources and so can give advice on matters related
to human resources of the organisation. Human Resource Management can offer advice to:

1. Advised to Top Management

Personnel manager advises the top management in formulation and evaluation of personnel programs, policies,
and procedures.

2. Advised to Departmental Heads

Personnel manager advises the the heads of various departments on matters such as manpower planning, job
analysis, job design, recruitment, selection, placement, training, performance appraisal, etc.
HRM Functions: 7 Major Functions of HRM (With Diagram)

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HRM in people centric industry is concerned with the ‘people’ dimensions of the organization. In order to
achieve the objectives as stated above, HRM must perform certain functions. Generally, it is said that to achieve
the organizational objectives, retailers must set up a proper correlation between the objectives and the functions.
Usually a particular set of functions helps realize specific objectives.
For example, personal objectives are thought to be realized through training & development, performance
management and compensation & benefits functions, while on the other hand, organizational objectives are
achieved through human resource planning, employees’ relations, recruitment, selection, training, compensation
and managerial relations functions as discussed in figure 18.2.
One point should be noted in this regard that most of the Asian and African countries are still dominated by
local/kirana/unorganized shops. Likewise, in India, we have over 12 million ‘kirana’ stores. All the employees
of that shop report to him or her. Be it strategic decision or day-to-day operations of the establishment are taken
by the proprietor. All issues related to recruitment, selection, promotion, training & development, hiring, firing
and so on depend upon the proprietor’s sole discretion.
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Actual need for HRM is felt by big retailers like Big Bazaar, Reliance Mart, Pantaloons, Shopper’s Stop, etc.
Further, the number of functional areas also varies from company to company according to nature, size and
merchandise offering.
Following are the common human resource functions, any typical retail organization will be having:
1. Job analysis and job design
2. Recruitment and selection of retail employees
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3. Employees’ training and development
4. Performance management
5. Compensation and benefits
6. Labor relations
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7. Managerial relations
These seven human resource areas and their associated functions share the common objectives of an adequate
number of competent employees with the abilities, experience, knowledge and skills required for fulfilling
organizational goals. Though a human resource function can be assigned to one of the seven areas of human
responsibility, some functions serve a variety of objectives. For example, performance management besides
motivating the retail employees leads to employees’ development as well as compensation and benefits.
Similarly, compensation and benefits function facilitates retention, training and development and also serves to
have cordial labor and managerial relations.
These human resource functions are expressed as under:
1. Job analysis and job design:
Job analysis is the process of describing the operations, duties and responsibilities of the job. In order to recruit
retail employees on a scientific and rational basis, it becomes necessary to determine in advance a standard of
personnel with which interested candidate can be compared. This standard must establish the minimum
acceptable qualities necessary for the accomplishment of tasks by retail employees.
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Simple stated, the process through which these qualitative requirements (standards) are determined is known as
Job analysis.
Various experts have defined Job Analysis as under:
In the words of Edwin B. Flippo, “Job analysis is the process of studying and collecting information relating to
the operations and responsibilities of a specific job”.
In the words of John A. Shbim, “Job analysis is the methodical compilation and study of work data in order to
define and characterize each occupation, in such a manner as to distinguish it from all others”.
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According to Michael J. Jucius, “Job analysis refers to the process of studying the operations, duties and
organizational aspects of jobs in order to derive specifications, or as they are called by some job descriptions”.
According to Scott Clothier and Spriegal, “Job analysis is the process of critically evaluating the operations,
duties and responsibilities of a specific job”.
Job Analysis Process:
The process provides information about what the job involves and what human features are essential to carry
out these activities. This information becomes vital to decide what sort of people to recruit and hire. The data
derived from job analysis process is beneficial for estimating the value and appropriate compensation for each
job.
The reason behind this is the belief and practice that compensation generally depends on the job’s required skill
and education level, safety hazards, degree of responsibility, and so on all these factors that are assessed through
job analysis. This ultimately provides the base for determining the relative worth of each job so that each job
should be properly classified.
Hence, job analysis is a data collection function performed by the HR department that includes the
following steps:

The above mentioned steps are discussed as under:

(i) Collection of factual materials:
The first step of job analysis process includes collecting factual information relating to the job.
This task is usually accomplished in four ways:
(a) With the help of structured questionnaire
(b) Using narrative descriptions
(c) Observations, and
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(d) By interviews
Two types of information are collected through above mentioned four techniques:
(a) Belonging to the job environment, i.e. its physical environment such as use of computers, sitting
arrangements, comforts, lighting, restrictions etc; its financial obligations (salary, bonus, commission, DA, TA,
fringe benefits, incentive schemes etc); its social environment (whether job is individual or in groups, shifts,
working hours, team work).
(b) Belonging to employees’ qualities:
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It includes following qualities of employees performing retail tasks:
i. Physical demands: number of working hours, store job/field job, physical (muscular energy).
ii. Intellectual demands: degree, diploma, working experience, fresher, problem solving ability.
iii. Personality demands: look, height, spoken language, humbleness, ability to listen, working under stress,
employees’ complaint handling.
(ii) Completing job description blank:
After collecting the information, job analysis puts such information in a standard job description form as a
comprehensive draft which shows full details of the activities of the retailing job. As per the nature and format
of the retail organization, separate forms may be used for various activities in the job and may be compiled later
on. In actual, the whole task of job analysis depends upon these forms, which are regularly consulted as
reference guide for the future planning tasks.
(iii) Preparation of the job specifications:
Job specifications are also prepared on the basis of information collected through data collecting techniques. Job
description basically refers to a statement of minimum acceptable qualities of a candidate whose selection
should be made.
(iv) Preparation of Report:
This report indicates various activities to be performed by the retail staff and expectations from them. It is
prepared by the job analyst on the basis of information collected. The report is then submitted to the HR
department for its suggestions and amendments.
(v) Approval:
The report submitted by the analyst and reviewed by the HR department may now be revised by the top
executives for:
(i) Competitive policies
(ii) Comments of HR department (if any)
(iii) Views of Trade Unions (if applicable)
(iv) Mission and vision of the organization
In some organizations, such drafts are usually approved by the HR manager while in some organizations by the
top executive, who has the ultimate responsibility to finalize it.
Note:
In actual, it is the prime duty of the retail store manager to prepare the job design since he/she is responsible for
conducting day-to-day activities of the store and also the reason for retail success. But it has been seen that in
most of the cases, job design is drafted by the HR department may be in consultation with the store manager.
2. Recruitment and selection of retail employees:
The success of a retail organization largely depends upon the team of efficient store employees who are chosen
out of a number of applicants for the job. Recruitment is a very first step in the employment process, which aim
at obtaining and maintaining an efficient store staff (floor employees) as a means of achieving sales targets.
Recruiting employees basically involves three major sub-functions:
(i) Recruitment,
(ii) Selection, and
(iii) Placement on the job.
Recruitment defined:
According to Edwin Flippo, “Recruitment is the process of searching for prospective employees and stimulating
them to apply for the jobs in the organization”.
According to Werther and K. Davis, “Recruitment is the process of finding and attracting capable applicants for
employment. The process begins when new recruits are sought and ends when their applications are submitted.
The result is a pool of applicants from which new employees are selected”.
Theoretically, recruitment is the positive process of employment aiming at searching for the prospective
employee and inspiring them to apply for jobs in the organization. In short, it increases the number of applicants
and number of posts vacant and thus provides an opportunity to the management to select the suitable person.
Selection defined:
Selection is the process by which qualified and suitable store employees are selected and placed on the jobs
according to their capabilities and organization’s requirements. Thus, it is a tool in the hands of the management
to differentiate the suitable and unsuitable applicants by applying various techniques such as group discussions,
personal interviews, game tests etc.
According to Thomas stone, “Selection is the process of differentiating between applicants in order to identify
those with a greater likelihood of success in the job”.
According to Dale Yolder, “Selection is the process in which candidates for employment are divided into two
classes, those who are to be offered employment and those who are not”.
Selection procedure employed in large retailing concerns:
Selection is a long process beginning with receipt of applicants and ending with the final placement. The
selection process varies from organization to organization and also between two different positions.
For example, in a retail company, when they are looking for entry level sales personnel, they tend to reply on
educational institutions, advertisements and employee recommendations. Moreover, when a retail company is
looking for middle-management positions, they are likely to use employment agencies, competitors,
advertisements and current employees. The recruitment process can be very costly. It takes a great deal of time
to set up an effective recruitment process.
Therefore, the company has to carry this job out in a systematic way. For instance, selection procedure for store
accountants, store supervisors, store managers will be long drawn and rigorous as compared to those applicants
who apply for floor staff position. The various steps in the selection of desirable employee in the organization
should be decided by the top management.
Note: The applicants are screened out at each step of selection process and those who are found suitable and fit
for the job, ultimately are selected. At any stage, any unfavorable criteria like unfavorable test scores or
physically unfit will simply lead to rejection of employees.
Following are the commonly used steps involved in the selection of retail employees:

3. Training and development:

After selecting the most suitable and eligible candidates in the organization, the next step of HR department are
to arrange for their training. All types of jobs require some type of training for their efficient performance and
therefore, all employees, new or old should be trained or re-trained from time to time.
Further, the way new and new retail formats are emerging, new developments are taking place throughout the
globe, it becomes imperative for any retail organization to systematically plan for the training program aiming
at increasing the knowledge, skills, abilities and aptitude of employees to perform the new competitive tasks.
4. Performance Management:
After selected, training and motivation, the next task, a HR manager has to perform is to evaluate the
personality and performance of each employee by quantitative factors (such as targets achieved). In actual, with
the help of performance management, the management through HR department would like to find out how
effective it has been hiring and placing employees. Performance management allows retailers gain access to the
reliable, timely information that drives better decisions.
The term ‘performance management’ and ‘performance appraisal’ are used synonymously by few authors and
subject experts. But the retailers throughout the globe believe that performance management is a broader term
that may include performance appraisal too.
A typical performance management system involves following actions:
(i) To develop job descriptions clearly.
(ii) Selecting right employees at right jobs with right selection process.
(iii) To negotiate requirements and accomplishment based performance standards, outcomes and measures as
and when required.
(iv) To provide appropriate training, education and induction.
(v) To facilitate ongoing coaching and feedback.
(vi) To conduct quarterly/half yearly performance development discussions.
(vii) To design appropriate compensation and appraisal system that rewards employees for their outstanding
contributions.
(viii) To provide career development opportunities for employees.
(ix) To assist with exit interviews to understand why loyal employees leave the organization.
5. Compensation and Benefits:
Compensation and benefits represent a substantial part of total cost in most of the organizations. Compensation
is not only the concern of the organization but is equally important for the workers and employees to maintain
their social image.
The main objective of such compensation and benefits are to control the costs, to establish a fair and equitable
remuneration to all, to utilize the compensation and benefits device as an incentive for greater employee
productivity and to establish a satisfactory public image.
Hence, it becomes imperative for the HR department of any retail business to have clear-cut policy guidelines
regarding employees’ compensation and various benefits. For effective implementation of compensation plans,
HR department should be aware about the benefits given to the employees in similar kind of organizations.
The attitude of the employees towards his employer will usually be determined by the extent to which he/she is
satisfied with the wages he/she is getting, though it is not the only reason for employee satisfaction. Even
motivation comes after an employee is satisfied with his/her basic compensation. It is also the best way to
satisfy the employee at the lower and middle level of management.
6. Labor Relations:
In modern days, retailing is carried on a large scale where hundreds of employees work together. The HR
manager is basically responsible for the control of labor (workers and employees) through human relation
approaches. Employees differ in nature and therefore, it is but natural that due to any communication gap, labor
relations may spoil within the organization. Therefore, the HR department should know the proper policies,
rules and regulations with regard to labor relations.
Harmonial relationships are necessary for both retailers and employees. It not only results in industrial peace
but also leads to better and higher sales targets. Most of the retail organizations these days besides having HR
department also take the services of legal experts (practitioners) for consultation from time to time. Further,
hiring legal experts within the organization has become necessary considering that each state has its different set
of rules for managing HR with some standard rules.
7. Managerial Relations:
The employment relationship, irrespective of nature of organization, usually has two parts: labour relations and
managerial relations. The former which covers the price of labour is more obvious. The labour relation is also
known as ‘market relations’. The managerial relations on the other side are the relationships that define how the
process takes place.
Labour relations describe the price for a particular shift (a set of number of hours) but managerial relations
determine how much work is performed in that time, at what specific task or tasks, who has the right to define
the tasks and change a particular mix of tasks and what penalties will be deployed for any failure to meet these
obligations (Clegg 1979:1).

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What are the Functions of Human Resource Management:
September 16, 2015 by Umar Farooq
Functions of human resource management described the scope of HR department. Every organization has its
human resources, which should be managed effectively, because the success of the organization in the
competitive environment is only due to the human resource factors, as all the other resources like financial,
technological etc are common to almost every organization. The HR department plays central role in managing
the employees of the organization. For this purpose, it performs certain functions of the Human Resource
Management, which we may also the key functions of human resource management. You should be aware of
them all.
Functions of Human Resource Management
 Staffing
 Human Resource Development
 Compensation & Benefits:
 Safety & Health
 Employee & Labor Relations
 Human Resource Research
Now each function is discussed one by one.
 1. Staffing:
The organization can become effective when it possess the qualified persons, who are designated for specific
position along with the proper place & timing. This would make an organization to achieve its organizational
objectives. Organization gets such qualified employees on time when its HR department performs effective
staffing function. Following are the important activities of the staffing function of HR department.
01- Job Analysis
02- Human Resource Planning (HRP)
03- Recruitment
04- Selection
 Job Analysis
In job analysis, systematic effort is made to ascertain the knowledge, skills & duties necessary to perform
certain jobs in the organization.
 Human Resource Planning (HRP)
Human Resource Planning is the systematic activity of staffing function of HR department, in which the
requirements of human resource are reviewed in order to confirm that the required number of workers with the
require skills & knowledge are made available when they are demanded.
 Recruitment
Recruitment is the systematic process of attracting & encouraging relatively large number of applicants to apply
for the required jobs of the organization.
 Selection
Selection is the final systematic process through which the organization identifies the best persons from a pool
of applicants for the job that can effectively fulfill the required criteria of performing the desired duties in the
organization.
2. Human Resource Development
Functions of human resource management include another important role of the Hr department in which the
training & development of the employees is conducted along with the career planning. For this purpose, certain
activities including performance appraisals are performed that identifies the needs for training &
development of the specified employees. The training is designed & given to provide the employees with the
required skills & knowledge for their current positions of the jobs. While development is much broader than
training in which the future aspect of employees are covered by providing them sufficient & knowledge to
perform more complex duties of future jobs.
The individual as well as the teams of employees can benefit from the human resource development which
ultimately benefits the organization by improving its entire performance. The human resource development is
not an optional activity but rather it the necessity of the employees as well as organization to cover the changing
skills, jobs & technology of the world.
Career planning is much more advance activity in which the employee determine his career goals & then he try
to point out the proper means to accomplish those goals. Organizations also use career development in which
properly qualified & experienced people are made available to the organization when needed.
The performance appraisals are prepared to check the performance level of the employees by analyzing the
performed tasked.
3. Compensation & Benefits
The HR department has also responsibility to perform the function of compensation & employee benefits. The
compensation is defined as all the rewards that are obtained by the employee as a result of his employment.
These rewards may take any of the following forms.
 Pay
The money received by an employee for performing his job.
 Benefits
Benefits are those extra financial rewards that are received other than pay. Benefits include sick leaves, paid
leaves, holiday& medical insurance.
 Non-financial Rewards
There are also some non financial rewards that are availed by the employees & which are non-monetary in
nature like pleasant working environment & delightedness of work performed etc.
4. Safety & Health
Safety & health is included in the functions of human resource management performed by the HR department
of the organization. In this function the safety of the employees form serious accidents in working environment
is ensured. Health is little different from safety in such a way that it is related to the normal physical & mental
well-being of employees that make them free from the illness. The safety & health issue of the employees is
very crucial for the HR department because employees are asset of the organization & their good health in a
safe working environment ensures the increased productivity & effectiveness of the organization in the long
run.
5. Employees & Labor Relations
The unionism of the employees is becoming popular for many years & now it becomes compulsory by law for
the organizations to declare a union of its employees & bargain with the union on certain matters. If the
employees of the organization wants to join the union, then the organization do not put pressure on them for
prevention. Although unionism is an earlier concept which is also working in the private industry but still many
organizations try to keep a union free environment because unions can become harmful for the organizations if
they are not properly handled.
6. Human Resource Research
The human resource research is not nominated as a function of the human resource management, but still it is
considered to be the one of the functions of HRM because it does not require cost for separate laboratory &
provide effective solutions for many issues of the HR department.
Interrelationship of the HRM Functions
All the functions of HRM are interrelated with each other & a single decision of HR department can affects
many areas of the organizations so management should keep focus on this fact while making certain policies &
rules for employees.

 Process and Methods of Job Analysis

Job Analysis - A Basic Understanding

Job Analysis is a systematic exploration, study and recording the responsibilities, duties, skills, accountabilities, work
environment and ability requirements of a specific job. It also involves determining the relative importance of the
duties, responsibilities and physical and emotional skills for a given job. All these factors identify what a job demands
and what an employee must possess to perform a job productively.

What Does Job Analysis Involve ?

The process of job analysis involves in-depth investigation in order to control the output, i.e., get the job performed
successfully. The process helps in finding out what a particular department requires and what a prospective worker
needs to deliver. It also helps in determining particulars about a job including job title, job location, job summary, duties
involved, working conditions, possible hazards and machines, tools, equipments and materials to be used by the existing
or potential employee.

However, the process is not limited to determination of these factors only. It also extends to finding out the necessary
human qualifications to perform the job. These include establishing the levels of education, experience, judgment,
training, initiative, leadership skills, physical skills, communication skills, responsibility, accountability, emotional
characteristics and unusual sensory demands. These factors change according to the type, seniority level, industry and
risk involved in a particular job.

Importance of Job Analysis

The details collected by conducting job analysis play an important role in controlling the output of the particular job.
Determining the success of job depends on the unbiased, proper and thorough job analysis. It also helps in recruiting the
right people for a particular job. The main purpose of conducting this whole process is to create and establish a perfect
fit between the job and the employee.

Job analysis also helps HR managers in deciding the compensation package and additional perks and incentives for a
particular job position. It effectively contributes in assessing the training needs and performance of the existing
employees. The process forms the basis to design and establish the strategies and policies to fulfill organizational goals
and objectives.

However, analysis of a particular job does not guarantee that the managers or organization would get the desired
output. Actually collecting and recording information for a specific job involves several complications. If the job
information is not accurate and checked from time to time, an employee will not be able to perform his duty well. Until
and unless he is not aware of what he is supposed to do or what is expected of him, chances are that the time and
energy spent on a particular job analysis is a sheer wastage of human resources. Therefore, proper care should be taken
while conducting job analysis.

A thorough and unbiased investigation or study of a specific job is good for both the managers and the employees. The
managers get to know whom to hire and why. They can fill a place with the right person. On the other hand, existing or
potential employee gets to know what and how he is supposed to perform the job and what is the desired output. Job
analysis creates a right fit between the job and the employee.

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Job Analysis & Design

 Job Analysis - Introduction

 Purpose of Job Analysis

 Job Analysis Process

 What to Collect during Job Analysis

 Job Analysis Methods

 Job Analysis Tools

 Job Analysis Problems

 Advantages and Disadvantages

 Job Analysis and Hiring Practices

 Job Analysis and Strategic HRM

 Job Analysis and TQM

 Job Description & Specification

 Purpose of Job Description

 Job Design

 Approaches to Job Design

 Issues in Job Design

 Factors affecting Job Design

 Job Redesign

 Job Analysis and Job Evaluation

 Job Evaluation & its Principles

 Job Classification

 Job Rotation

 Benefits of Job Rotation

 Tips for Successful Job Rotation

 Planning and Implementing Successful Job Rotation

 Disadvantages of Job Rotation

 Job Enrichment

 Job Enlargement

 Importance of Job Rotation, Enrichment and Enlargement in Career Growth

 How Smart Job Rotation Policies Can Enhance Organizational and Employee Effectiveness

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5. Purpose of Job Analysis

Purpose of Job Analysis

As discussed already, job analysis involves collecting and recording job-related data such as knowledge and skills
required to perform a job, duties and responsibilities involved, education qualifications and experience required and
physical and emotional characteristics required to perform a job in a desired manner.

The main purposes of conducting a job analysis process is to use this particular information to create a right fit between
job and employee, to assess the performance of an employee, to determine the worth of a particular task and to analyze
training and development needs of an employee delivering that specific job.

Let’s understand the concept with the help of an example. If the job of an executive sales manager is to be analyzed, the
first and foremost thing would be to determine the worth of this job. The next step is to analyze whether the person is
able to deliver what is expected of him. It also helps in knowing if he or she is perfect for this job. The process doesn’t
finish here. It also involves collection of other important facts and figures such as job location, department or division,
compensation grade, job duties, routine tasks, computer, educational, communicational and physical skills, MIS
activities, reporting structure, ability to adapt in a given environment, leadership skills, licenses and certifications, ability
to grow and close sales, ability to handle clients, superiors and subordinates and of course, the presentation of an
individual.

Purpose of Job Analysis

Job Analysis plays an important role in recruitment and selection, job evaluation, job designing, deciding compensation
and benefits packages, performance appraisal, analyzing training and development needs, assessing the worth of a job
and increasing personnel as well as organizational productivity.
  Recruitment and Selection: Job Analysis helps in determining what kind of person is required to perform a
particular job. It points out the educational qualifications, level of experience and technical, physical, emotional
and personal skills required to carry out a job in desired fashion. The objective is to fit a right person at a right
place.

 Performance Analysis: Job analysis is done to check if goals and objectives of a particular job are met or not. It
helps in deciding the performance standards, evaluation criteria and individual’s output. On this basis, the
overall performance of an employee is measured and he or she is appraised accordingly.

 Training and Development: Job Analysis can be used to assess the training and development needs of
employees. The difference between the expected and actual output determines the level of training that need
to be imparted to employees. It also helps in deciding the training content, tools and equipments to be used to
conduct training and methods of training.

 Compensation Management: Of course, job analysis plays a vital role in deciding the pay packages and extra
perks and benefits and fixed and variable incentives of employees. After all, the pay package depends on the
position, job title and duties and responsibilities involved in a job. The process guides HR managers in deciding
the worth of an employee for a particular job opening.

 Job Designing and Redesigning: The main purpose of job analysis is to streamline the human efforts and get the
best possible output. It helps in designing, redesigning, enriching, evaluating and also cutting back and adding
the extra responsibilities in a particular job. This is done to enhance the employee satisfaction while increasing
the human output.

Therefore, job analysis is one of the most important functions of an HR manager or department. This helps in fitting the
right kind of talent at the right place and at the right time.

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The article is Written By “Prachi Juneja” and Reviewed By Management Study Guide
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We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free
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Job Analysis & Design

 Job Analysis - Introduction

 Purpose of Job Analysis

 Job Analysis Process

 What to Collect during Job Analysis

 Job Analysis Methods

 Job Analysis Tools

 Job Analysis Problems

 Advantages and Disadvantages

 Job Analysis and Hiring Practices

 Job Analysis and Strategic HRM

 Job Analysis and TQM

 Job Description & Specification

 Purpose of Job Description

 Job Design

 Approaches to Job Design

  Issues in Job Design

 Factors affecting Job Design

 Job Redesign

 Job Analysis and Job Evaluation

 Job Evaluation & its Principles

 Job Classification

 Job Rotation

 Benefits of Job Rotation

 Tips for Successful Job Rotation

 Planning and Implementing Successful Job Rotation

 Disadvantages of Job Rotation

 Job Enrichment

 Job Enlargement

 Importance of Job Rotation, Enrichment and Enlargement in Career Growth

 How Smart Job Rotation Policies Can Enhance Organizational and Employee Effectiveness

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Job Analysis Process

Where to place the employees in order to best utilize their skills and talent? How to determine the need of new
employees in the organization? How to eliminate unneeded jobs? How to set realistic performance measurement
standards? How to identify the jobs and prepare a plan to fill them?

Well, all this can be effectively done by a proper and thorough job analysis. Managers deal such kinds of challenges in
day-to-day company operations where they need to fulfill effectively and efficiently fulfill the organization’s
requirements related to human resource recruitment, selection, performance, satisfaction and cutting down and adding
extra responsibilities and duties. And there is no scope where they can avert the risk of being wrong.
An effective and right process of analyzing a particular job is a great relief for them. It helps them maintain the right
quality of employees, measure their performance on realistic standards, assess their training and development needs
and increase their productivity. Let’s discuss the job analysis process and find out how it serves the purpose.

Job Analysis Process

 Identification of Job Analysis Purpose: Well any process is futile until its purpose is not identified and defined.
Therefore, the first step in the process is to determine its need and desired output. Spending human efforts,
energy as well as money is useless until HR managers don’t know why data is to be collected and what is to be
done with it.
  Who Will Conduct Job Analysis: The second most important step in the process of job analysis is to decide who
will conduct it. Some companies prefer getting it done by their own HR department while some hire job analysis
consultants. Job analysis consultants may prove to be extremely helpful as they offer unbiased advice, guidelines
and methods. They don’t have any personal likes and dislikes when it comes to analyze a job.

 How to Conduct the Process: Deciding the way in which job analysis process needs to be conducted is surely the
next step. A planned approach about how to carry the whole process is required in order to investigate a specific
job.

 Strategic Decision Making: Now is the time to make strategic decision. It’s about deciding the extent of
employee involvement in the process, the level of details to be collected and recorded, sources from where data
is to be collected, data collection methods, the processing of information and segregation of collected data.

 Training of Job Analyst: Next is to train the job analyst about how to conduct the process and use the selected
methods for collection and recoding of job data.

 Preparation of Job Analysis Process: Communicating it within the organization is the next step. HR managers
need to communicate the whole thing properly so that employees offer their full support to the job analyst. The
stage also involves preparation of documents, questionnaires, interviews and feedback forms.

 Data Collection: Next is to collect job-related data including educational qualifications of employees, skills and
abilities required to perform the job, working conditions, job activities, reporting hierarchy, required human
traits, job activities, duties and responsibilities involved and employee behaviour.

 Documentation, Verification and Review: Proper documentation is done to verify the authenticity of collected
data and then review it. This is the final information that is used to describe a specific job.

 Developing Job Description and Job Specification: Now is the time to segregate the collected data in to useful
information. Job Description describes the roles, activities, duties and responsibilities of the job while job
specification is a statement of educational qualification, experience, personal traits and skills required to
perform the job.

Thus, the process of job analysis helps in identifying the worth of specific job, utilizing the human talent in the best
possible manner, eliminating unneeded jobs and setting realistic performance measurement standards.

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Authorship/Referencing - About the Author(s)

The article is Written By “Prachi Juneja” and Reviewed By Management Study Guide
Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts.
We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free
for learning and education purpose. Please reference authorship of content used, including link(s) to
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Job Analysis & Design

 Job Analysis - Introduction

 Purpose of Job Analysis

 Job Analysis Process

 What to Collect during Job Analysis

 Job Analysis Methods

 Job Analysis Tools

 Job Analysis Problems

 Advantages and Disadvantages

 Job Analysis and Hiring Practices

 Job Analysis and Strategic HRM

 Job Analysis and TQM

  Job Description & Specification

 Purpose of Job Description

 Job Design

 Approaches to Job Design

 Issues in Job Design

 Factors affecting Job Design

 Job Redesign

 Job Analysis and Job Evaluation

 Job Evaluation & its Principles

 Job Classification

 Job Rotation

 Benefits of Job Rotation

 Tips for Successful Job Rotation

 Planning and Implementing Successful Job Rotation

 Disadvantages of Job Rotation

 Job Enrichment

 Job Enlargement

 Importance of Job Rotation, Enrichment and Enlargement in Career Growth

 How Smart Job Rotation Policies Can Enhance Organizational and Employee Effectiveness

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5. What to Collect during Job Analysis ?

What to Collect during Job Analysis ?

Gathering job-related information involves lots of efforts and time. The process may become cumbersome if the main
objective of it is not known. Any information can be gathered and recorded but may be hazardous for health and
finances of an organization if it is not known what is required and why.

Before starting to conduct a job analysis process, it is very necessary to decide what type of content or information is to
be collected and why. The purpose of this process may range from uncovering hidden dangers to the organization or
creating a right job-person fit, establishing effective hiring practices, analyzing training needs, evaluating a job, analyzing
the performance of an employee, setting organizational standards and so on. Each one of these objectives requires
different type of information or content.

While gathering job-related content, a job analyst or the dedicated person should know the purpose of the action and
try to collect data as accurate as possible. Though the data collected is later on divided in to two sets - job description
and job specification but the information falls in three different categories during the process of analyzing a specific job -
job content, job context and job requirements.

What to Collect ?

 Job Content

 Job Context

 Job Requirements

1. Job Content: It contains information about various job activities included in a specific job. It is a detailed account
of actions which an employee needs to perform during his tenure. The following information needs to be
collected by a job analyst:

 Duties of an employee

 What actually an employee does

 Machines, tools and equipments to be used while performing a specific job

 Additional tasks involved in a job

 Desired output level (What is expected of an employee?)

 Type of training required

Fig 1.1 Categorization of Job Analysis Information

The content depends upon the type of job in a particular division or department. For example, job content of a factory-
line worker would be entirely different from that of a marketing executive or HR personnel.

2. Job Context: Job context refers to the situation or condition under which an employee performs a particular job.
The information collection will include:

 Working Conditions

 Risks involved

 Whom to report

 Who all will report to him or her

 Hazards

 Physical and mental demands

 Judgment

Well like job content, data collected under this category are also subject to change according to the type of job in a
specific division or department.

3. Job Requirements: These include basic but specific requirements which make a candidate eligible for a
particular job. The collected data includes:

 Knowledge or basic information required to perform a job successfully

 Specific skills such as communication skills, IT skills, operational skills, motor skills, processing skills and
so on

 Personal ability including aptitude, reasoning, manipulative abilities, handling sudden and unexpected
situations, problem-solving ability, mathematical abilities and so on

 Educational Qualifications including degree, diploma, certification or license

  Personal Characteristics such as ability to adapt to different environment, endurance, willingness, work
ethic, eagerness to learn and understand things, behaviour towards colleagues, subordinates and
seniors, sense of belongingness to the organization, etc

For different jobs, the parameters would be different. They depend upon the type of job, designation, compensation
grade and responsibilities and risks involved in a job.

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Authorship/Referencing - About the Author(s)

The article is Written By “Prachi Juneja” and Reviewed By Management Study Guide
Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts.
We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free
for learning and education purpose. Please reference authorship of content used, including link(s) to
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 Search

Job Analysis & Design

 Job Analysis - Introduction

 Purpose of Job Analysis

 Job Analysis Process

 What to Collect during Job Analysis

 Job Analysis Methods

 Job Analysis Tools

 Job Analysis Problems

 Advantages and Disadvantages

 Job Analysis and Hiring Practices

 Job Analysis and Strategic HRM

 Job Analysis and TQM

 Job Description & Specification

 Purpose of Job Description

 Job Design

 Approaches to Job Design

 Issues in Job Design

 Factors affecting Job Design

 Job Redesign

 Job Analysis and Job Evaluation

 Job Evaluation & its Principles

 Job Classification

 Job Rotation

 Benefits of Job Rotation

 Tips for Successful Job Rotation

 Planning and Implementing Successful Job Rotation

 Disadvantages of Job Rotation

 Job Enrichment
  Job Enlargement

 Importance of Job Rotation, Enrichment and Enlargement in Career Growth

 How Smart Job Rotation Policies Can Enhance Organizational and Employee Effectiveness

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5. Job Analysis Methods

Job Analysis Methods

Though there are several methods of collecting job analysis information yet choosing the one or a combination of more
than one method depends upon the needs and requirements of organization and the objectives of the job analysis
process. Typically, all the methods focus on collecting the basic job-related information but when used in combination
may bring out the hidden or overlooked information and prove to be great tools for creating a perfect job-candidate fit.

Selecting an appropriate job analysis method depends on the structure of the organization, hierarchical levels, nature of
job and responsibilities and duties involved in it. So, before executing any method, all advantages and disadvantages
should be analyzed because the data collected through this process serves a great deal and helps organizations cope
with current market trends, organizational changes, high attrition rate and many other day-to-day problems.

Let’s discuss few of job analysis methods that are commonly used by the organizations to investigate the demands of a
specific job.

Job Analysis Methods

Most Common Methods of Job Analysis

 Observation Method: A job analyst observes an employee and records all his performed and non-performed
task, fulfilled and un-fulfilled responsibilities and duties, methods, ways and skills used by him or her to perform
various duties and his or her mental or emotional ability to handle challenges and risks. However, it seems one
of the easiest methods to analyze a specific job but truth is that it is the most difficult one. Why? Let’s Discover.

It is due to the fact that every person has his own way of observing things. Different people think different and interpret
the findings in different ways. Therefore, the process may involve personal biasness or likes and dislikes and may not
produce genuine results. This error can be avoided by proper training of job analyst or whoever will be conducting the
job analysis process.

This particular method includes three techniques: direct observation, Work Methods Analysis and Critical Incident
Technique. The first method includes direct observation and recording of behaviour of an employee in different
situations. The second involves the study of time and motion and is specially used for assembly-line or factory workers.
The third one is about identifying the work behaviours that result in performance.

 Interview Method: In this method, an employee is interviewed so that he or she comes up with their own
working styles, problems faced by them, use of particular skills and techniques while performing their job and
insecurities and fears about their careers.

This method helps interviewer know what exactly an employee thinks about his or her own job and responsibilities
involved in it. It involves analysis of job by employee himself. In order to generate honest and true feedback or collect
genuine data, questions asked during the interview should be carefully decided. And to avoid errors, it is always good to
interview more than one individual to get a pool of responses. Then it can be generalized and used for the whole group.

 Questionnaire Method: Another commonly used job analysis method is getting the questionnaires filled from
employees, their superiors and managers. However, this method also suffers from personal biasness. A great
care should be takes while framing questions for different grades of employees.

In order to get the true job-related info, management should effectively communicate it to the staff that data collected
will be used for their own good. It is very important to ensure them that it won’t be used against them in anyway. If it is
not done properly, it will be a sheer wastage of time, money and human resources.

These are some of the most common methods of job analysis. However, there are several other specialized methods
including task inventory, job element method, competency profiling, technical conference, threshold traits analysis
system and a combination of these methods. While choosing a method, HR managers need to consider time, cost and
human efforts included in conducting the process.
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Job Analysis & Design

 Job Analysis - Introduction

 Purpose of Job Analysis

 Job Analysis Process

 What to Collect during Job Analysis

 Job Analysis Methods

 Job Analysis Tools

 Job Analysis Problems

 Advantages and Disadvantages

 Job Analysis and Hiring Practices

 Job Analysis and Strategic HRM

 Job Analysis and TQM

 Job Description & Specification

 Purpose of Job Description

 Job Design

 Approaches to Job Design

 Issues in Job Design

 Factors affecting Job Design

 Job Redesign

 Job Analysis and Job Evaluation

 Job Evaluation & its Principles

 Job Classification

 Job Rotation

 Benefits of Job Rotation

 Tips for Successful Job Rotation

 Planning and Implementing Successful Job Rotation

 Disadvantages of Job Rotation

 Job Enrichment

 Job Enlargement

 Importance of Job Rotation, Enrichment and Enlargement in Career Growth

 How Smart Job Rotation Policies Can Enhance Organizational and Employee Effectiveness
 1. Home

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5. Job Analysis Tools

Job Analysis Tools

Job Analysis supports all other management activities including recruitment and selection, training and development
need analysis, performance analysis and appraisal, job evaluation, job rotation, enrichment and enlargement, a right
job-individual fit creation and regulation of entry and exit of talent in an organization. The process is the basis of all
these important management activities, therefore, requires solid ground preparation. A properly performed job analysis
is adequate for laying strong organization foundation.

There are various tools and techniques such as O*Net model, PAQ model, FJA model, F-JAS model and competency
model that help HR managers to develop genuine job description and job specification data. Though not very new but
these specialized tools and techniques are used by only a few of very high profile organizations. Not very common in use
but once understood, these systematic approaches prove to be extremely useful for measuring the worth of any job in
an organization.

Job Analysis Tools

O*Net Model: The beauty of this model is that it helps managers or job analysts in listing job-related data for a very
large number of jobs simultaneously. It helps in collecting and recording basic and initial data including educational
requirements, physical requirements and mental and emotional requirements to some extent. It also links the level of
compensation and benefits, perks and advantages to be offered to a prospective candidate for a specific job.
FJA Model: FJA stands for Functional Job Analysis and helps in collecting and recording job-related data to a deeper
extent. It is used to develop task-related statements. Developed by Sidney Fine and his colleagues, the technique helps
in determining the complexity of duties and responsibilities involved in a specific job. This work-oriented technique
works on the basis of relatedness of job-data where complexity of work is determined on a scale of various scores given
to a particular job. The lower scores represent greater difficulty.

PAQ Model: PAQ represents Position Analysis Questionnaire. This well-known and commonly used technique is used to
analyze a job by getting the questionnaires filled by job incumbents and their superiors. Designed by a trained and
experienced job analyst, the process involves interviewing the subject matter experts and employees and evaluating the
questionnaires on those bases.

F-JAS Model: Representing Fleishman Job Analysis System, it is a basic and generic approach to discover common
elements in different jobs including verbal abilities, reasoning abilities, idea generation, quantitative abilities,
attentiveness, spatial abilities, visual and other sensory abilities, manipulative abilities, reaction time, speed analysis,
flexibility, emotional characteristics, physical strength, perceptual abilities, communication skills, memory, endurance,
balance, coordination and movement control abilities.

Competency Model: This model talks about the competencies of employees in terms of knowledge, skills, abilities,
behaviors, expertise and performance. It also helps in understanding what a prospective candidate requires at the time
of entry in an organization at a particular designation in a given work environment and schedule. The model also
includes some basic elements such as qualifications, experience, education, training, certifications, licenses, legal
requirements and willingness of a candidate.

Job Scan: This technique defines the personality dynamics and suggests an ideal job model. However, it does not discuss
the individual competencies such as intellect, experience or physical and emotional characteristics of an individual
required to perform a specific job.

Different tools can be used in different situation. Selection of an ideal job analysis tool depends upon job analysis needs
and objectives and amount of time and resources.

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Authorship/Referencing - About the Author(s)

The article is Written By “Prachi Juneja” and Reviewed By Management Study Guide
Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts.
We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free
for learning and education purpose. Please reference authorship of content used, including link(s) to
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Job Analysis & Design

 Job Analysis - Introduction

 Purpose of Job Analysis

 Job Analysis Process

 What to Collect during Job Analysis

 Job Analysis Methods

 Job Analysis Tools

 Job Analysis Problems

 Advantages and Disadvantages

 Job Analysis and Hiring Practices

 Job Analysis and Strategic HRM

 Job Analysis and TQM

 Job Description & Specification

 Purpose of Job Description

  Job Design

 Approaches to Job Design

 Issues in Job Design

 Factors affecting Job Design

 Job Redesign

 Job Analysis and Job Evaluation

 Job Evaluation & its Principles

 Job Classification

 Job Rotation

 Benefits of Job Rotation

 Tips for Successful Job Rotation

 Planning and Implementing Successful Job Rotation

 Disadvantages of Job Rotation

 Job Enrichment

 Job Enlargement

 Importance of Job Rotation, Enrichment and Enlargement in Career Growth

 How Smart Job Rotation Policies Can Enhance Organizational and Employee Effectiveness

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5. Problems with Job Analysis

Problems with Job Analysis

No process can be entirely accurate and fully serves the purpose. Job analysis is no exception to it. The process involves
a variety of methods, tools, plans and a lot of human effort. And where ‘people’ are involved, nothing can be 100
percent accurate. However, they may be appropriate considering various factors including organizational requirements,
time, effort and financial resources. Since the entire job analysis processes, methods and tools are designed by humans
only, they tend to have practical issues associated with them. Human brain suffers with some limitations, therefore,
everything created, designed or developed by humans too have some or other constraints.

Coming back to the subject, even the process of job analysis has lot of practical problems associated with it. Though the
process can be effective, appropriate, practical, efficient and focused but it can be costly, time consuming and disruptive
for employees at the same time. It is because there are some typical problems that are encountered by a job analyst
while carrying out the process. Let’s discuss them and understand how the process of job analysis can be made more
effective by treating them carefully.

Problems with Job Analysis

 Lack of Management Support: The biggest problem arises when a job analyst does not get proper support from
the management. The top management needs to communicate it to the middle level managers and employees
to enhance the output or productivity of the process. In case of improper communication, employees may take
it in a wrong sense and start looking out for other available options. They may have a notion that this is being
carried out to fire them or take any action against them. In order to avoid such circumstances, top management
must effectively communicate the right message to their incumbents.

 Lack of Co-operation from Employees: If we talk about collecting authentic and accurate job-data, it is almost
impossible to get real and genuine data without the support of employees. If they are not ready to co-operate, it
is a sheer wastage of time, money and human effort to conduct job analysis process. The need is to take the
workers in confidence and communicating that it is being done to solve their problems only.

 Inability to Identify the Need of Job Analysis: If the objectives and needs of job analysis process are not
properly identified, the whole exercise of investigation and carrying out research is futile. Managers must decide
in advance why this process is being carried out, what its objectives are and what is to be done with the
collected and recorded data.

 Biasness of Job Analyst: A balanced and unbiased approach is a necessity while carrying out the process of job
analysis. To get real and genuine data, a job analyst must be impartial in his or her approach. If it can’t be
avoided, it is better to outsource the process or hire a professional job analyst.
  Using Single Data Source: A job analyst needs to consider more than one sources of data in order to collect true
information. Collecting data from a single source may result in inaccuracy and it therefore, defeats the whole
purpose of conducting the job analysis process.

However, this is not the end. There may be many other problems involved in a job analysis process such as insufficient
time and resources, distortion from incumbent, lack of proper communication, improper questionnaires and other
forms, absence of verification and review of job analysis process and lack of reward or recognition for providing genuine
and quality information.

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Authorship/Referencing - About the Author(s)

The article is Written By “Prachi Juneja” and Reviewed By Management Study Guide
Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts.
We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free
for learning and education purpose. Please reference authorship of content used, including link(s) to
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Search

Job Analysis & Design

 Job Analysis - Introduction

 Purpose of Job Analysis

 Job Analysis Process

 What to Collect during Job Analysis

 Job Analysis Methods

 Job Analysis Tools

 Job Analysis Problems

 Advantages and Disadvantages

 Job Analysis and Hiring Practices

 Job Analysis and Strategic HRM

 Job Analysis and TQM

 Job Description & Specification

 Purpose of Job Description

 Job Design

 Approaches to Job Design

 Issues in Job Design

 Factors affecting Job Design

 Job Redesign

 Job Analysis and Job Evaluation

 Job Evaluation & its Principles

 Job Classification

 Job Rotation

 Benefits of Job Rotation

 Tips for Successful Job Rotation

 Planning and Implementing Successful Job Rotation

  Disadvantages of Job Rotation

 Job Enrichment

 Job Enlargement

 Importance of Job Rotation, Enrichment and Enlargement in Career Growth

 How Smart Job Rotation Policies Can Enhance Organizational and Employee Effectiveness

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5. Advantages and Disadvantages of Job Analysis

Advantages and Disadvantages of Job Analysis

Though job analysis plays a vital role in all other human related activities but every process that has human interventions
also suffers from some limitations. The process of job analysis also has its own constraints. So, let us discuss the
advantages and disadvantages of job analysis process at length.

Advantages of Job Analysis

  Provides First Hand Job-Related Information: The job analysis process provides with valuable job-related data
that helps managers and job analyst the duties and responsibilities of a particular job, risks and hazards involved
in it, skills and abilities required to perform the job and other related info.

 Helps in Creating Right Job-Employee Fit: This is one of the most crucial management activities. Filling the right
person in a right job vacancy is a test of skills, understanding and competencies of HR managers. Job Analysis
helps them understand what type of employee will be suitable to deliver a specific job successfully.

 Helps in Establishing Effective Hiring Practices: Who is to be filled where and when? Who to target and how for
a specific job opening? Job analysis process gives answers to all these questions and helps managers in creating,
establishing and maintaining effective hiring practices.

 Guides through Performance Evaluation and Appraisal Processes: Job Analysis helps managers evaluating the
performance of employees by comparing the standard or desired output with delivered or actual output. On
these bases, they appraise their performances. The process helps in deciding whom to promote and when. It
also guides managers in understanding the skill gaps so that right person can be fit at that particular place in
order to get desired output.

 Helps in Analyzing Training & Development Needs: The process of job analysis gives answer to following
questions:

 Who to impart training

 When to impart training

 What should be the content of training

 What should be the type of training: behavioral or technical

 Who will conduct training

 Helps in Deciding Compensation Package for a Specific Job: A genuine and unbiased process of job analysis
helps managers in determining the appropriate compensation package and benefits and allowances for a
particular job. This is done on the basis of responsibilities and hazards involved in a job.

Disadvantages of Job Analysis

 Time Consuming: The biggest disadvantage of Job Analysis process is that it is very time consuming. It is a major
limitation especially when jobs change frequently.
  Involves Personal Biasness: If the observer or job analyst is an employee of the same organization, the process
may involve his or her personal likes and dislikes. This is a major hindrance in collecting genuine and accurate
data.

 Source of Data is Extremely Small: Because of small sample size, the source of collecting data is extremely small.
Therefore, information collected from few individuals needs to be standardized.

 Involves Lots of Human Efforts: The process involves lots of human efforts. As every job carries different
information and there is no set pattern, customized information is to be collected for different jobs. The process
needs to be conducted separately for collecting and recording job-related data.

 Job Analyst May Not Possess Appropriate Skills: If job analyst is not aware of the objective of job analysis
process or does not possess appropriate skills to conduct the process, it is a sheer wastage of company’s
resources. He or she needs to be trained in order to get authentic data.

 Mental Abilities Can not be Directly Observed: Last but not the least, mental abilities such as intellect,
emotional characteristics, knowledge, aptitude, psychic and endurance are intangible things that can not be
observed or measured directly. People act differently in different situations. Therefore, general standards can
not be set for mental abilities.

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Authorship/Referencing - About the Author(s)

 The article is Written By “Prachi Juneja” and Reviewed By Management Study Guide
Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts.
We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free
for learning and education purpose. Please reference authorship of content used, including link(s) to
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Search

Job Analysis & Design

 Job Analysis - Introduction

 Purpose of Job Analysis

 Job Analysis Process

 What to Collect during Job Analysis

 Job Analysis Methods

 Job Analysis Tools

 Job Analysis Problems

 Advantages and Disadvantages

 Job Analysis and Hiring Practices

 Job Analysis and Strategic HRM

 Job Analysis and TQM

 Job Description & Specification

 Purpose of Job Description

 Job Design

 Approaches to Job Design

 Issues in Job Design

 Factors affecting Job Design

 Job Redesign

 Job Analysis and Job Evaluation

  Job Evaluation & its Principles

 Job Classification

 Job Rotation

 Benefits of Job Rotation

 Tips for Successful Job Rotation

 Planning and Implementing Successful Job Rotation

 Disadvantages of Job Rotation

 Job Enrichment

 Job Enlargement

 Importance of Job Rotation, Enrichment and Enlargement in Career Growth

 How Smart Job Rotation Policies Can Enhance Organizational and Employee Effectiveness

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5. Role of Job Analysis in Establishing Effective Hiring Practices

Role of Job Analysis in Establishing Effective Hiring Practices

A major change has been observed in the world of work since 1980s. The era of structured jobs, packed or fixed work
schedules, male-dominated working culture and no family intruding started diminishing gradually.

Companies and employees around the world faced dramatic effects of modernization, flexibility in work schedules, job
sharing, work from home options and employee-supportive policies, etc. All thanks to the then managers who analyzed
the importance of fitting an individual at a job he or she excelled at to increase the company turnover, employee
satisfaction and achieve a professional-personal life balance. And all this was possible by analyzing the worth of a
specific job and collecting genuine job-related data.

A proper job analysis, hence, may prove to be a turning point for an organization. It not only creates the right job-
candidate fit but also enhance the success of management practices, which in turn, lays the foundation for a strong
organization.
A step-by-step process of discovering the different aspects of a job results in a proper regulation of incoming and
outgoing of the talent or human resource. Job Analysis thus, started gaining popularity in early 1990s in order to create
competitive advantage and has been considered as the basis for other HRM practices since then.

The data collected during the process helps managers in identifying the risks and challenges involved in a specific job
and kind of person suitable for delivering the desired duties perfectly. An employer’s recruitment and selection process
purely depends on job analysis. Until the recruiting managers do not know about job to be performed, expectations
from prospective candidate and the right individual profile required for performing a specific job, it is almost impossible
to source or target talent or human resource in order to fill the vacancy.

Job analysis process helps in establishing effective hiring practices and guides managers in identifying the selection
criteria required to deliver the expected output. Let’s discuss how.

How to Establish Effective Hiring Strategies ?

 Identifying KRAs: Job Analysis process helps in identifying Key Result Areas/Key Responsibilities Areas (KRAs)
such as knowledge, technical, communication and personal skills, mental, aptitude, physical and emotional
abilities to perform a particular task.

Different jobs have different requirements. Therefore, the process needs to be performed every time when there is a
requirement to fill the job opening. This is a basis for developing questionnaires, devising interview questions and
setting selection test papers. The information in the form of scores or grades can then be used for hiring process.

 Setting Selection Standards: Job Analysis also helps managers in setting certain standards for selection process
in terms of educational qualifications, work experience, expertise, special skill sets, unusual sensory abilities,
specific career track, certifications and licenses and other legal requirements. This helps in identifying the basic
requirements that make a candidate eligible for a particular post.

 Identifying KSAs: The process also helps managers in determining Key Success Areas or Key Performance Areas.
These are performance measurement tools that are used by companies around the world to measure those
aspects that determine success of a job such as organizational goals, individual goals and the actions required to
achieve these goals. This is about comparing the actual results delivered by an individual with pre-set success
factors and analyzing the performance. Once through, the whole process may require few changes if achieved
results are around the set standards. They may require a complete change if there is a huge gap between the
expected and delivered results.
Therefore, a thorough and unbiased job analysis process can help organizations source right candidates, hire the most
suitable individual and set appropriate selection standards.

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Authorship/Referencing - About the Author(s)

The article is Written By “Prachi Juneja” and Reviewed By Management Study Guide
Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts.
We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free
for learning and education purpose. Please reference authorship of content used, including link(s) to
ManagementStudyGuide.com and the content page url.
 Search

Job Analysis & Design

 Job Analysis - Introduction

 Purpose of Job Analysis

 Job Analysis Process

 What to Collect during Job Analysis

 Job Analysis Methods

 Job Analysis Tools

 Job Analysis Problems

 Advantages and Disadvantages

 Job Analysis and Hiring Practices

 Job Analysis and Strategic HRM

 Job Analysis and TQM

 Job Description & Specification

 Purpose of Job Description

 Job Design

 Approaches to Job Design

 Issues in Job Design

 Factors affecting Job Design

 Job Redesign

 Job Analysis and Job Evaluation

 Job Evaluation & its Principles

 Job Classification

 Job Rotation

 Benefits of Job Rotation

 Tips for Successful Job Rotation

 Planning and Implementing Successful Job Rotation

 Disadvantages of Job Rotation

 Job Enrichment

 Job Enlargement
  Importance of Job Rotation, Enrichment and Enlargement in Career Growth

 How Smart Job Rotation Policies Can Enhance Organizational and Employee Effectiveness

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5. Job Analysis and Strategic HRM

Job Analysis and Strategic HRM

Human Resource Management is the most critical function of any organization as it deals with the most complicated
problems - the people problems, especially when the organizations are operating in highly competitive and uncertain
environments. Strategic HRM lays emphasis on developing and implementing policies and strategies in order to get the
desired output. Therefore, job analysis and strategic HRM are inter-related. In fact, we can say, establishing a person-
job-environment fit is the basic function of SHRM.

Person-Job-Environment Fit

Job analysis demonstrates who can fit at a particular place and why. The process promotes the alignment of other HR
processes and functions. Additionally, it supports the organizational strategy to deal with talent crisis and market
competition. The process of job analysis involves collecting job-related information and assembling it together to design
a corporate strategy that helps HR managers in determining whom to target and how to fill a particular job vacancy.

It also creates linkages between other HR verticals including recruitment and selection, training needs analysis,
performance evaluation and appraisal, entry and exit of talent and many more. Strategic Human Resource Management
endeavors to connect all these HR functions with organizational goals, work quality, organizational culture, annual
turnover and profit and tapping resources for future organizational needs.

SHRM is basically concerned with the strength, weakness, opportunities and threats of an organization. The
identification of organization’s competencies and flaws is extremely crucial for its success. It provides a clear vision to
managers to source, recruit and retain people, develop their skills and competency, address their issues and concerns,
motivate people to produce desired output and ensure future planning.

Inter-relationship between Job Analysis and SHRM

Job Analysis, being an integral part of strategic planning, provides a detailed analysis of tasks and responsibilities, risks
and hazards, functions and duties, tools and equipments to be used and the expected output. The main objective of
conducting the process is to understand who to fit at a particular place to get the work done. Whereas, the fundamental
aim of Strategic Human Resource Management is to determine how to exploit human capital to achieve organizational
goals.
Job Analysis deals in determining the training needs analysis of employees to get the desired output whereas SHRM
decides upon the training content, when and how to train the employees to increase the output to achieve higher
business profits. To successfully plan the future strategies of a company, the process of job analysis serves as the basis. If
information collected during the process is genuine, managers can make effective strategies and policies in advance and
can remain pro-active to deal with unforeseen situations.

The main aim of conducting job analysis process is to determine the things affecting human behaviour in an
organization. The idea is to find out if they are competent enough to perform the assigned job successfully or they need
to be placed somewhere else. Strategic Human Resource Management is all about making strategies and policies to
place right person at the right place and at the right time to get the maximum out of an employee. In other way, it is
concerned about optimal utilization of human resources.

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Authorship/Referencing - About the Author(s)

 The article is Written By “Prachi Juneja” and Reviewed By Management Study Guide
Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts.
We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free
for learning and education purpose. Please reference authorship of content used, including link(s) to
ManagementStudyGuide.com and the content page url.

Search

Job Analysis & Design

 Job Analysis - Introduction

 Purpose of Job Analysis

 Job Analysis Process

 What to Collect during Job Analysis

 Job Analysis Methods

 Job Analysis Tools

 Job Analysis Problems

 Advantages and Disadvantages

 Job Analysis and Hiring Practices

 Job Analysis and Strategic HRM

 Job Analysis and TQM

 Job Description & Specification

 Purpose of Job Description

 Job Design

 Approaches to Job Design

 Issues in Job Design

 Factors affecting Job Design

 Job Redesign

 Job Analysis and Job Evaluation

  Job Evaluation & its Principles

 Job Classification

 Job Rotation

 Benefits of Job Rotation

 Tips for Successful Job Rotation

 Planning and Implementing Successful Job Rotation

 Disadvantages of Job Rotation

 Job Enrichment

 Job Enlargement

 Importance of Job Rotation, Enrichment and Enlargement in Career Growth

 How Smart Job Rotation Policies Can Enhance Organizational and Employee Effectiveness

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5. Job Analysis and Total Quality Management (TQM)

Job Analysis and Total Quality Management (TQM)

TQM is a management approach that concentrates on teamwork, integrity, continuous improvement and continuous
assessment jobs and their worth. On the other hand, job analysis deals in investigating each job separately and
collecting the job-related information. Usually, the process is conducted in an organization once in a while especially
when HR department has to source candidates for a particular job. TQM is a new approach and is almost inconsistent
with traditional management approaches and processes. Job Analysis is no exception.

Points of Inconsistency between Job Analysis and TQM

The concept of Total Quality Management stresses on continuous improvement of management processes as well as
employees. For example, if employee joins an organization at a certain level, according to TQM, he or she should not
confine themselves to their basic jobs only. Instead they should consider other options and try to learn more and more
in order to explore other areas of operations. Whereas, job analysis process is conducted to determine what an
employee is supposed to do and how specific duties and activities need to be performed.
Total Quality Management approach focuses on an all-round development of employees and expects them to do
everything while on job in order to attain higher levels of quality. It also concentrates on their continuous
improvement personally as well as professionally. While job analysis defines specific duties and responsibilities of an
employee and each one of them is supposed to do only what is assigned to them. The concept is just opposite to TQM
approach.

The job description and job specification talk about employee’s job title, job summary, job duties, job responsibilities,
educational qualifications and working conditions. While it does not discuss about maintaining quality in operations,
treating waste and scraps properly and quality of services delivered. It simply gives brief details about what an employee
needs to do and how. Though it deals in assessing a job but has nothing to do with improving quality in operations.

TQM does not confine employees only to a particular job. The concept leaves scope for additional duties along with the
basic job duties. Whereas, it is not true in case of job analysis. It simply measures the worth of a job and determines the
duties involved in it. Employees are not encouraged to explore other areas of operations. Instead they are supposed to
perform only the assigned job.

Relevance of Job Analysis

Job Analysis is not consistent with TQM. They do not go hand in hand as they focus on entirely different theories and
operate on different models. But it does not mean that job analysis has lost its relevance in today’s world. It has its own
importance and is still required to be carried out as this gives basic information related to specific jobs and helps
managers in decision making process.

It assists in various other management processes including recruitment and selection, job evaluation, performance
evaluation and appraisal and training and development need analysis. It also regulates the entry of talent in an
organization and helps in sourcing and attracting a pool of talent to work with the organization.

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Authorship/Referencing - About the Author(s)

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Job Analysis & Design

 Job Analysis - Introduction

 Purpose of Job Analysis

 Job Analysis Process

 What to Collect during Job Analysis

 Job Analysis Methods

 Job Analysis Tools

 Job Analysis Problems

 Advantages and Disadvantages

 Job Analysis and Hiring Practices

 Job Analysis and Strategic HRM

 Job Analysis and TQM

 Job Description & Specification

 Purpose of Job Description

 Job Design

 Approaches to Job Design

  Issues in Job Design

 Factors affecting Job Design

 Job Redesign

 Job Analysis and Job Evaluation

 Job Evaluation & its Principles

 Job Classification

 Job Rotation

 Benefits of Job Rotation

 Tips for Successful Job Rotation

 Planning and Implementing Successful Job Rotation

 Disadvantages of Job Rotation

 Job Enrichment

 Job Enlargement

 Importance of Job Rotation, Enrichment and Enlargement in Career Growth

 How Smart Job Rotation Policies Can Enhance Organizational and Employee Effectiveness

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5. Job Description and Job Specification

Job Description and Job Specification

Job Analysis is a primary tool to collect job-related data. The process results in collecting and recording two data sets
including job description and job specification. Any job vacancy can not be filled until and unless HR manager has these
two sets of data. It is necessary to define them accurately in order to fit the right person at the right place and at the
right time. This helps both employer and employee understand what exactly needs to be delivered and how.

Both job description and job specification are essential parts of job analysis information. Writing them clearly and
accurately helps organization and workers cope with many challenges while onboard.
Though preparing job description and job specification are not legal requirements yet play a vital role in getting the
desired outcome. These data sets help in determining the necessity, worth and scope of a specific job.

Job Description

Job description includes basic job-related data that is useful to advertise a specific job and attract a pool of talent. It
includes information such as job title, job location, reporting to and of employees, job summary, nature and objectives
of a job, tasks and duties to be performed, working conditions, machines, tools and equipments to be used by a
prospective worker and hazards involved in it.

Purpose of Job Description

 The main purpose of job description is to collect job-related data in order to advertise for a particular job. It
helps in attracting, targeting, recruiting and selecting the right candidate for the right job.

 It is done to determine what needs to be delivered in a particular job. It clarifies what employees are supposed
to do if selected for that particular job opening.

 It gives recruiting staff a clear view what kind of candidate is required by a particular department or division to
perform a specific task or job.

 It also clarifies who will report to whom.

Job Specification

Also known as employee specifications, a job specification is a written statement of educational qualifications, specific
qualities, level of experience, physical, emotional, technical and communication skills required to perform a job,
responsibilities involved in a job and other unusual sensory demands. It also includes general health, mental health,
intelligence, aptitude, memory, judgment, leadership skills, emotional ability, adaptability, flexibility, values and ethics,
manners and creativity, etc.

Purpose of Job Specification

 Described on the basis of job description, job specification helps candidates analyze whether are eligible to
apply for a particular job vacancy or not.
  It helps recruiting team of an organization understand what level of qualifications, qualities and set of
characteristics should be present in a candidate to make him or her eligible for the job opening.

 Job Specification gives detailed information about any job including job responsibilities, desired technical and
physical skills, conversational ability and much more.

 It helps in selecting the most appropriate candidate for a particular job.

Job description and job specification are two integral parts of job analysis. They define a job fully and guide both
employer and employee on how to go about the whole process of recruitment and selection. Both data sets are
extremely relevant for creating a right fit between job and talent, evaluate performance and analyze training needs and
measuring the worth of a particular job.

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 Job Analysis and TQM

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 Job Design

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Authorship/Referencing - About the Author(s)

The article is Written By “Prachi Juneja” and Reviewed By Management Study Guide
Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts.
We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free
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Job Analysis & Design

 Job Analysis - Introduction

 Purpose of Job Analysis

 Job Analysis Process

 What to Collect during Job Analysis

 Job Analysis Methods

 Job Analysis Tools

 Job Analysis Problems

 Advantages and Disadvantages

 Job Analysis and Hiring Practices

 Job Analysis and Strategic HRM

 Job Analysis and TQM

 Job Description & Specification

 Purpose of Job Description

 Job Design

 Approaches to Job Design

 Issues in Job Design

 Factors affecting Job Design

 Job Redesign

 Job Analysis and Job Evaluation

 Job Evaluation & its Principles

 Job Classification

 Job Rotation

 Benefits of Job Rotation

 Tips for Successful Job Rotation

 Planning and Implementing Successful Job Rotation

 Disadvantages of Job Rotation

 Job Enrichment

 Job Enlargement

 Importance of Job Rotation, Enrichment and Enlargement in Career Growth

 How Smart Job Rotation Policies Can Enhance Organizational and Employee Effectiveness

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5. General and Specific Purpose of Job Description

General and Specific Purpose of Job Description

Job description is all about collecting and recording basic job-related data that includes job title, job location, job
summary, job duties, reporting information, working conditions, tools, machines and equipments to be used and
hazards and risks involved in it. A job description may or may not have specific purpose. It depends on what HR
managers want to determine and what is the objective of conducting the process of job analysis.

Job Description is a summary of job analysis findings that helps managers determine what an employee is supposed to
do when onboard. The purpose of job description depends on the level of details the job findings include. Job
description carried for general purpose typically involves job identification (title, designation, location) and a statement
of duties and functions of a prospective or existing employee. A specifically carried job description includes detailed
information about the kind of job, how it is supposed to be performed and what is expected to be delivered. Let’s
discuss the general and specific purpose of conducting a job description process.

General Purpose of Job Description

General purpose job descriptions are used by organizations to find the very basic information about a particular job
opening. Though data includes worker’s duties but does not contain sub tasks, performance standards and basis for
evaluating jobs and establishing right compensation packages.

Advantages

The main benefit of general purpose job description is that it does not consume much time and quickly provides basic
information to managers. It does not require much human efforts and is very easy and convenient to carry out.
Additionally, a job analyst does not have to conduct deep research to gather the required details.

Disadvantages

The main disadvantage of general purpose job description is that it does not provide managers with full-fledged
information about job context and sub tasks. Sometimes, a manager may fail to extract correct information from such
small amount of data.

Specific Purpose of Job Description

Specific purpose job description includes detailed information about job responsibilities of an employee. It also covers
sub tasks, essential functions and detailed job duties. It involves huge amount of details such as what an employee
needs to do, how it is to be done and what are the performance standards, etc.

Advantages

The main benefit of specific purpose job description is that it offers ample information to evaluate job performance and
determine training needs of employees. It serves as a basis for all other HR processes including recruitment and
selection, performance appraisal, compensation decision and many more.

Disadvantages

Though it assists managers in decision making process but it has its own limitations. The process, however, may take
very long and consume lots of human efforts. Since, it involves collecting detailed information; the biased nature of job
analyst can cause severe problems. The data collected may not be 100 percent genuine.

Therefore, it can be said that information collected during job analysis defines the purpose of job description. If data
collected is extremely basic, it will serve only the general purpose and therefore, can not be used for making
management decisions. On the other hand, detailed data serves the specific purpose and can be easily used while
making important decisions.

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Authorship/Referencing - About the Author(s)

 The article is Written By “Prachi Juneja” and Reviewed By Management Study Guide
Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts.
We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free
for learning and education purpose. Please reference authorship of content used, including link(s) to
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Search

Job Analysis & Design

 Job Analysis - Introduction

 Purpose of Job Analysis

 Job Analysis Process

 What to Collect during Job Analysis

 Job Analysis Methods

 Job Analysis Tools

 Job Analysis Problems

 Advantages and Disadvantages

 Job Analysis and Hiring Practices

 Job Analysis and Strategic HRM

 Job Analysis and TQM

 Job Description & Specification

 Purpose of Job Description

 Job Design

 Approaches to Job Design

 Issues in Job Design

 Factors affecting Job Design

 Job Redesign

 Job Analysis and Job Evaluation

  Job Evaluation & its Principles

 Job Classification

 Job Rotation

 Benefits of Job Rotation

 Tips for Successful Job Rotation

 Planning and Implementing Successful Job Rotation

 Disadvantages of Job Rotation

 Job Enrichment

 Job Enlargement

 Importance of Job Rotation, Enrichment and Enlargement in Career Growth

 How Smart Job Rotation Policies Can Enhance Organizational and Employee Effectiveness

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5. Job Design - Meaning, Steps and its Benefits

Job Design - Meaning, Steps and its Benefits

Job design follows job analysis i.e. it is the next step after job analysis. It aims at outlining and organising tasks, duties
and responsibilities into a single unit of work for the achievement of certain objectives. It also outlines the methods and
relationships that are essential for the success of a certain job. In simpler terms it refers to the what, how much, how
many and the order of the tasks for a job/s.

Job design essentially involves integrating job responsibilities or content and certain qualifications that are required to
perform the same. It outlines the job responsibilities very clearly and also helps in attracting the right candidates to the
right job. Further it also makes the job look interesting and specialised.

There are various steps involved in job design that follow a logical sequence, those that were mentioned earlier on.
The sequence is as follows:

1. What tasks are required to e done or what tasks is part of the job?

2. How are the tasks performed?

 3. What amount are tasks are required to be done?

4. What is the sequence of performing these tasks?

All these questions are aimed at arriving upon a clear definition of a specific job and thereby make it less risky for the
one performing the same. A well defined job encourages feeling of achievement among the employees and a sense of
high self esteem.

The whole process of job design is aimed to address various problems within the organisational setup, those that pertain
to ones description of a job and the associated relationships. More specifically the following areas are fine tuned:

 Checking the work overload.

 Checking upon the work under load.

 Ensuring tasks are not repetitive in nature.

 Ensuring that employees don not remain isolated.

 Defining working hours clearly.

 Defining the work processes clearly.

The above mentioned are factors that if not taken care of result into building stress within the employees.

Benefits of Job Design

The following are the benefits of a good job design:

1. Employee Input: A good job design enables a good job feedback. Employees have the option to vary tasks as per
their personal and social needs, habits and circumstances in the workplace.

2. Employee Training: Training is an integral part of job design. Contrary to the philosophy of “leave them alone’
job design lays due emphasis on training people so that are well aware of what their job demands and how it is
to be done.

3. Work / Rest Schedules: Job design offers good work and rest schedule by clearly defining the number of hours
an individual has to spend in his/her job.

4. Adjustments: A good job designs allows for adjustments for physically demanding jobs by minimising the energy
spent doing the job and by aligning the manpower requirements for the same.

Job design is a continuous and ever evolving process that is aimed at helping employees make adjustments with the
changes in the workplace. The end goal is reducing dissatisfaction, enhancing motivation and employee engagement at
the workplace.

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Authorship/Referencing - About the Author(s)

The article is Written By “Prachi Juneja” and Reviewed By Management Study Guide
Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts.
We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free
for learning and education purpose. Please reference authorship of content used, including link(s) to
ManagementStudyGuide.com and the content page url.

Search

Job Analysis & Design

 Job Analysis - Introduction

 Purpose of Job Analysis

 Job Analysis Process

 What to Collect during Job Analysis

 Job Analysis Methods

 Job Analysis Tools

 Job Analysis Problems

 Advantages and Disadvantages

 Job Analysis and Hiring Practices

 Job Analysis and Strategic HRM

 Job Analysis and TQM

 Job Description & Specification

 Purpose of Job Description

 Job Design

 Approaches to Job Design

 Issues in Job Design

 Factors affecting Job Design

 Job Redesign

 Job Analysis and Job Evaluation

 Job Evaluation & its Principles

 Job Classification

 Job Rotation

 Benefits of Job Rotation

 Tips for Successful Job Rotation

 Planning and Implementing Successful Job Rotation

 Disadvantages of Job Rotation

 Job Enrichment

 Job Enlargement

 Importance of Job Rotation, Enrichment and Enlargement in Career Growth

 How Smart Job Rotation Policies Can Enhance Organizational and Employee Effectiveness

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 4. Job Analysis & Design

5. Approaches to Job Design

Approaches to Job Design

Job design is the next step after job analysis that aims at outlining, and organizing tasks and responsibilities associated
with a certain job. It integrates job responsibilities and qualifications or skills that are required to perform the same.
There are various methods or approaches to do this. The important ones are discussed below

Human Approach

The human approach of job design laid emphasis on designing a job around the people or employees and not around the
organizational processes. In other words it recognizes the need of designing jobs that are rewarding (financially and
otherwise) and interesting at the same time.

According to this approach jobs should gratify an individual’s need for recognition, respect, growth and responsibility.
Job enrichment as popularized by Herzberg’s research is one the ways in human approach of job design. Herzberg
classified these factors into two categories - the hygiene factors and the motivators.

Motivators include factors like achievement, work nature, responsibility, learning and growth etc that can motivate an
individual to perform better at the work place.

Hygiene factor on the other hand include things like working conditions, organizational policies, salary etc that may not
motivate directly but the absence of which can lead to dissatisfaction at the work place.

Engineering Approach

The engineering approach was devised by FW Taylors et al. They introduced the idea of the task that gained prominence
in due course of time. According to this approach the work or task of each employee is planned by the management a
day in advance. The instructions for the same are sent to each employee describing the tasks to e undertaken in detail.
The details include things like what, how and when of the task along with the time deadlines.

The approach is based on the application of scientific principles to job design. Work, according to this approach should
be scientifically analyzed and fragmented into logical tasks. Due emphasis is then laid on organizing the tasks so that a
certain logical sequence is followed for efficient execution of the same. The approach also lays due emphasis on
compensating employees appropriately and training them continuously for work efficiency.

The Job Characteristics Approach

The job characteristics approach was popularized by Hackman and Oldham. According to this approach there is a direct
relationship between job satisfaction and rewards. They said that employees will be their productive best and
committed when they are rewarded appropriately for their work. They laid down five core dimensions that can be used
to describe any job - skill variety, task identity, task significance, autonomy and feedback.

 Skill variety: The employees must be able to utilize all their skills and develop new skills while dealing with a job.

 Task Identity: The extent to which an identifiable task or piece or work is required to be done for completion of
the job.

 Task Significance: How important is the job to the other people, what impact does it create on their lives?

 Autonomy: Does the job offer freedom and independence to the individual performing the same.

 Feedback: Is feedback necessary for improving performance.

These are different approaches but all of them point to more or less the same factors that need to be taken into
consideration like interest, efficiency, productivity, motivation etc. All these are crucial to effective job design.

The 3 Job Analysis Methods Every HR Professional Needs To Know

17 January

by Martina Markovska

6 minute read

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Job analysis in human resource management (HRM) refers to the process of identifying and determining the duties,
responsibilities, and specifications of a given job. It encompasses the collection of data required to put together a job
description that will attract the right person to fill in the role. Job analysis in HRM helps establish the level of experience,
qualifications, skills and knowledge needed to perform a job successfully.

Now, there are obviously a vast number of different techniques that facilitate the job analysis process that HR can use to
ensure an employee is performing at their best (or if they are fit for the role at all).
However, we can really boil these down to 3 job analysis methods that every HR professional needs to know.

Job Analysis Method: Interview

With this job analysis method, job analysts conduct interviews with incumbents to collect information about their tasks
and how they are coping with them. Interviews can be structured and unstructured depending on your corporate
culture.

Structured interviews follow a systematic approach where employees are interviewed accurately and consistently,
following a preset format. In a structured interview, you typically see that:

 All interviewees are asked the same questions in the same order.

 Interviewers record, compare and evaluate answers against standardized criteria.

 The interview process remains the same even if the interviewer changes.

Thanks to this consistency, structured interviews have a high level of reliability and validity.

Unstructured interviews, on the other hand, unravel without a preset structure. The interview process is carried out as a
conversation with no specific questions predefined. Nevertheless, the interviewer should make the purpose and focus of
the interview clear to the employees. Namely, that the purpose of the interview is to understand their job role better in
order to improve or modify their role. In an unstructured interview, you typically see that:

 Interviewees may receive different questions or the same questions may be asked in a different order.

 Interviewers don’t always use standardized criteria for recording, comparing and evaluating answers.

 The interview process varies depending on the interviewer.

Using interviews as the only job analysis method has several drawbacks, too. One disadvantage of using the interview
job analysis method is that employees may exaggerate or omit vital details. To overcome this possible issue, HR
professionals and job analysts should interview more than one employee in the same position (if applicable). This will
provide more reliable results and data for the job analysts and HR professionals to work with.

Think of this as a scientific study where you need a larger pool of clients to make the results solid. You can't determine
how a role works with only one person's opinion - you need a larger sample size to see what is the same and different
across the board.

Job Analysis Method: Questionnaires

As the name suggests, the questionnaire job analysis method requires employees, supervisors, and managers to fill out
forms, namely questionnaires. It’s one of the most widely used job analysis methods because it’s inexpensive to create
and easy to distribute to numerous individuals at a faster rate. Questionnaires can have different question forms, such
as open-ended questions, multiple choice, checklists or a mix of all of them.
Questionnaires used for job analysis collect data about all aspects that influence how a job is completed, including both
internal and external factors. These are the most common areas that questionnaires focus on:

 Knowledge, skills, experience, and qualifications

 Duties performed daily

 Duties performed less frequently

 Equipment and materials used for duties

 Time spent on different job duties

 Physical and emotional input

 Level of job satisfaction

 Salary and compensation

 Work conditions

 Additional comments

Although questionnaires help begin the job analysis process, they are not enough to collect data that is both reliable and
useful. They merely scratch the surface of job analysis. In fact, questionnaires do have several disadvantages, such as
question misinterpretation, high non-response rates and inaccurate information given by participants. And inaccurate
data is the complete opposite of what job analysts aim for.
Going back to the scientific example. Questionnaires create that larger sample size but do so in a way that is less
authentic and, therefore, less impactful.

It’s important that job analysis in HRM yields reliable information. Therefore, it’s best to combine questionnaires with
other job analysis methods. This will help job analysts retain and improve work conditions for current incumbents, as
well as create a job description that will attract the right talent for future openings.

Job Analysis Method: Observation

The observation method enables job analysts to observe employees in their daily routines. The information collected
through observation is extremely useful and reliable since it’s via first-hand knowledge. Observation is the only job
analysis method that allows the job analyst or HR professional to directly obtain the data, whereas other job analysis
methods collect data indirectly and in an orchestrated environment.

When using this particular method, a job analyst observes an employee and records what they do and do not do. This
helps job analysts and HR professionals reach a more reliable conclusion. However, even the observation method comes
with flaws. Some of the disadvantages of using the observation job analysis method include:

 Distortion of information if an employee is aware of the observation.

 Awareness may affect the work output during the observation.

 Not all job duties and reactions can be observed in the set time frame.

 Higher managerial and executive roles may be difficult to observe fully.

So, in other words, this process allows the analyst to create a wide-reaching sample pool while also understanding the
factors at work when observing employees. It stands to reason that an employee will work harder when they know they
are being analyzed - though it still gives the analyst a good framework to judge how well the role is being performed.

What Is the Purpose of Job Analysis in HRM?

Job analysis plays a significant part in the structure of HR departments. The job analysis process identifies the need for
talent and recognizes the type of talent needed to fill it. Apart from assisting the preparations of a succinct job
description, the purpose of job analysis in HRM extends to other areas in the HR department. Here are some of the main
purposes of job analysis in HRM:

 Job designing and redesigning – By frequently using these three job analysis methods, HR managers, and job
analysts can work to improve job specifications, increase professional output and incite company growth.

 Human resource recruitment and selection – Job analysis defines the type of person that is needed for a
particular position. Job analysis data highlights the level of education, qualifications, experience, and skills that
need to be held by ideal candidates. Additionally, job analysis helps develop advertisements, salary levels,
interview questions, selection tests, evaluation forms, and orientation materials for new recruits.

 Determining training needs – Job analysis processes help HR professional develop adequate training
procedures. Job analysis can determine training content, assessment tests, training equipment and methods of
training.

 Establishing a compensation management policy – A well-defined compensation management policy helps

organizations retain, motivate and guide current talent, while also attracting new talent. Job analysis processes
 aid HR professionals to develop an effective compensation management policy that focuses on elements such as
pay scale, bonus and incentive plans, work environment and restructuring positions as needed.

 Conducting performance reviews – Using data from the job analysis process is necessary for when HR
professionals carry out performance reviews. Job analysis clearly defines the objectives of a job and sets scalable
goals for employees that reflect their performance.

Job analysis in HRM takes a lot of planning, structuring and analysis. However, the job analysis process is vital to the
growth and success of an organization. Without the proper use of job analysis methods, HR professionals would have
little to no success in talent acquisition and filling in the gaps within an organization.

When choosing the best job analysis method for your organization, you must consider all the efforts, costs, time and
risks that go into job analysis. You may even need to combine two or more job analysis methods for maximum
efficiency. Plan your job analysis process with the help of experienced HR professionals and job analysts to ensure
reliable and valid data.

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Job Analysis: Definition, Process & Methods

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Job Analysis
Job Analysis in layman’s language means the procedure of gathering information about a job. This process
involves two sets of information:
1. Job Description
2. Job Specification
Before going into these two sets let us talk about a few definitions of Job Analysis.
 Job Analysis is a method of collecting and studying about the information related to a particular job. It
includes the operations and tasks of a specific job.
 Another meaning of Job analysis is a complete examination of activities in a job. It can be considered a
technical procedure that can be used to classify the duties and responsibilities of a job.
 It can also be defined as a group of tasks which can be performed by a lone employee towards the
production of some services or products of an organization.
If we take it in a specific manner, Job Analysis involves the below steps:
→ Recording and collecting the information related to a job.
→ To check the accuracy of the job information.
→ Note down the Job Description as per the data gathered.
→ Use the data to determine the skills and knowledge that is required for a particular job.
→ Updating the gathered information from time to time.
As mentioned earlier Job Analysis is classified into two parts, Let us now discuss these two important parts:
(a). Job Description: This is a very vital document which is usually explanatory in nature. It consists of both
organizational as well as functional information. It provides information as to the scope of activities, position of
the job and the responsibilities. It gives the employees a very clear picture of what is required of him to meet the
goals of his job. A good Job Description must consist of the following:
(i). It should include the nature and scope of the job along with accountability.
(ii). A good Job Description should be lucid about the position, responsibilities and duties.
(iii). The complexity of the job.
(iv). The amount of skills required for that particular job.
(v). How far are the problems consistent?
(vi). The level of responsibility the worker has for each stage of work.
∗ Contents of Job Description
Usually the Job Description consists of the following:
→ Job classification: This includes title of the job, alternate title if any, job code, division or department etc.
The title of the job designates the job properly and division or department indicates which department and
location does the employee work.
→ Job Summary: It serves two purposes here; one is that when the Job Title is not sufficient it gives additional
information on the job. Secondly it gives more descriptive information about the particular job.
→ Duties and Responsibilities: This lists out the entire duties and responsibilities of a particular job.
Sometimes duties and responsibilities are also listed for particular skills and their incidence of occurrence.
→ Relation to other jobs: This gives the employees a fair amount of picture as to the hierarchy of the position.
Like to whom they are reporting: senior, junior, etc.
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(b). Job Specification: Job Specification converts the job description to qualifications that are required for, in
performing the job. This is usually a statement which consists of qualification, characteristics, traits etc, for an
employee to possess to perform his duties. The first thing here is to prepare a directory of all jobs and then the
next step is to make a write up of each and every job.
∗ Contents of Job Specification
The following are the contents of Job Specification:
→ Physical Qualifications: These qualifications or specifications vary from job to job. Physical Qualifications
are nothing but the capabilities of employees. These include height, weight, hearing, vision, capacity to handle
machines etc.
→ Mental Qualifications: This includes the ability to interpret data, calculations, planning, general knowledge,
judgement, memory etc.
→ Social and Emotional specifications: This is vital for the role of Managers and Supervisors. It includes
emotional constancy and elasticity. It also includes the way they dress, personality and relationship.
→ Behavioral Qualifications: This qualification is very important in selecting employees for higher levels of
management. This specification asks to depict the acts of the managers rather than traits which cause those acts.
This includes creativity, research, maturity level, dominance etc.

Methods of Job Analysis

The most general Job Analysis methods are discussed below:
1. Observation Method: In this method the job analyst observes the employees work and records all the tasks
that are performed and also those that are not performed. This may seem to be an easy method of job analysis,
but it is the most difficult one. The main reason being that every person has a different way of observing things,
which might involve personal bias, likes and dislikes which will not give the desired results.
2. Interview Method: In this method the manpower is interviewed. The employee under this method comes up
with different ideas towards their working style, problems faced by them and uncertainties or insecurities faced
by them. It helps the organization in knowing exactly what the employees are thinking about their jobs. This
helps in minimizing errors as not only one employee is interviewed, but everyone in the organization is
interviewed.
3. Questionnaire Method: This is another common method of Job Analysis, which uses a questionnaire to be
filled by the employees. Care should be taken while framing questions for this, because this method also suffers
from bias by the superiors. It is always better if the staff is communicated in a better way to make them
understand that the data collected is for their own good. Here different types of questionnaires are prepared for
different grades which is also time consuming.
Job analysis information can be gathered in a variety of ways. One consideration is who is to conduct the job analysis. M
this effort. Depending on which of the methods discussed next is used, others who often participate are managers, superv
complex analyses, industrial engineers may conduct time and motion studies.

Another consideration is the method to be used. Common methods are observations, interviews, questionnaires, and spec
approaches frequently are used, depending on the situation and the organization. Each of these methods is discussed in s

Observation

When the observation method is used, a manager, job analyst, or industrial engineer observes the individual performing
performed. Observation may be continuous or based on intermittent sampling.

Use of the observation method is limited because many jobs do not have complete and easily observed job duties or com
useful for repetitive jobs and in conjunction with other methods. Managers or job analysts using other methods may watc
familiarity with the job and the conditions under which it is performed. Multiple observations on several occasions also
methods more effectively.

WORK SAMPLING

As a type of observation, work sampling does not require attention to each detailed action throughout an entire work cyc
pace of a typical workday through statistical sampling of certain actions rather than through continuous observation and
useful for routine and repetitive jobs.

EMPLOYEE DIARY/LOG

Another method requires that employees “observe” their own performances by keeping a diary/log of their job duties, no
required for each duty. Although this approach sometimes generates useful information, it may be burdensome for emplo
sometimes perceive this approach as creating needless documentation that detracts from the performance of their work.

Interviewing

The interview method of gathering information requires that a manager or HR specialist visit each job site and talk with
interview form is used most often to record the information. Frequently, both the employee and the employee’s supervis
understanding of the job.
Some typical interview questions include:
 What is the job being performed?
 What are the major duties of your job position? What exactly do you do?
 What physical locations do you work in?
 What are the education, experience, skill, and [where applicable] certification and
  licensing requirements?
 In what activities do you participate?
 What are the job’s responsibilities and duties?
 What are the basic accountabilities or performance standards that typify your work?
 What are your responsibilities? What are the environmental and working conditions
 involved?
 What are the job’s physical demands? The emotional and mental demands?
 What are the health and safety conditions?
 Are you exposed to any hazards or unusual working conditions?
The interview method can be quite time consuming, especially if the interviewer talks with two or three employees doin
more complicated to analyze and usually require longer interviews. For these reasons, combining the interview with one

Questionnaires

The questionnaire is a widely used method of gathering data on jobs. A survey instrument is developed and given to emp
questionnaire often covers the areas shown below. The major advantage of the questionnaire method is that information
inexpensively in a relatively short period of time. However, the questionnaire method assumes that employees can accur
their jobs. Employees may vary in their perceptions of the jobs, and even in their literacy. For these reasons, the question
and observations to
clarify and verify the questionnaire information.
One type of questionnaire sometimes used is a checklist. Differing from the open-ended questionnaire, the checklist offe
information. An obvious difficulty with the checklist is constructing it, which can be a complicated and detailed process.

Job Analysis Questionnaire

 Materials and equipment used

 Financial/budgeting input
 External and internal contacts
 Knowledge, skills, and abilities used
 Working conditions
 Special duties performed less frequently
 Duties and percentage of time spent on each
 Work coordination and supervisory responsibilities
 Physical activities and characteristics
 Decisions made and discretion exercised
  Records and reports prepared
 Training needed

Critical incident technique.

The critical incident technique involves observation and recording of examples of particularly effective or ineffective be
"ineffective" in terms of results produced by the behavior.

The following information should be recorded for each "critical incident" of behavior: (1) what led up to the incident and
the employee did that was particularly effective or ineffective; (3) the perceived consequences or results of the behavior;
employee had over the results his or her behavior produced (to what degree should the employee be held responsible for

The critical incident method differs from direct observation and work methods analysis in that observations of behavior
the behavior has been judged to be either particularly effective or ineffective in terms of results produced. This means th
describe a behavior in retrospect, or after the fact, rather than as the activity unfolds. Accurate recording of past observat
they occur.

Job Analysis and the U.S. Department of Labor

A variety of resources related to job analysis are available from the U.S. Department of Labor (DOL). The resources hav
various entities with the DOL, primarily the Employment and Training Administration.

FUNCTIONAL JOB ANALYSIS (FJA)

This method is a comprehensive approach to job analysis. FJA considers:
1. goals of the organization,
2. what workers do to achieve those goals in their jobs,
3. level and orientation of what workers do,
4. performance standards, and
5. training content.
A functional definition of what is done in a job can be generated by examining the three components of data, people, and
identify and compare important elements of jobs given in the Dictionary of Occupational Titles (DOT), a standardized d

Specialized Job Analysis Methods

Several job analysis methods are built on the questionnaire approach. Some of these methods are described next.

POSITION ANALYSIS QUESTIONNAIRE (PAQ)

The Position Analysis Questionnaire (PAQ) developed by McCormick, Jeanneret, and Mecham (1972) is a structured
and relate them to human characteristics.
The PAQ is a specialized questionnaire method incorporating checklists. Each job is analyzed on 27 dimensions compos
divisions, with each division containing numerous job elements. The divisions include:
 Information input: Where and how does the worker get information to do the job?
 Mental process: What levels of reasoning are necessary on the job?
 Work output: What physical activities are performed?
 Relationships with others: What relationships are required to perform the job?
 Job context: What working conditions and social contexts are involved?
 Other: What else is relevant to the job?
The PAQ focuses on “worker-oriented” elements that describe behaviors necessary to do the job, rather than on “job-ori
the work. Although its complexity may deter many potential users, the PAQ is easily quantified and can be used to cond
in helping to ensure internal pay fairness because it considers the varying demands of different jobs.

MANAGERIAL JOB ANALYSIS

Because managerial jobs are different in character from jobs with clearly observable routines and procedures, some spec
of the most well known and widely used methods was developed at Control Data Corporation and is labeled the Manage
Composed of a listing of over 200 statements, the MPDQ examines a variety of managerial dimensions, including decisi

Computerized Job Analysis

As computer technology has expanded, researchers have developed computerized job analysis systems. They all have se
are administered. First, analysts compose task statements that relate to all jobs. They are then distributed as questionnair
responses on computer-scannable documents are fed into computer-based scoring and reporting services capable of reco
information about any job.
An important feature of computerized job analysis sources is the specificity of data that can be gathered. All of this spec
A computerized job analysis system often can reduce the time and effort involved in writing job descriptions. These syst
each of the task and scope statements of the questionnaires.
As is evident, the melding of computer technology with job analysis methodology allows firms to develop more accurate
compensation programs, and performance appraisal systems. These processes can also provide better data for legal defen

Combination Methods

There are indeed a number of different ways to obtain and analyze information about a job. No specific job analysis met
various courts in all situations. Therefore, in dealing with issues that may end up in court, care must be taken by HR spec
all of the steps taken. Each of the methods has strengths and weaknesses, and a combination of methods generally is pref

Job Analysis: Definitions, Methods, Process and Importance of Job Analysis

by Shraddha Bajracharya in Human resource

Updated May 3, 2018
Job analysis is a process of identifying and determining in detail the particular job duties and requirements and
the importance of these duties for a given job. It helps an organization determine which employee is best for a
specific job.
In other words, job analysis is used to determine placement of jobs. It allows human resource managers to
identify the path of job progression for employers looking to advance their career and compensation.
To be clear, job analysis targets the job, not the person. Data for job analysis is collected from the job holders
through interviews or questionnaires, but the result of analysis is a description of the job and not a description of
the job holder.

History
Russian researcher Morris Viteles was one of the first industrial-organizational psychologists to introduce the
concept of job analysis. In 1922, he used the method of job analysis to choose employees for a trolley car
company.
Frederick Winslow Taylor and Lillian Moller Gilbreth also conceptualized job analysis in the early 20th
century.

Definitions of job analysis

Some popular definitions of job analysis are as follows:
Harry L. Wylie:
“Job analysis deals with the anatomy of the job…..This is the complete study of the job embodying every
known and determinable factor, including the duties and responsibilities involved in its performance; the
conditions under which performance is carried on; the nature of the task; the qualifications required in the
worker; and the conditions of employment such as pay, hours, opportunities and privileges.”
Michael J. Jucius:
“Job analysis refers to the process of studying the operations, duties and organisational aspects of jobs in order
to derive specification or, as they are called by some job description”
Blum:
“A job analysis is an accurate study of the various components of a job. It is concerned not only with an
analysis of the duties and conditions of work, but also with the individual qualifications of the worker.”
John A Shubin:
“Job analysis is the methodical compilation and study of work data in order to define and characterise each
occupation in such a manner as to distinguish it from all others.”

Purpose of job analysis

Job analysis is used in preparation of job descriptions and job specifications which help in the hiring of right
personnel for the job. The general purpose of job analysis is to establish and document the requirements of a
job.
The aim of job analysis is to answer questions such as:
 What is the purpose of the job?
 What physical and mental task does the job holder undertake?
 When is the job to be performed?
 Where is the job to be performed?
 What are the conditions required for the job to be performed?
Training needs assessment
Job analysis is used to determine training needs such as training content, assessment tests, test equipment and
methods of training. It is also useful in identifying the areas where an employee needs training.
Compensation management
Compensation management/salary administration is one of the core HR functions. Job analysis can be used in
determining skill levels, compensable job factors, required level of education, etc. It is important in deciding
pay packages and job benefits of employees. The pay depends on the position, job title, duties and
responsibilities associated with a job. Job analysis guides HR managers in deciding how much an employee is
worth.
Recruitment and selection procedures
Job analysis helps in hiring the right person for a job. It helps in identifying the job duties that should be
included in vacancy announcements. It also helps in collecting information on educational qualifications,
minimum requirements, and appropriate salary level.
Performance review
Every organisation has goals and objectives to achieve and certain performance standards to be maintained by
its employees. Job analysis helps in identifying the goals and objectives, performance standards and evaluation
criteria and duties to be evaluated.

Process of job analysis

Job analysis process involves the implementation of following steps:

Organizational analysis
The first step in the job analysis process is to determine its purpose. This will help determine what kind of data
to collect and how to collect it. The necessary background information for this step can be collected by using
organization charts, process charts and job descriptions.
Select representative positions
It will be time consuming and costly to analyse all jobs in an organization. So, it is essential to select a
representative sample of jobs for detail job analysis.
Collect data
The next step is to collect job-related data such as educational qualification, duties, responsibilities, working
conditions, employee behaviour, skills and abilities. Data is collected by using methods such as observation,
interviews and questionnaire.
Review collected data
A job analysis report is prepared by using the gathered data. The information is then verified with the worker
performing the job and their supervisor.
Developing job description
The information collected is used to develop a written statement known as job description. Job description is a
document that describes the responsibilities, working conditions, locations, risks and tasks required for effective
job performance.
Developing job specification
The final step in the process is to develop job specification. Job specification and job descriptions are two
tangible products of the job analysis process. Job specification is a statement of personal traits, educational
qualification, experience, background and skills needed to perform a job.

Approaches to job analysis

Job analysis is done by using two approaches:
Task oriented approach
Task oriented approach to job analysis focus on the actual activities involved in a job. It mainly considers duties
and responsibilities of a job. HR managers develop task statements that state the functions of a job in great
detail.
The tasks are then rated on the basis of importance, frequency, difficulty etc. This helps in having a greater
understanding of the requirements of a job.
Worker oriented approach
Examining human attributes of a job is another approach of job analysis. These attributes are classified as
knowledge, skills, abilities, and other characteristics, collectively known as KSAO.
Knowledge refers to the information required by an employee to perform the job. Skills are the proficiencies
needed for good performance. Abilities refers to the attributes of employees that are stable over time. Other
attributes such as personality factors are other characteristics.
Methods of job analysis
Different methods such as observation, interview, checklists, task inventories, and questionnaire can be used
individually or in combination. Choosing the method or combination of methods of job analysis depends upon
the needs and requirements of the organization.
Here are the three most common job analysis methods used by organizations:

Observation method
The job analyst observes and records the tasks, responsibilities and duties of an employee. This also includes
the methods and skills used by them to perform the job. This is the most difficult method of job analysis.
This is because every person has their own way of observation and interpretation, which can involve personal
biases. This error can be minimized by choosing a properly trained job analyst.
Interview method
The job analyst interviews employees to know about their working style, problems faced, skills and techniques
used and insecurities about their careers.
This method helps the analyst to know what an employee thinks of his job and the responsibilities it entails. The
success of this method depends upon the genuineness of data and feedback collected from employees.
Questionnaire method
In this method, the job analyst gives an employee a simple questionnaire to identify the duties, responsibilities,
work environment and problems related to a job. This method can also be biased if the questions are not framed
properly.
Performing Job Analysis

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Scope—This article addresses the area of human resources known as job analysis. This treatment will discuss
how job analysis can be used to identify the knowledge, skills and expertise required to effectively perform job
assignments, establish criteria for selection and promotions, design objectives for training and development
programs, develop the standards for the measurement of performance, and assist with the determination of pay
classification levels. This article discusses the methods and processes used in conducting job analysis. It
describes the difference between a job evaluation and a job analysis and defines common practices and trends.
Overview
Job analysis is the systematic study of a job to determine which activities and responsibilities it includes, its
relative importance to other jobs, the personal qualifications necessary for performance of the job and the
conditions under which the work is performed. An important concept in job analysis is that the job, not the
person doing the job, is assessed, even though HR may collect some job analysis data from incumbents. See Job
Analysis: How do I conduct a job analysis to ensure the job description actually matches the duties performed
by the employee in the job?
Job analysis is often confused with job evaluation, but the two activities are quite different. Job evaluation is the
process of comparing a job to other jobs within the organization to determine the appropriate pay rate and is not
addressed in this toolkit. See Performing Job Evaluations.
This toolkit covers the following topics:
 Reasons organizations invest time in performing job analysis.
 HR's responsibilities in conducting job analyses.
 The data collection process.
 Job analysis methods.
 Job descriptions.
 Job analysis resources.
Business Case
An organization's success depends on its employees' performance. Ideally, each job should interrelate to
optimize achievement of the organization's mission, goals and objectives. Each employee's understanding of his
or her role influences the return on investment (ROI). As a result, many HR leaders see job analysis as a pivotal
aspect of effective human resource practice. It can affect every major HR competency area, depending on its
adequacy. For example, although the types of data each HR practice needs may vary, job analysis data can
identify the knowledge, skills and expertise required for effective performance, establish criteria for selection
and promotions, design objectives for training and development programs, develop performance measurement
standards, and assist with setting pay classification levels. A job analysis is normally documented via a job
analysis questionnaire, and the end product is a job description, inclusive of clearly defined job specifications
(i.e., required or preferred qualifications) for the job incumbent.
Uses for job analysis within an organization include:
 HR workforce planning.
 Organizational design.
 Performance management.
 Affirmative action plans.
 Recruiting and selection.
 Career and succession planning.
 Training and development.
 Compensation administration.
 Health, safety and security.
 Employee/labor relations.
 Legal defense.
 Risk management.
See Using Job Analyses to Prevent Musculoskeletal Injuries.
HR's Role
HR professionals play a key role in job analysis. They help managers determine the functions the organization
requires and the best organizational structure and market price for such functions. HR also presents the
compensation system as an equitable method of encouraging high employee engagement and performance.
The HR department and line management must work closely together to ensure that the job analysis process is
effective. The following outlines a typical division of responsibilities between HR and line management. The
outcome of the job analysis is the job description, which includes job specifications.
Typical HR responsibilities in the job analysis process include:
 Coordinating the job analysis process.
 Drafting job descriptions and specification for management review.
 Reviewing job descriptions and specifications periodically.
 Reviewing managerial input for accuracy.
  Seeking advice from outside sources for difficult or unusual analyses, if needed.
 Acting as a job analyst or panel facilitator as needed.
Typical line management responsibilities in the job analysis process include:
 Completing or delegating responsibility to complete job analysis information.
 Reviewing and maintaining job descriptions/job specification accuracy.
 Requesting revisions to the analysis as jobs change.
 Identifying performance standards based on job analysis information.
 Acting as a subject matter expert or panel member, if needed.
Job Analysis and Data Collection
Job analysis involves collecting information on characteristics that differentiate jobs. The following factors help
make distinctions between jobs:
 Knowledge, skills and abilities (KSAs) needed.
 Work activities and behaviors.
 Interactions with others (internal and external).
 Performance standards.
 Financial budgeting and impact.
 Machines and equipment used.
 Working conditions.
 Supervision provided and received.
Grouping jobs with related functions is helpful in the job analysis process by identifying the job family, job
duties and tasks of related work.
The following provides an example of how an organization may group related jobs:
 Job family. Grouping of related jobs with broadly similar content.
 Job. Group of tasks, duties and responsibilities an individual performs that make up his or her total work
assignment.
 Task. A specific statement of what a person does, with similar tasks grouped into a task dimension (i.e.,
a classification system).
A technical service job family, for example, could be identified as follows:
 Job family. Technical Service.
 Job. Technical service representative.
 Task. Provides technical support to customers by telephone.
Job Analysis Methods
Determining which tasks employees perform is not easy. The observer's perception influences direct
observation. The most effective technique, if feasible, is to collect information directly from the most qualified
incumbent(s). It is preferable to use two methods, if possible—for example, direct observation and a structured
questionnaire from job incumbents, or interviews and open-ended questionnaires from the job incumbents. The
following describes the most common job analysis methods.
Open-ended questionnaire
Job incumbents and sometimes their managers fill out questionnaires about the KSAs necessary for the job. HR
compiles the answers and publishes a composite statement of job requirements. This method produces
reasonable job requirements with input from employees and managers and helps analyze many jobs with limited
resources.
Highly structured questionnaire
These questionnaires allow only specific responses aimed at determining the frequency with which specific
tasks are performed, their relative importance and the skills required. The structured questionnaire is helpful to
define a job objectively, which also enables analysis with computer models.
Interview
In a face-to-face interview, the interviewer obtains the necessary information from the employee about the
KSAs needed to perform the job. The interviewer uses predetermined questions, with additional follow-up
questions based on the employee's response. This method works well for professional jobs.
Observation
Employees are directly observed performing job tasks, translating observations into the necessary KSAs for the
job. Observation provides a realistic view of the job's daily tasks and activities and works best for short-cycle
production jobs.
Work diary or log
A work diary or log is an anecdotal record the employee maintains and includes frequency and timing of tasks.
The employee keeps logs over an extended period. HR analyzes the logs, identifies patterns and translates them
into duties and responsibilities. This method provides an enormous amount of data, but much of it is difficult to
interpret, not job-related and difficult to keep up-to-date.
Other methodologies
Analyzing jobs in different categories (e.g., a job requiring lower skill versus a complex technical job) requires
a different approach. The concept of a "job" is changing shape as it becomes more common for employees to
work in cross-functional project team environments and in matrix reporting relationships. Thus, job analysis
methodologies that focus on the KSAs required to accomplish the primary duties and responsibilities of a
particular job have come to the forefront.
Behavioral event interviewing, a competency-based job analysis, differs from the traditional job analysis, which
focuses solely on the evaluation of tasks, duties and responsibilities. In behavioral event interviewing:
 A team of senior managers identifies future performance areas critical to the organization's business and
strategic plans.
 HR assembles panels composed of individuals who are knowledgeable about the organization's jobs
(i.e., subject matter experts). These groups may include high- and low-performing employees, managers,
supervisors, trainers and others.
  A facilitator from HR or an outside consultant interviews panel members to obtain examples of job
behaviors and actual occurrences on the jobs.
 The facilitator develops detailed descriptions of each competency, including descriptive phrases for
clarity.
 HR rates the competencies, and panel members identify levels required to meet them.
 HR identifies performance standards for each job. The organization must develop and implement
selection, screening, training and compensation instruments, or processes that focus on competencies.
According to a 2014 SHRM survey, the leading methods to conduct job analysis were interview (50 percent),
observation (33 percent) and structured questionnaires (27 percent). See SHRM/ACT: Job Analysis Activities.
Job Descriptions and Specifications
HR uses the job analysis output to develop a job description and job specifications. The job description
summarizes and organizes the information for the organization's job-related actions. Generally, the job
description and specifications are combined but compartmentalized to enable independent updating as needed.
The sections of a job description are outlined below.
 Identification. The first part of the job description lists the title, reporting relationships, department,
location and the date of the analysis. This section also often includes other information useful in tracking
positions and employees through the human resource information system (HRIS), such as internal job
code, pay grade, exempt or nonexempt status and Equal Employment Opportunity Commission (EEOC)
job classification.
 Job summary. The descriptive summary is a concise statement of the general duties and responsibilities
that make the job unique.
 Duties and responsibilities. This section lists the job's essential duties and responsibilities using clear,
declarative statements in priority order.
 Job specifications. This section identifies both the essential skills and experience and the nonessential
skills and experience (i.e., preferred qualifications) to perform the job, and includes all information
necessary to determine any possible accommodations under Americans with Disabilities Act (ADA)
regulations. Job specifications are typically designated as KSAs, education and experience, and physical
demands and work environment, depending on the nature and scope of the job.
 Disclaimers and approval. The disclaimer informs the employee that the job description is not a
contract between the employee and the employer, that the employer may change the job description or
that the employer may request the employee to perform additional duties. The approval component
should include a section for the signatures of the supervisor and HR professional and the date approved.
The job incumbent should also sign and date the document.
See How To Develop a Job Description and Sample Job Descriptions.
Compensation Decisions
In relation to employee pay practices, job analysis has two critical uses: It establishes similarities and
differences in job content, and it helps determine the internal equity and relative worth of like jobs. If jobs have
equal content, then the pay established for them will likely be equal. If, on the other hand, job content is
perceptibly different, then those differences, along with the market rates, will become part of the rationale for
paying certain jobs differently.
Selection Assessments
Job analysis information can also be used as a basis for developing employment assessments. Specifically,
assessments are developed to measure the most critical tasks or KSAs resulting from the job analysis for a given
job. Some assessments involve work samples that simulate job tasks and require candidates to demonstrate that
they can perform these tasks effectively. HR uses job-oriented or task-based job analysis data as a basis for
developing these types of assessments because they focus directly on assessing how well job candidates can
perform critical work tasks. Other assessment methods focus on measuring KSAs that are required to perform
job tasks effectively, such as various mental abilities, physical abilities or personality traits, depending on the
job's requirements. If one were selecting a manager, for example, it would be important to assess whether
candidates could solve complex business problems, be decisive and communicate effectively. Alternatively, if
one were selecting an administrative assistant, KSAs such as the ability to perform work conscientiously and
the ability to perform work with speed and accuracy would be much more important for identifying capable
candidates. HR uses worker-oriented or KSA-based job analysis data as a basis for developing assessment
methods that focus on a job candidate's underlying abilities to perform important work tasks.
According to the 2014 SHRM survey, 45 percent of HR professionals have used information from job analyses
for purposes beyond identifying what was required for a job/role, such as developing interview
questions. See Three-Fourths of HR Professionals Use Job Analysis Data for Recruitment, New SHRM Survey
Finds.
Resources
O*Net, the Occupational Information Network, is a comprehensive database containing information on
hundreds of standardized and occupation-specific descriptors sponsored by the U.S. Department of Labor's
Employment and Training Administration through a grant to the North Carolina Department of Commerce.
O*Net covers more than 950 occupations based on the Standard Occupational Classification (SOC) developed
by the U.S. government. The O*Net system supersedes the Dictionary of Occupational Titles (DOT).
HR practitioners may use this source to develop job descriptions and define job-specific success factors and for
other purposes related to training, recruiting and selection. O*Net also provides extensive links to additional
workplace resources. It is a timesaving resource for job analysis and for others writing job descriptions and
specifications.

Methods of job analysis

Subject: Business, Human Resource Management Topic: Assignment
Job analysis is a collection of duties and responsibilities which are given together to an individual employee.
Job analysis is the process of studying and collecting information relating to operations and responsibilities of a
specific job.
There are different methods used by organization to collect information and conduct the job analysis.
The methods of job analysis are:
Personal observation :-
In this method the observer actually observes the concerned worker. He makes a list of all the duties performed
by the worker and the qualities required to perform those duties based on the information collected, job analysis
is prepared.
Actual performance of the job :-
In this method the observer who is in charge of preparing the job analysis actually does the work himself. This
gives him an idea of the skill required, the difficulty level of the job, the efforts required etc.

Interview method :-
In this method an interview of the employee is conducted. A group of experts conduct the interview. They ask
questions about the job, skilled levels, and difficulty levels. They question and cross question and collect
information and based on this information job analysis is prepared.
Critical incident method :-
In this method the employee is asked to write one or more critical incident that has taken place on the job. The
incident will give an idea about the problem, how it was handled, qualities required and difficulty levels etc.
critical incident method gives an idea about the job and its importance. (a critical means important and incident
means anything which takes place in the job)
Questioner method :-
In this method a questioner is provided to the employee and they are asked to answer the questions in it. The
questions may be multiple choice questions or open ended questions. The questions decide how exactly the job
analysis will be done. The method is effective because people would think twice before putting anything in
writing.
Log records :-
Companies can ask employees to maintain log records and job analysis can be done on the basis of information
collected from the log record. A log record is a book in which employees record /write all the activities
performed by them on the job. The records are extensive as well as exhausted in nature and provide a fair idea
about the duties and responsibilities in any job.
Job Analysis Methods: Methods of Data Collection for Job Analysis

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Job analysis is based on job data. Hence the question: how to collect job related data? A variety of methods are
available for collecting job data.The method that was historically linked to the concept of job analysis was
observation supplemented by the interview.
In recent years, questionnaires, check lists, critical incidents, diaries, personnel records and technical conference
method have also been experimented for collecting job-related data. A brief description of each method is in
order.
Observation:
Under this method, data is collected through observing an employee while at work. The job analyst on the basis
of observation carefully records what the worker does, how he/she does, and how much time is needed for
completion of a given task. This is the most reliable method of seeking first hand information relating to a job.
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This method is suitable for jobs that consist primarily of observable physical ability, short job cycle activities.
The jobs of draftsman, mechanic, spinner or weaver are the examples of such jobs. However, the flip side of
this method is that this method is not suitable for jobs that involve unobservable mental activities reveal
overlaps and grey areas and have not complete job cycle.
That it is time consuming is it’s yet another handicap. Given these, the job analyst needs to be quite skillful in
collecting data about jobs with a high degree of discretion or decision content. Training can make the job
analyst skillful.
Interview:
In this method, the job analyst directly interviews the job holder through a structured interview form to elicit
information about the job. This method is found suitable particularly for jobs wherein direct observation is not
feasible. By way of directly talking to the job holder, the interviewer job analyst may extract meaningful
information from the job holder about his/her job.
However the interview method is both time consuming and costly. Particularly, the professional and managerial
jobs due to their complicated nature of job, require a longer interview’ This may also be a possibility that bias
on the part of the analyst and the job holder i.e., the respondent may cloud the accuracy and objectivity of the
information gathered through interview. Nonetheless, the effectiveness of the interview method will depend on
the ability of both interviewer and respondent in asking questions and responding them respectively.
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The following guidelines, as outlined by Carrol L. Shartle, Otis and Lenhert, may help the interviewer
make his/her interview more effective:
a. Introduce yourself to make the worker know who you are and why you are there.
b. Allay the worker’s fear whatsoever by showing keen interest in both him/her and his/her job.
c. Do not advise the worker how to do the job.
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d. Try to talk to the worker in his/her language, to the extent possible.
e. Do not create confusion between the work and the worker.
f. Make a full — fledged job study within the objectives of the programmes; and
g. Verify the job information whatsoever obtained.
Questionnaire:
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Questionnaire method of job data collection is desirable especially in the following two situations:
First, where the number of people doing the same job is large and to personally interview them is difficult and
impracticable.
Second, where giving enough time to employees is desirable to enable them to divulge and explore the special
aspects of the jobs.
In this method, the employee is given structured questionnaire to fill in, which are then returned to the
supervisors. The supervisor, after making the required and necessary corrections in the information contained in
the questionnaire, submits the corrected information to the job analyst. Questionnaire provides comprehensive
information about the job.
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Information so obtained can be quantified and processed in the computer. The greatest advantage of the
questionnaire method is that it enables the analyst to cover a large number of job holders in the shortest possible
time. However, the method suffers from certain shortcomings as well.
In the absence of direct rapport between the job analyst and the employee, both cooperation and motivation on
the part of the employee tends to be at low level. Often employee due to lack of training and skill, do not
express the job related information in a meaningful and clear fashion. As such, job related data tends to be
inaccurate. Moreover, the method is time-consuming and costly.
Checklists:
The checklist method of job data collection differs from the questionnaire method in the sense that it contains a
few subjective questions in the form of yes or no. The job holder is asked to tick the questions that are related to
his/her job. Checklist can be prepared on the basis of job information obtained from various sources such as
supervisors, industrial engineers, and other people who are familiar with the particular job.
Once the checklist is prepared, it is then sent, to the job holder to check all the tasks listed in the list he/she
performs. He/she is also asked to mention the amount of time spent on each task by him/her and the type of
training and experience required to do each task. Information contained in checklist is, then, tabulated to obtain
the job-related data.
Like questionnaire method, the checklist method is suitable in the large organisations wherein a large number of
workers are assigned one particular job. Since the method is costly and, therefore, is not suitable for small
organisations.
Critical Incidents:
This method is based on the job holder’s past experiences on the job. They are asked to recapitulate and
describe the past incidents related to their jobs. The incidents so reported by the job holders are, then, classified
into various categories and analysed in detail. Yes, the job analyst requires a high degree of skill to analyse the
incidents appropriately described by the job holders. However, this method is also time-consuming one.
Diaries or Log Records:
In this method, the job holder is asked to maintain a diary recording in detail the job-related activities each day.
If done judiciously, this method provides accurate and comprehensive information about the job. This
overcomes memory lapses on the part of the job holder. As recording of activities may spread over several days,
the method, thus, becomes time-consuming one.
The disadvantage associated with this method is that it remains incomplete because it does not give desirable
data on supervisor relationship, the equipment used and working conditions prevalent at the work place.
Technical Conference Method:
In this method, a conference is organised for the supervisors who possess extensive knowledge about job. They
deliberate on various aspects of the job. The job analyst obtains job information from the discussion held among
these experts/supervisors. The method consumes less amount of time. However, the main drawback of this
method is that it lacks accuracy and authenticity as the actual job holders are not involved in collecting job
information.
It is seen from the preceding description that no single method is complete and superior. In fact, none of the
method is to be considered as mutually exclusive. The best data related to a job can be obtained by a
combination of all methods described above.
Before we skip to the next content, a brief mention about the problems faced with job analysis is in order.
The problems that may crop up while conducting job analysis are:
1. Lack of support from the top management.
2. Relying on one source and method of data collection.
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3. Non-trained and non-motivated job holders who are the actual source of job data.
4. Distorted information/data provided by the respondents i.e., the job holders because of non- preparedness on
their part.
Job Analysis Methods

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Everything you need to know about the job analysis methods. Job analysis, is the process of determining and
recording all the pertinent information about a specific job, including the tasks involved, the knowledge and
skill set required to perform the job, the responsibilities attached to the job and the abilities required to perform
the job successfully.
Job analysis differentiates one job from the other, in an organisation, and is based on observation and study. It
is also referred to as job review or job classification. Job analysis provides the basic foundation for many of the
HR activities.
Though there are several methods of collecting job analysis information yet choosing the one or a combination
of more than one method depends upon the needs and requirements of organization and the objectives of the job
analysis process.
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Typically, all the methods focus on collecting the basic job-related information but when used in combination
may bring out the hidden or overlooked information and prove to be great tools for creating a perfect job-
candidate fit.
The various methods of job analysis are as follows:-
1. Observation Method 2. Interview Method 3. Daily Method 4. Technical Conference Method 5. Functional
Job Analysis (FJA) 6. Questionnaire Method
7. Job Inventories or Checklists 8. Job Performance Method 9. Individual Psychographic Method 10. Job
Psychographic Method 11. Job Analysis by Test 12. Motion Study Method
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13. Employee Job Diary 14. Conference of Experts 15. Combination of Methods 16. Competency Profiling
Method 17. Reference Materials Method 18. Critical Incident Method and 19. Group Interview Method.
Methods of Job Analysis: Interview Method, Questionnaire Method, Conference Method, Group
Interview Method and Few Others
Job Analysis Methods – Top 8 Methods: Observation Method, Interview Method, Daily Method,
Conference Method, Questionnaire Method and a Few Others
Job analysis, is the process of determining and recording all the pertinent information about a specific job,
including the tasks involved, the knowledge and skill set required to perform the job, the responsibilities
attached to the job and the abilities required to perform the job successfully. Job analysis differentiates one job
from the other, in an organisation, and is based on observation and study. It is also referred to as job review or
job classification. Job analysis provides the basic foundation for many of the HR activities.
The analysis involves compiling a detailed description of tasks, determining the relationship of the job to
technology and to other jobs and examining the knowledge, qualifications or employment standards,
accountabilities and other incumbent requirements. In short, job analysis is a recording of all the activities
involved in a job and the skill and knowledge requirements of the performer of the job.
Job analysis provides the necessary inputs for a number of HR activities like recruitment, selection, job design,
estimating job worth, training, and appraisal. These activities depends on job analysis and its end products for
their own functioning. For example, job description and job specification-the end products of a job analysis –
form the basis for recruitment.
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They help in evaluating a candidate against the requirements of the job and selecting the most suitable one.
Similarly, job analysis provides inputs for training. While training employees for a particular position, the
parameters on which the employees need to be trained can be obtained from job analysis. Job analysis also
helps management in evaluating the relative worth of each job, which would be one of the basic inputs in
designing the compensation system.
Job analysis plays a key role in designing and managing the performance appraisal system in an organisation. It
helps in identifying the key responsibility areas (KRAs) for a position and then setting the goals or objectives
for the appraisal period. This forms the basis for the evaluation of an employee’s performance.
A comparison of the job specifications arrived at, at the end of a job analysis, with the existing competencies of
an employee, helps in identifying his training needs. Thus, job analysis contributes either directly, or indirectly,
to almost all the fields of human resource management.
The various methods of job analysis are as follows:
1. Observation Method:
Three methods of Job Analysis are based on observation. These are- Direct Observation; Work Method
Analysis, including time and motion studies and micro-motion analysis; and critical incident method.
2. Interview Method:
It involves discussions between job analysis and job occupants or experts. Job analysis data from individual and
group interviews with employees are often supplemented by information from supervisors of employees whose
jobs are to be analysed.
3. Daily Method:
It requires the job holders to record in details their activities on a daily basis.
4. Technical Conference Method:
In this method, services of the supervisors who possess extensive knowledge about a job are used with the help
of a conference of the supervisors. The analyst initiates discussion which provides details about the job.
5. Functional Job Analysis (FJA):
It is a method that uses precise terminology and a structured job analysis “schedule” to record information
regarding the job content. It is especially useful to the recruiting and selection functions.
6. Questionnaire Method:
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These can be filled out by the employees on an individual basis or by job analysts for a group of employees.
7. Job Inventories or Checklists:
These are structured questionnaires that require a respondent to check or rate behaviour and/or worker character
necessary to a particular job or occupation. Job inventories can either be Task/Job Oriented or
Qualifications/Worker oriented.
8. Job Performance Method:
In this method the job analyst actually performs the job in question and thus receives 1st hand experiences of
contextual factors on the job including physical hazards, social demands, and emotional pressures mental
requirements.

Job Analysis Methods – Survey Method, Interview Method, Observation Method, Record Method, Job
Psychographic Method, Job Analysis by Test and a Few Others
1. Questionnaire or Survey Method:
In this method a questionnaire is prepared to get the job information and it is circulated among all job holders.
The questionnaire asks the job holder to supply the several types of information sought in job analysis. It may,
in addition, ask the immediate supervisor to examine and comment on the replies provided by the job holders.
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No single questionnaire is appropriate for all types of jobs. However, most of them follow an outline that first
identifies the job, seeks information on the principal tasks involved and then ask questions design to discover
the mental skill and physical requirements of a satisfactory job holder.
2. Interview Method:
In this method the job analyst interviews the job holders and asks questions from them while observing
the following rules:
(i) Interview should be taken in leisure time.
(ii) Job analyst must introduce himself to the job holder first and tell him the purpose of the interview.
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(iii) Job analyst must take an interest in job holder and his work.
(iv) He must concentrate on the job and not on the HR matters.
(v) The job holder should be motivated to speak more.
(vi) As far as possible, the atmosphere of interview must remain congenial and conversation must be held in the
language of the job holder.
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(vii) An average job holder should be selected for interview. The information will not be useful if the best job
holder is contacted.
3. Observation Method:
Here the job analyst observes the work and worker while the worker is involved with the work. An experienced
and expert analyst combines interviewing and on-the-job observation to provide a more accurate analysis than is
usually secured by the use of either one of the methods.
4. Record Method:
Various types of job information are collected from the old records of the HR department.
The job analyst goes through the records and notes the relevant aspects of job details.
5. Individual Psychographic Method:
In this method, the mental peculiarities of an individual successful in a particular kind of job are examined, and
a list of these peculiarities is compiled. This list is transcribed in a graph. This provides some standard of
judgement in future recruitments for the same job.
6. Job Psychographic Method:
According to Viteles, the following three things are essential for the job psychographic method:
(i) Accurate classification of mental qualities required for the job.
(ii) Valid method of evaluation.
(iii) Direct examination or analysis by trained examiners. In this method, some specialist analysts study the
work, and they evolve a valid and standard method of evaluation. They prepare a very accurate list in which the
various mental qualities required for the job are properly and reliably classified. A graph of these qualities is
prepared so that selection of candidates for the job may become easier.
7. Job Analysis by Test:
In the test method, some reliable and valid tests are performed on the basis of essential qualities and abilities;
the candidates are tested for selection and suitability on the basis of these tests.
8. Motion Study Method:
Under this method, the speed of an individual worker in performing some job and time consumed therein are
both noted. Similar examinations being performed on other individuals doing the same work, and the results
obtained are compared. Such a study of speed and time helps in job analysis and classification of the workers.

Job Analysis Methods – 7 Important Methods Used to Collect Information about Jobs: Personal
Observation, Interview, Employee Diary, Job Performance and a Few Others
A number of methods are used to collect information about jobs.
Method # 1. Personal Observation:
The job analyst actually observes the work being performed by workers and records his or her observations in
the following manners; what the work accomplishes, what equipment is used, what the work environment is
like, and any other relevant factor to the job.
Method # 2. Interview:
The understanding of the job may also be gained through interviewing both the supervisor and the employee as
either an individual or a group setting. Face to face interviews are an effective way to collect job information,
because the job holders are most familiar with the job. This method can provide information about standard as
well as nonstandard activities of the job and can supplement the information obtained through personal
observation.
Method # 3. Employee Diary:
In this method, the employee describe their daily work activities in a diary or log. After analyzing the diary or
log over a specified period of time, a job analyst is able to record the essential characteristics of a job. This
method does not give any desirable data on supervisor’s relationship, the equipment used and working
conditions. Maintaining logs are time consuming and costly.
Method # 4. Job Performance:
With this approach, the job analyst actually performs the job and to gets first hand exposure. The job analyst
gets an actual feel of job as well as the physical, environmental and social demands of the job. This method is
not suitable for the jobs that are hazardous in nature and quite inappropriate for jobs that require extensive
training.
Method # 5. Questionnaire:
The job analyst administers a structured questionnaire to employees who then identify the tasks they perform in
accomplishing the job. After completion, the questionnaire are handed over to supervisors. The supervisor is
supposed to discuss any errors in the employee’s response with him make corrections and then questionnaire is
given to the job analyst.
The structured questionnaire must cover all job related aspects such as tasks and behaviours. This method is less
time consuming and economical to use but framing the questionnaires are not an easy tasks.
Method # 6. Conference of Experts:
This method utilizes senior job holders and supervisors with extensive knowledge of the job. The interaction
with the members during the interview adds insight and details that the analyst might not get from individual
job holders.
Method # 7. Combination:
Generally, an analyst does not use one job analysis method exclusively, rather, a combination is often used. For
instance, in analysing clerical and administrative jobs, the analyst might use questionnaire supported by
interviews and limited observation. On the other hand for production, jobs interviews supplemented by a greater
degree of work observation may provide the needed data. Combination of methods can ensure high accuracy at
minimum costs.
Job Analysis Methods – Methods Used for Collection of Data
Job analyst collects data in respect of the duties, responsibilities and activities of the job from the different
people e.g., employees in the job, supervisor, and peers. Various methods/techniques are used for collection of
data.
These are:
1. Interview method
2. ‘Study and observe’ method
3. Self-performance method
4. Employee’s Job Diary
5. Questionnaire method
6. Conference method.
1. Interview Method:
Job information is collected through interview. Under the interview method questions are asked and replies are
recorded for analysis.
Interviews are:
i. Individual interviews with individual employee
ii. Group interviews with individual supervisor or group of supervisors are asked during interview.
For collecting information from the interviewee questions like:
a. What is done?
b. Why is it done?
c. How is it done?
d. When is it done?
e. To what is it done?
Questions are structured in such a way that the interviewee supplies all information about the job activities
performed by him, as also characteristics of the job to the job analyst.
Interview method is very easy to use for collection of information. Generally, employees like to respond to
questions made by those people who are very much interested to know their job activities, working conditions,
hazards etc. Through well designed and effective interview job analyst may come to know some new area of
activities / behaviour which may help him to arrive at some conclusion.
Job analyst may get complete information at a short time from the employees, as they use this platform to elicit
their difficulties, hardship etc. to others. Interview method is very much expensive.
In large organizations it is difficult to use, to collect information. Employees may not give actual information /
data to job analyst as they feel these data will be used for determining their pay rates and fringe benefits.
Collecting information through interview method needs extra skill and ability of job analyst. Interview results
are difficult to analyse.
2. Study and Observation Method:
The another method of collecting information for job analysis is through study and observation of the job
people do.
This method involves:
i. Watching of the whole process of job activities and time taken to complete each process and also the entire
process
ii. Observance of situation, conditions under which an employee works
iii. Study of responsibilities shouldered by the employee
iv. Review of job performance of employee through films
v. Watching of the materials, tools used to perform job.
This method is effective when jobs involve physical activities that are measurable. Job analyst gets thorough
idea regarding the jobs employees perform. So job performance information becomes correct and accurate. This
method yields reliable results as the data are collected through direct observation. Collection of data is very easy
as it does not need extra skill, ability of the analyst.
This method is not free from limitations. It becomes unreliable and ineffective when jobs consist of
immeasurable mental activity (that means jobs need mental work, decision making, judgemental activity,
planning, directing, controlling etc.)
In some cases, job performance information may not be correct as constant watch of analyst over a job may
create such situation where employees cannot function freely and properly. It requires much time to complete
the information collection exercise especially, in cases when employees occasionally need to perform some
work.
3. Self-Performance Method:
Under this method, job analyst engages himself to perform a job and records information. The approach of this
method is like ‘perform job and obtain information’. Job analyst through performance of job gets understanding
of –
i. The whole process of activity i.e. job cycle
ii. Time taken to complete some activity
iii. The hazards and difficulties faced to perform job
iv. The working environment, machines, tools used, supervision needed
v. Skill, ability, knowledge required to complete the job.
This method is effective for job analysis when jobs are very simple and are easy to perform. But this method
does not yield results if, the jobs are technical in nature and are difficult to perform without training. The scope
of use of this method is limited.
4. Employee’s Job Diary:
Another technique to collect information on job is to use diary maintained by the employees to record their day
to day activities in their work performance.
This method has the following characteristics:
(i) Each employee is given a diary to keep records of his daily activities
(ii) At the end of each work shift, the employee starts writing on the diary – (a) all the activities he had
undertaken that day (b) the time taken for completion of any process of activity (c) difficulties, problems if he
had faced to perform his job.
(iii) Job diary needs to be maintained for a long period so that all activities are covered.
(iv) Information recorded by the employee in the diary are verified / checked by the concerned supervisor to
ensure that factual data are taken.
This method is simple to use as it does not need extra skill, ability to record information. Since, employee
himself writes diary it is possible that all job performance information are recorded.
Diary method is time consuming as it takes much time to collect information for job analysis. The employee
may not remember the job activities at the end of work shift when he records in the diary. So, the data is based
on assumption the employee holds.
5. Questionnaire Method:
This is one of the methods used by organization to collect job information. Under this method job related
questions are prepared and employees are asked to reply to the questions. This method is very much popular to
gather information concerning job related duties and responsibilities of employees.
Questionnaires are of two types—structured questionnaire and open ended (unstructured) questionnaire. In case
of structured questionnaire a long list of possible task items is designed and sent to employees with the request
to indicate whether or not they perform the tasks as mentioned in the questionnaire and if so, how much time is
taken to perform each task?
Open ended (unstructured) questionnaire is very simple that asks the employees to describe something in
respect of their job related duties, responsibilities etc. The question may be like ‘state the major duties you
perform’.
The specially designed questionnaires are sent to employees who submit them to supervisors after duly
completed/filled out. Supervisors after verification, consultation with concerned employees, if need arises, give
those questionnaires to the job analyst.
The questionnaire method is easy to use for collection of job information. Coverage of population under this
method is wide. Questionnaires are sent to a large number of employees. So, it is a speedy and excellent way for
gathering information at a shorter period of time. Cost wise this method is cheap for collection of information.
The method is not free from limitations. Designing questionnaire (i.e., area coverage, type and number of
questions to be asked for etc.) needs special skill. Employees may take it casually to fill out questionnaires and
to return them.
Generally, employees avoid to submit information in writing that may be due to their inability to express or due
to their unwillingness to respond to the questions mentioned in the questionnaire. The preparation of
questionnaire is also expensive and time consuming.
6. Conference Method:
This is one of the methods of collecting information for job analysis. Under this method job analyst gathers
information relating to job of employees through experienced and knowledgeable supervisors.
Conference method includes the following activities:
i. Selection of areas, subject matter over which questions will be asked to supervisors
ii. Deciding on number of questions to be asked, design of questions whether open-ended or structured
questions
iii. Structure of time for completion of interview with supervisor.
This method yields results if supervisors are effective, competent, experienced and have a great depth of
knowledge on subordinates’ job. Collection of job information through this method is time consuming and
expensive.

Job Analysis Methods – 2 Most Important Methods: Qualitative and Quantitative Methods
The determination of job tasks, the concomitant skills and abilities necessary for successful performance, and
the responsibilities inherent in the job can be obtained through the following methods-
1. Qualitative Methods:
(i) Personal Observation Method:
The most reliable and practical technique for obtaining the information in relation to the job is through the
direct observation of the work performed coupled with the discussion with the supervisor of the job.
The materials and equipment used, the working conditions and probable hazards, and an understanding of what
the work involves are facts which should be known by an analyst. Direct observation is especially useful in jobs
that consist primarily of observable physical ability like the jobs of draftsman, mechanic, spinner, or weaver.
(ii) Questionnaire Method:
In this method, the questionnaire is prepared by the job analyst and distributed among the workers. The
questions are answered by the workers to the best of their knowledge and belief. This method is usually
employed by engineering consultants. Properly drafted questionnaires are sent out to the job holders for
completion and are returned to supervisors.
The idea of issuing questionnaires is to elicit the necessary information from the job holders so that any error
may first be discussed with the employee and after due corrections may be submitted to the job analyst.
(iii) Personal Interviews:
Personal interviews may be held by the employees and answers to the relevant questions may be recorded. But
this method is relatively time consuming and costly. This method is a prime method used by the job analyst for
data collection. The job analyst contacts the workers and the supervisors concerned and asks questions
regarding the various jobs performed by them for collecting the relevant information.
(iv) Record:
In this method, the employee is asked to maintain the daily diary record of duties he performs, stating the time
at which each task is started and finished. But this method is incomplete, because it does not give the desirable
data on supervisor relationship, equipment used and the working conditions. This record is also maintained by
the personnel department regarding the job holders. The analyst collects this information from the record
maintained by the personnel department.
(v) Job Performance:
In this method, the job is actually performed by the job analyst for obtaining first-hand experience in relation to
the actual tastes, physical and social demand, and the working environment of the job. This method can be used
only for jobs where skill requirements are low and can therefore, be learnt quickly and easily.
2. Quantitative Methods:
(i) Position Analysis Questionnaire (PAQ):
It is a structured job analysis questionnaire. The PAQ is filled by the job analyst. It contains 194 items, each of
which represents an important component of the job. The job analyst decides whether each item plays a role on
the job and if so to what extent.
Advantages of PAQ:
(a) It classifies the jobs.
(b) It provides a quantitative score or the profile of the job.
(c) The results of PAQ can be used to compare one job with the other.
(d) PAQ is also used for the fixation of pay levels.
Disadvantages of PAQ:
(a) It is time-consuming.
(b) It involves a complicated analysis on the part of job analyst.
(ii) Management Position Description Questionnaire (MPDQ):
It is a standardised instrument which is specifically designed for the use in the analysis of managerial jobs. Its
questionnaire consists of 15 sections including 274 items. In this method, the respondents have to respond on
the importance of each item to the position.
The management description factors include:
(a) Internal Business Control
(b) Public and Customer Relations
(c) Staff Service
(d) Supervision
(e) Broad Personnel Responsibility
(f) Complexity and Stress
(g) Approval of Financial Commitments
(h) Autonomy of Actions
(i) Advanced Consulting
(j) Product, Marketing, and Financial Strategy Planning
(k) Coordination of Other Organisational Units and Personnel
(l) Products and Service Responsibility
(iii) Functional Job Analysis:
This approach of job analysis is worker oriented. The functional job analysis approach attempts to describe the
whole person on the job. It examines three fundamental components of ‘data, people, and things’.
The four main dimensions which are rated under this method are:
(a) The language and verbal facilities required to perform the job.
(b) The mathematical ability required to perform the job.
(c) The extent to which specific instructions are necessary to perform the job.
(d) The extent to which judgement and reasoning are required to perform the job.
This method is used frequently for government jobs. It provides a quantitative score of each as a function of its
complexity in relationship with people, data, and things.

Job Analysis Methods – Common Techniques/Methods Employed by Management for Analysis of Jobs
Though there are several methods of collecting job analysis information yet choosing the one or a combination
of more than one method depends upon the needs and requirements of organization and the objectives of the job
analysis process. Typically, all the methods focus on collecting the basic job-related information but when used
in combination may bring out the hidden or overlooked information and prove to be great tools for creating a
perfect job-candidate fit.
Selecting an appropriate job analysis method depends on the structure of the organization, hierarchical levels,
nature of job and responsibilities and duties involved in it. So, before executing any method, all advantages and
disadvantages should be analyzed because the data collected through this process serves a great deal and helps
organizations cope with current market trends, organizational changes, high attrition rate and many other day-
to-day problems.
Some common techniques/methods employed by management are given below:
1. Observation Method:
A job analyst observes an employee and records all his performed and non-performed task, fulfilled and un-
fulfilled responsibilities and duties, methods, ways and skills used by him or her to perform various duties and
his or her mental or emotional ability to handle challenges and risks.
Merits & Demerits of Observation Method:
i. It is one of the easiest methods to analyse a specific job.
ii. The limitation is that every person has his own way of observing things.
iii. Different people think different and interpret the findings in different ways.
iv. Therefore, the process may involve personal likes and dislikes and may not produce genuine results.
v. This error can be avoided by proper training of job analyst or whoever will be conducting the job analysis
process.
2. Interview Method:
In this method, an employee is interviewed so that he or she comes up with their own working styles, problems
faced by them, use of particular skills and techniques while performing their job and insecurities and fears about
their careers.
This method helps interviewer know what exactly an employee thinks about his or her own job and
responsibilities involved in it. It involves analysis of job by employee himself/herself. In order to generate
honest and true feedback or collect genuine data, questions asked during the interview should be carefully
decided. And to avoid errors, it is always good to interview more than one individual to get a pool of responses.
Then it can be generalized and used for the whole group.
Merits of Interview Method:
i. Interviewing is a flexible method for all levels and types of job. An interview may focus on what a
hypothetical job might involve.
ii. Interviews generate descriptive data and enable job-holders to interpret their activities.
iii. A good interviewer can probe sensitive areas in more depth. Structured questionnaires cannot easily do this.
Jobholders can give overviews of their work and offer their perceptions and feelings about their job and the
environment.
Demerits of Interview Method:
i. Rigid questionnaires tend to be less effective where the more affective aspects of work are concerned.
ii. Information from different interviews can be hard to bring together there is potential for interviewer bias
certain areas of the work may fail to be picked up an interview may stress one area and neglect others.
iii. Here are problems in interpretation and analysis with the possibility of distorted impressions the subjectivity
of the data captured needs to be considered.
iv. Interviews are time consuming and training is needed.
3. Questionnaire Method:
Another commonly used job analysis method is getting the questionnaires filled from employees, their superiors
and managers. However, this method also suffers from personal biases. A great care should be takes while
framing questions for different grades of employees.
In order to get the true job-related info, management should effectively communicate it to the staff that data
collected will be used for their own good. It is very important to ensure them that it won’t be used against them
in anyway. If it is not done properly, it will be a sheer wastage of time, money and human resources.
Advantages of Questionnaires:
i. Questionnaires are cost-efficient.
ii. Questionnaires are also a practical way to gather data. They can be targeted to groups of your choosing and
managed in various ways.
iii. Questionnaires bring Speedy results.
iv. Questionnaires and surveys allow the HR Manager to gather information from a large audience.
v. Most survey and questionnaire providers are quantitative in nature and allow an easy analysis of results.
vi. Questionnaires ensure User anonymity.
vii. When using mail-in, online or email questionnaires, there’s no time limit and Respondents can take their
time to complete the question.
viii. Questionnaires cover all aspects of a topic.
Disadvantages of Questionnaires:
i. While there are many positives to questionnaires, dishonesty can be an issue. Respondents may not be 100
percent truthful with their answers.
ii. There is no way to know if the respondent has really thought the question through before answering.
iii. Without someone to explain the questionnaire fully and ensure each individual has the same understanding,
results can be subjective.
iv. Respondents may also have trouble grasping the meaning of some questions that may seem clear to the
creator. This miscommunication can lead to skewed results.
v. A survey or questionnaire cannot fully capture emotional responses or the feelings of the respondents.
vi. Some questions are difficult to analyse.
vii. As with any sort of research, bias can be an issue. Participants in your survey may have an interest the
product, idea or service. Others may be influenced to participate based on the subject of the questionnaire.
viii. When using questionnaires, there is a chance that some questions will be ignored. If questions are not
required, there is always that risk they will not be answered.
4. Work Methods Analysis:
The form of analysis on work methods is applicable to describe manual and repeated manufacturing jobs, for
example the jobs of assembly-line. Such analysis on work methods consists of analysis of time, motion study
and micro motion.
5. Task Inventory Method:
Indeed, a task inventory lists all discrete activities which create a certain job or certain company.
6. Job Element Method:
This style is somehow similar to the method of critical incident technique. The method concentrates on
behaviors during working and such consequences that the behaviors bring about more than look at abstract
characteristics. This method was developed by Ernest Prim off.
7. Diary Method:
The method of diary is considered to be a very useful tool to analyse jobs. In this method jobs are assessed
thanks to workers’ daily records or their lists of activities that they practice day by day.
8. Checklists and Rating Scales:
In this method jobs are analysed by using a list keeping track of such job elements. Many questions can be
raised, such as working purposes, key roles and responsibilities, organization; relationships; decision-making;
authority; Skills, knowledge, experience; working conditions.
9. Competency Profiling Method:
This form of job analysis is an activity that determines certain capacities which are characteristics of high levels
of performance in a certain job. It includes skills, knowledge, capacities, values, interests, personalities.
10. Examining Manuals/Reference Materials Method:
In analysing jobs, the analysts use manuals/or materials of reference including quality manual, human resource
manual, procedures, instruction, forms, job description. These documents are available so that organizations can
apply them in accordance with standards of ISO 9000.
11. Technical Conference Method:
This tool is of great usefulness in analyzing jobs based on Subject Matter Experts (SMEs). SMEs will
implement sessions of brainstorming to discover elements of jobs. In this method, SMEs can apply a full mix of
all methods of job analysis.

Job Analysis Methods – Top 10 Job Analysis Methods: Observation, Interview, Critical Incident, Group
Interview, Structured Questionnaire, Check-List and a Few Others
Job analysis is a process that consumes more time. It is a tedious exercise collecting information to determine
job elements, aptitudes and attitudes of an individual for a successful job performance.
Some of the important job analysis methods are given below:
1. Observation Method:
It is a job analysis technique in which employees are directly watched or films of workers on the job are
reviewed and the data regarding the job collected. In this method the supervisors observe and gather
information with regard to tasks, working conditions, etc., related to a job, while the employees are performing
their job. This method is particularly suitable for analyzing manual and unskilled jobs. It may not be suitable for
mental, analytical and technical jobs.
2. Interview Method:
The job is analyzed by interviewing every individual employee separately. It is a time consuming task. In this
method the employees are selected and intensively and extensively interviewed to know more about every
aspect of their job such as the problem and inconvenience they face while performing the job, desirable
qualification, tech-know-how, training required, etc.
3. Critical Incident Method:
This method is used to gather information about a job based on the past experiences and critical incidents which
are frequently or seldom experienced while performing the job. These incidents are analyzed in detail by the
brainstorming technique. But, it requires more time and is dependent the analytical skill of the analysts.
4. Group Interview Method:
It is done like the individual interview method but more people are interviewed simultaneously. It creates an
atmosphere for the interviewees to open up their minds and give information, share ideas, opinions, positive and
negative aspects of the job. Sometimes, group dynamics may hinder its effectiveness.
5. Structured Questionnaire Method:
In this method a questionnaire is prepared which consist of questions/statements pertaining to job and the
employees. The respondents are asked to put a tick mark against their choice or rate every item given therein. It
is good method used widely for data collection.
6. Check-List Method:
In this method, the job is analyzed and necessary information regarding the job is collected by asking the
employees some subjective questions in the form of ‘Yes’ or ‘No’ objective type questions. The job holder is
asked to put a tick mark against his/her choice.
7. Video Tape Method:
While on the job-floor, during the course of performing the job, the employees are video graphed. These video
tapes are used to assess the job. The advantage of this method is that it can be reviewed again and again
whenever needed.
8. Review of Record Method:
The work and repair records which are maintained in the human resources department of the organization are
used for job analysis. This method is not appreciated and it is defective and ineffective.
9. Conference Method:
The supervisors utilize this method to collect information. The experts share their expertise and interact with
employee participants to gather information about the jobs they perform.
10. Diary or Work Log Record Method:
The job incumbents are given a diary and asked to write a brief account of their job activities they performed at
the end of every day. It is a cost and time consuming method but it facilities collection of too much of
information at the end in which most of them may not be pertaining to the job activities. It is better to use more
than one method of job analysis to make it more effective.

Job Analysis Methods – Methods of Collecting Job Analysis Information: Questionnaire, Checklist,
Participation, Critical Incidents, Self-Recording of Diary and a Few Others
The various methods of collecting job analysis information are as under:
Method # 1. Questionnaire:
Usually this method is used to gather information about jobs through a mail survey. The job incumbents who
can easily express themselves in writing they are asked to provide data about their jobs in their own words.
Hence, this method is, best suited to clerical workers.
But it is often a very time consuming the reason is questionnaires are sent by mail. The receipt of duly filled
questionnaires from the respondents is quite often delayed and after obstructed against the process of analysing
the data obtained in this manner using.
Method # 2. Checklist:
Under this method the worker is required to check the task that he performs from a long list of possible task
statements. However, in order to prepare the checklist, extensive preliminary work is demanded in collecting
appropriate task statements. While checklists are easy for the incumbent to respond to, they do not provide an
integrated picture of the job in question. They are easily administered to large groups and are easy to tabulate.
Method # 3. Participation:
Under this method, the job analyst actually performs the job himself. By doing so he is able to gather first-hand
information about what characteristics made up the job under investigation. This method has some limitations
as it fairly good for simple jobs however, in case of complex jobs advance training of the analyst becomes
mandatory. The method is also time-consuming and too costly.
Method # 4. Critical Incidents:
Under this method, the supervisor is asked to give instances of on-the-job behaviours of people which he
considers to be important. Such instances can be both of good and bad on-the-job behaviour. The number of
such instances can be as many as the supervisor can recall. These instances can provide information about
critical aspects of the job. However, the shortcoming of the method is that it does not provide an integrated
picture of the entire task.
Method # 5. Self-Recording of Diary:
Under this method, the job incumbent is asked to record his daily activities each day using certain type of
logbook or diary. The method is good as it systematically collects a great deal of information about the nature of
and the time spent on various activities during the day by each incumbent.
Although, it is too time-consuming and exhausting consequently the incumbent may start complaining that he
has to spend more time in making entries in his diary than in doing his job. However, this method is particularly
useful for high-level managerial jobs.
Method # 6. Technical Conference:
Under this method, information about the characteristics of the job is collected from the experts. They are
usually the supervisors and not the actual job incumbents. One serious limitation of this method is that the
experts may at times show poor knowledge about the job which they are not actually performing themselves
and may give answers based upon their past experience.
Method # 7. Interview:
Under this method, a group of representative job incumbents are selected for extensive interview usually outside
of the actual job situation. The interview of the candidates or interviewees may be carried out either individually
or in a group to save time. The replies acquired from these are then combined into a single job description. This
method though too expensive and time-consuming helps in getting a complete scenario of the job.
Method # 8. Observation:
This method can be followed right on the job. The analyst observes the incumbent as he performs his work and
questions him to get the required data. Besides being slow and expensive this method also interferes with
normal work operations.
However, it generally produces a good and complete job description. This method is particularly desirable
where manual operations are prominent and where the work cycle is short. Working conditions and hazards can
also be better explained when observed personally by the analyst.

 Planning and Forecasting Personnel Needs

1. Small Business»
2. Managing Employees»
3. Recruiters»
Forecasting Methods Used in Personnel Planning and Recruiting
by Marcia Moore, MSSW

Related Articles
 1Statistical Techniques for Manpower Planning
 2Skills Inventory and Internal Recruitment Methods
 3Critical Success Factors for Human Resource Departments
 4How Temp Agencies Work
Human-resources departments plan for future staffing requirements based on the forecasting of positions
the company must fill to meet future needs. Forecasts are based on the estimated demands for products
and services. Therefore, revenues are determined first and staffing plans developed accordingly.
Forecasts of demand are calculated based on company-wide needs or individual units. Three possible
areas to forecast are anticipated personnel headcount, the present supply of internal candidates and the
supply of external candidates.
Personnel Needs
Trend analysis is used to review the past employment needs to predict future needs. There are two ways
used most frequently in trend analysis. The first is computing the number of employees at the end of a
certain number of years. The second way is the number of employees in a certain function (i.e. sales,
marketing, human resources, finance and administrative). Sometimes, it is best to use both methods to
cover all bases.
Present Supply of Internal Candidates
Qualification inventories are one way of forecasting inside candidates. A list of employees, their
education, any internal training, special skills, and succession planning for promotion is beneficial to the
future planning. A second method is referred to as personnel replacement. This is defined as the
employee's present performance and the desire for promotion to additional positions based on
performance, skills and experience.
Future Supply of External Candidates
There are numerous factors to consider for external candidates. They include the geographic area of the
company, potential candidates graduating from high school or college, individuals entering or leaving the
workforce, the level of skills and experience required to perform the internal jobs and the competing
employers for the same skill set. This information is beneficial in determining competitive benefits and
salary offerings.
Researching Internal and External Staffing Resources
Obtaining candidates to meet future needs is an important part of the forecasting process. Internal
postings can build morale as employees appreciate the opportunity to move up in the organization.
Employee-referral programs can be beneficial in bringing qualified people into the organization. Top
performers tend to know other top performers, and a cash award is motivation to present employees to
recommend these qualified candidates. Other external-staffing resources include temporary agencies,
colleges, job boards and social-networking sites.
Forecasting Personnel Needs
(Labor Demand)
Forecasting Personnel Needs (Labor Demand). How many people with what skills will we need? Managers
consider several factors.
For example, when Dan Hilbert took over staffing at Valero Energy, he reviewed Valero’s projected
retirements, growth plans, and turnover history. He discovered that projected employment shortfalls were four
times more than Valero could fill with its current recruitment procedures. He formulated new personnel plans
for boosting employee retention and recruiting and screening more candidates
A firm’s future staffing needs reflect demand for its products or services, adjusted for changes the firm plans to
make in its strategic goals and for changes in its turnover rate and productivity. Forecasting workforce demand
therefore starts with estimating what the demand will be for your products or services.
Short term, management should be concerned with daily, weekly, and seasonal forecasts. For example, retailers
track daily sales trends because they know, for instance, that Mother’s Day produces a jump in business and a
need for additional store staff. Seasonal forecasts are critical for retailers contemplating end-of-year holiday
sales, and for many firms such as landscaping and air-conditioning vendors.
Longer term, managers will follow industry publications and economic forecasts closely, to try to get a sense
for future demand. Such future predictions won’t be precise, but should help you address the potential changes
in demand.
The basic process for forecasting personnel needs is to forecast revenues first. Then estimate the size of the staff
required to support this sales volume.
However, managers must also consider other factors. These include projected turnover, decisions to upgrade (or
downgrade) products or services, productivity changes, financial resources, and decisions to enter or leave
businesses.
The basic tools for projecting personnel needs include trend analysis, ratio analysis, and the scatter plot.
Trend analysis
means studying variations in the firm’s employment levels over the past few years. For example, compute the
number of employees at the end of each of the last 5 years in each subgroup (like sales, production, secretarial,
and administrative) to identify trends.
Trend analysis can provide an initial rough estimate of future staffing needs.
However, employment levels rarely depend just on the passage of time. Other factors (like productivity and
retirements, for instance), and changing skill needs will influence impending workforce needs.
Ratio Analysis
Another simple approach, ratio analysis, means making forecasts based on the historical ratio between
(1) some causal factor (like sales volume) and
(2) the number of employees required (such as number of salespeople).
For example, suppose a salesperson traditionally generates $500,000 in sales. If the sales revenue to
salespeople ratio remains the same, you would require six new salespeople next year (each of whom produces
an extra $500,000) to produce a hoped-for extra $3 million in sales.
Like trend analysis, ratio analysis assumes that things like productivity remain about the same. If sales
productivity were to rise or fall, the ratio of sales to salespeople would change.
22 Jun
Forecasting Personnel Needs
Dr Mohamed Sabry
|
demand, forcasting, Functional job analysis, hr, hrm, human resource, human resource
management, personnel, talent, wokforce
|
HR Article, hrm Blog, Human Resource Management
|
Forecasting Personnel Needs
(Labor Demand)
Forecasting Personnel Needs (Labor Demand). How many people with what skills will we need? Managers
consider several factors.
For example, when Dan Hilbert took over staffing at Valero Energy, he reviewed Valero’s projected
retirements, growth plans, and turnover history. He discovered that projected employment shortfalls were four
times more than Valero could fill with its current recruitment procedures. He formulated new personnel plans
for boosting employee retention and recruiting and screening more candidates
A firm’s future staffing needs reflect demand for its products or services, adjusted for changes the firm plans to
make in its strategic goals and for changes in its turnover rate and productivity. Forecasting workforce demand
therefore starts with estimating what the demand will be for your products or services.
Short term, management should be concerned with daily, weekly, and seasonal forecasts. For example, retailers
track daily sales trends because they know, for instance, that Mother’s Day produces a jump in business and a
need for additional store staff. Seasonal forecasts are critical for retailers contemplating end-of-year holiday
sales, and for many firms such as landscaping and air-conditioning vendors.
Longer term, managers will follow industry publications and economic forecasts closely, to try to get a sense
for future demand. Such future predictions won’t be precise, but should help you address the potential changes
in demand.
The basic process for forecasting personnel needs is to forecast revenues first. Then estimate the size of the staff
required to support this sales volume.
However, managers must also consider other factors. These include projected turnover, decisions to upgrade (or
downgrade) products or services, productivity changes, financial resources, and decisions to enter or leave
businesses.
The basic tools for projecting personnel needs include trend analysis, ratio analysis, and the scatter plot.
Trend analysis
means studying variations in the firm’s employment levels over the past few years. For example, compute the
number of employees at the end of each of the last 5 years in each subgroup (like sales, production, secretarial,
and administrative) to identify trends.
Trend analysis can provide an initial rough estimate of future staffing needs.
However, employment levels rarely depend just on the passage of time. Other factors (like productivity and
retirements, for instance), and changing skill needs will influence impending workforce needs.
Ratio Analysis
Another simple approach, ratio analysis, means making forecasts based on the historical ratio between
(1) some causal factor (like sales volume) and
(2) the number of employees required (such as number of salespeople).
For example, suppose a salesperson traditionally generates $500,000 in sales. If the sales revenue to
salespeople ratio remains the same, you would require six new salespeople next year (each of whom produces
an extra $500,000) to produce a hoped-for extra $3 million in sales.
Like trend analysis, ratio analysis assumes that things like productivity remain about the same. If sales
productivity were to rise or fall, the ratio of sales to salespeople would change.
The scatter plot
Is a graphical method used to help identify the relationship between two variables.
The scatter plot shows graphically how two variables—such as sales and your firm’s staffing levels—are
related. If they are, then if you can forecast the business activity (like sales), you should also be able to estimate
your personnel
needs.
For example, suppose a 500-bed hospital expects to expand to 1,200 beds over the next 5 years. The human
resource director wants to forecast how many registered nurses the hospital will need. The human resource
director realizes she must determine the relationship between hospital size (in number of beds) and number of
nurses required. She calls eight hospitals of various sizes and finds this:
22 Jun
Forecasting Personnel Needs
Dr Mohamed Sabry
|
demand, forcasting, Functional job analysis, hr, hrm, human resource, human resource
management, personnel, talent, wokforce
|
HR Article, hrm Blog, Human Resource Management
|
Forecasting Personnel Needs
(Labor Demand)
Forecasting Personnel Needs (Labor Demand). How many people with what skills will we need? Managers
consider several factors.
For example, when Dan Hilbert took over staffing at Valero Energy, he reviewed Valero’s projected
retirements, growth plans, and turnover history. He discovered that projected employment shortfalls were four
times more than Valero could fill with its current recruitment procedures. He formulated new personnel plans
for boosting employee retention and recruiting and screening more candidates
A firm’s future staffing needs reflect demand for its products or services, adjusted for changes the firm plans to
make in its strategic goals and for changes in its turnover rate and productivity. Forecasting workforce demand
therefore starts with estimating what the demand will be for your products or services.
Short term, management should be concerned with daily, weekly, and seasonal forecasts. For example, retailers
track daily sales trends because they know, for instance, that Mother’s Day produces a jump in business and a
need for additional store staff. Seasonal forecasts are critical for retailers contemplating end-of-year holiday
sales, and for many firms such as landscaping and air-conditioning vendors.
Longer term, managers will follow industry publications and economic forecasts closely, to try to get a sense
for future demand. Such future predictions won’t be precise, but should help you address the potential changes
in demand.
The basic process for forecasting personnel needs is to forecast revenues first. Then estimate the size of the staff
required to support this sales volume.
However, managers must also consider other factors. These include projected turnover, decisions to upgrade (or
downgrade) products or services, productivity changes, financial resources, and decisions to enter or leave
businesses.
The basic tools for projecting personnel needs include trend analysis, ratio analysis, and the scatter plot.
Trend analysis
means studying variations in the firm’s employment levels over the past few years. For example, compute the
number of employees at the end of each of the last 5 years in each subgroup (like sales, production, secretarial,
and administrative) to identify trends.
Trend analysis can provide an initial rough estimate of future staffing needs.
However, employment levels rarely depend just on the passage of time. Other factors (like productivity and
retirements, for instance), and changing skill needs will influence impending workforce needs.
Ratio Analysis
Another simple approach, ratio analysis, means making forecasts based on the historical ratio between
(1) some causal factor (like sales volume) and
(2) the number of employees required (such as number of salespeople).
For example, suppose a salesperson traditionally generates $500,000 in sales. If the sales revenue to
salespeople ratio remains the same, you would require six new salespeople next year (each of whom produces
an extra $500,000) to produce a hoped-for extra $3 million in sales.
Like trend analysis, ratio analysis assumes that things like productivity remain about the same. If sales
productivity were to rise or fall, the ratio of sales to salespeople would change.
The scatter plot
Is a graphical method used to help identify the relationship between two variables.
The scatter plot shows graphically how two variables—such as sales and your firm’s staffing levels—are
related. If they are, then if you can forecast the business activity (like sales), you should also be able to estimate
your personnel
needs.
For example, suppose a 500-bed hospital expects to expand to 1,200 beds over the next 5 years. The human
resource director wants to forecast how many registered nurses the hospital will need. The human resource
director realizes she must determine the relationship between hospital size (in number of beds) and number of
nurses required. She calls eight hospitals of various sizes and finds this:

graph compares hospital size and number of nurses. If the two are related, then the points you plot (from the
data above) will tend to fall on a straight line, as here. If you carefully draw in a line to minimize the distances
between the line and each one of the plotted points, you will be able to estimate the number of nurses needed for
each hospital size. Thus, for a 1,200-bed hospital, the human resource director would assume she needs about
1,210 nurses.
While simple, tools like scatter plots have drawbacks :
1. Historical sales/personnel relationships assume that the firm’s existing activities and skill needs will continue
as is.
2. They tend to reward managers for adding employees, irrespective of the company’s needs.
3. They tend to institutionalize existing ways of doing things, even in the face of
change.
Computerized systems and Excel spreadsheets help managers translate estimates of projected productivity and
sales levels into forecast-able personnel requirements.
determining the Relationship Between
hospital Size and number of nurses

Managerial Judgement
Few historical trends, ratios, or relationships will continue unchanged into the future. Judgment is thus needed
to adjust the forecast.
Important factors that may modify your initial forecast of personnel requirements include decisions to upgrade
quality or enter into new markets; technological and administrative changes resulting in increased productivity;
and financial resources available, for instance, a projected budget crunch.
What Is Forecasting in HR?
by Sam Ashe-Edmunds; Reviewed by Michelle Seidel, B.Sc., LL.B., MBA; Updated January 25, 2019

Related Articles
 1How Can Human Resource Planning Assist an Organization?
 2Benefit of Forecasting & Business Trend Research
  3Internal Factors to Consider in Human Resource Planning
 4Organization Management & Development
Human resources (HR) forecasting involves projecting labor needs and the effects they’ll have on a business.
An HR department forecasts both short- and long-term staffing needs based on projected sales, office growth,
attrition and other factors that affect a company’s need for labor. In addition to forecasting the number and type
of workers you’ll need, HR planning includes analyzing the various costs and administrative work that go along
with adding workers or downsizing.
Using an Organization Chart
One of the most basic forecasting tasks for a human resources manager is the creation and maintenance of a
company’s organization chart. If your business uses a flat organizational structure consisting of a few key
employees who work directly with you, it’s a good idea to create a chart that shows how your company will be
organized a year or two down the road. You might begin adding departments, such as accounting, marketing,
sales and human resources, each of which requires a department head and multiple employees.
An organization chart helps you hire proactively and avoid ending up with employees who don’t fit in to your
future organization.
Production and Scheduling
If you make a product, your labor needs change as sales rise and fall. Your human resources manager should
keep in close touch with your sales manager to be aware of any spikes or declines in sales that affect your labor
needs. This prevents falling behind on order fulfillment or paying idle workers.
A simple example of labor forecasting is a restaurant that has nights with many bookings and large parties and
other nights when few diners make reservations. The manager forecasts the restaurant’s wait staff, bar and
kitchen needs. At a factory, the sales, production and human resources managers work together to address
seasonal spikes, large orders or the loss of a major customer or retailer.
Forecasting and Succession Planning
Human resources forecasting helps you avoid long-term holes in your staffing needs by keeping on top of which
of your employees might be retiring, leaving or asked to leave. Using this information, your HR manager plans
to fill these holes with internal staff or prepares for a quick recruiting effort.
As you receive the results of your staff forecasting, prepare your coordinators to move up to manager positions
one day and your managers to make the move to directors, if possible. Lower-level staff can’t fill some
positions because they require specific degrees or certifications, but some positions might best be filled by
internal employees. Add employee training to your human resources efforts to prepare key staff to rise within
the organization as staff members need to be replaced.
Budgeting Based on Future Staffing Levels
In addition to forecasting labor needs, human resources forecasting helps you plan budgets based on your future
staffing levels. For example, demand forecasting might show a need for more seasonal workers. An HR review
might determine the best way to handle this is with part-time workers or paying overtime to current employees.
If your labor needs won’t change next year, you might still have increased employee costs based on annual
raises and benefits increases. Your HR manager forecasts your personnel costs each year to help with your
budgeting.
5-1 Personnel Planning 5 and Recruiting 5-2 Learning Objectives 1. List the steps in the recruitment and
selection process. 2. Explain the main techniques used in employment planning and forecasting. 3. Explain and
give examples for the need for effective recruiting. 5-3 Learning Objectives 4. Name and describe the main
internal sources of candidates. 5. List and discuss the main outside sources of candidates. 6. Develop a help
wanted ad. 7. Explain how to recruit a more diverse workforce. 5-4 Human Resources Planning Process
Forecast demand Analyze supply Plan and implement programs to balance supply and demand 5-5 The steps in
the recruitment and selection process. 5-6 The Five Steps • Positions to be filled • Pool of candidates •
Applications and screening • Selection tools • Make an offer 5-7 Review • Positions • Candidates • Screening •
Selection • Offers 5-8 Explain the main techniques used in employment planning and forecasting. 5-9
Workforce Planning and Forecasting • Strategy and workforce planning • Forecasting personnel needs (labor
demand) oTrend analysis oRatio analysis oThe scatter plot oMarkov analysis 5-10 5-11 5-12 5-13 5-14
Forecasting the Supply of Inside Candidates • Manual systems and replacement charts • Computerized skills
inventories • Privacy 5-15 Forecasting the Supply of Outside Candidates • Talent management • Action
planning for labor supply and demand • The recruiting yield pyramid 5-16 The recruiting yield pyramid 5-17
Review • Forecasting • Manual vs. computerized systems • Managing talent • Action planning • Recruiting
pyramid 5-18 Explain and give examples for the need for effective recruiting. 5-19 Employee recruiting •
Employee recruiting means finding and/or attracting applicants for the employer’s open positions. 5-20 The
Need for Effective Recruiting • Why recruiting is important • What makes recruiting a challenge? • Organizing
how you recruit oThe supervisor’s role 5-21 Review • Importance • Challenge • Organizing 5-22 Name and
describe the main internal sources of candidates. 5-23 Internal Sources of Candidates • Using internal sources •
Finding internal candidates • Rehiring • Succession planning oIdentify key needs oDevelop inside candidates
oAssess and choose 5-24 Review • Internal sources • Finding internal candidates • Rehiring • Succession
planning 5-25 List and discuss the main outside sources of candidates. 5-26 Outside Candidates • Internet
recruiting oOnline recruiting oTexting o Dot-jobs oVirtual job fairs oTracking oEffectiveness • Advertising –
media 5-27 Review • Internet recruiting • Advertising • Media http://www.careerbuilder.com 5-28 Develop a
help wanted ad 5-29 Writing the Ad • Attention • Interest • Desire • Action 5-30 Employment Agencies • Public
• Nonprofit agencies • Private agencies 5-31 Temp Agencies and Alternative Staffing • Pros and cons • What
supervisors should know about temporary employees’ concerns • Legal guidelines • Alternative staffing 5-32
Other Sources of Candidates • Offshoring and outsourcing jobs • Executive recruiters oPros and cons
oGuidelines • On-demand recruiting services 5-33 Other Sources of Candidates • College recruiting oOn-
campus recruiting goals oThe on-site visit oInternships 5-34 Recruiting • Referrals and walk-ins •
Telecommuters • Military personnel • Recruiting source use and effectiveness 5-35 Other Issues • Recruiting
source use and effectiveness • Measuring recruiting effectiveness 5-36 Review • Writing the ad • Employment
agencies • Temp agencies, alternative staffing • Other sources of candidates • Recruiting • Measuring
effectiveness 5-37 Explain how to recruit a more diverse workforce. 5-38 Recruiting a More Diverse Workforce
• Single parents • Older workers • Recruiting minorities • Welfare-to-work • Disabled workers 5-39 Developing
and Using Application Forms • Purpose of application forms • Application guidelines • Application forms and
EEO law • Predicting job performance • Mandatory arbitration 5-40 Review • Recruiting a more diverse
workforce • Developing and using application forms
How to Plan Personnel Needs for Projects
As a project manager, you must determine how many people you’ll need to complete the project on time.
Planning personnel needs begins with identifying whom you need and how much effort they have to invest. You
can use a Human Resources Matrix to display this information.
Work effort is related to, but different from, duration. According to the matrix, J. Jones works on this activity
for 32 person-hours, and an unnamed analyst works on it for 24 person-hours:
The Human Resources Matrix depicts the people assigned to each project activity and the work effort each
person will contribute to each assignment.
Work effort is related to, but different from, duration. According to the matrix, J. Jones works on this activity
for 32 person-hours, and an unnamed analyst works on it for 24 person-hours.
Knowing the work effort required to complete a work package alone, however, doesn’t tell you the duration of
the work package. For example, if both people assigned to the questionnaire design work package can do their
work on it at the same time, if they’re both assigned 100 percent to the project, and if no other aspects of the
task take additional time, the activity may be finished in four days. However, if either person is available for
less than 100 percent of the time, if one or both people must work overtime, or if one person has to finish her
work before the other can start, the duration won’t be four days.
Begin to create your Human Resources Matrix by specifying in the top row the different types of personnel you
need for your project. You can use three types of information to identify the people you need to have on your
project team:
 Skills and knowledge: The specific skills and knowledge that the person who’ll do the work must have
 Position name or title: The job title or the name of the position of the person who’ll do the work
 Name: The name of the person who’ll do the work
Eventually, you want to specify all three pieces of information for each project team member. Early in your
planning, try to specify needed skills and knowledge, such as must be able to develop work process flow
charts or must be able to use Microsoft PowerPoint. If you can identify the exact skills and knowledge that a
person must have for a particular task, you increase the chances that the proper person will be assigned.
Often, you want to identify people you want on your project by name. The reason is simple: If you’ve worked
with someone before and he’s done a good job, you want to work with him again. Although it’s great for that
person’s ego, this method, unfortunately, often reduces the chances that you’ll get an appropriately qualified
person to work on your project. People who develop reputations for excellence often get more requests to
participate on projects than they can handle. When you don’t specify the skills and knowledge needed to
perform the particular work on your project, the manager — who has to find a substitute for that overextended
person — doesn’t know what skills and knowledge that the alternate needs to have.
3 Ways to Determine Your Company’s Personnel Needs
August 3, 2012 by Jessica Oman 0 Comments
 If you want to grow your business, you’re going to need help. You can’t do it
all yourself forever. Intrinsically, you probably know that – but – chances are you’ll underestimate just how
much help you need to sustain the growth of your business.
How do you determine your staffing needs? There’s no one size fits all solution, but here are a few ideas:
Look at your Competitors
Assess a few businesses similar in size to yours, and ideally, direct competitors. Also look at larger businesses
in your category, so you have an idea of how they’ve scaled. Try to determine the organizational structure of
each one, and look at the different positions in the business, as well as how many positions exist. Some
businesses overstaff, and some understaff; try to find a happy medium that also works with your management
style.
Consider Contractors Instead
If the work you want to delegate is irregular, you might consider hiring a contractor or a virtual assistant to feel
what it’s like to be a boss. Be careful, though, that you’re not breaking any laws. There’s often a fine line
between who can be considered a contractor and who can be considered an employee, and you need to know the
difference in order to protect your business.
Create an Organizational Chart
Even if you’re the only person working in your business, create an organizational chart with all the possible
roles you’ll fill, and put that in your business plan. It will serve as a guide for your own operations, as well as
show potential investors how you see your business being structured.
Another tip: don’t forget to budget at least 15% in addition to wages, to cover mandatory benefits like
employment insurance.
Have you staffed your business for growth? Let us know in the comments below.
Forecasting Personnel Needs
The most common personnel planning approaches involve the use of simple techniques like trend analysis and
ratio analysis to estimate staffing needs based on sales projections and historical sales to personnel
relationships. The usual process is to forecast revenues first, and then estimate the size of the staff required to
reach the sales volume. Several techniques used by Human Resource Managers:
Trend Analysis
Trend Analysis means studying variations in a firm’s employment levels over the last few years. You might
compute the number of workers in a firm at the end of each of the last five years or maybe the number in each
subgroup at the end of each of those years. The purpose is to identify trends that might continue into the future.
Ratio Analysis
Ratio Analysis means making forecast based on the ratio between some causal factor like sales volume and the
number of workers required such as number of salespeople. Ratio analysis assumes that productivity remains
about the same. If sales productivity were to increase or decrease, the ratio of sales to salespeople would
change.
The Scatter Plot
Scatter plot shows how two variables such as a measure of business activity and firm’s staffing levels are
related. If they are, then if you can forecast the level of business activity, you should be able to estimate
personnel requirements
5 Factors that Must be Considered for Assessing the Future Personnel Needs

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5 Factors that Must be considered for Assessing the Future Personnel Needs in an Organisation.
The primary purpose for forecasting manpower needs is to prepare for employment, training and development
of human resources as the need arises. Forecasting has become very important due to organizational
requirement for more skilled personnel which are in short supply.

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In the forecasting process, organizations need to consider past use of human resources, future organizational
plans and general economic trends. Large organizations use sophisticated econometric models and computer
software for forecasting their future need for human resources.
Some of the factors taken into consideration for assessing the future personnel needs are:
1. Anticipated growth of the organization:
The growth rate can be calculated from the past trends on the assumption that all variables affecting this growth
will remain constant.
2. Budget constraints and allocations:
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The budget allocation, specifically for the purpose of new employees will determine the number of new workers
that can be hired, thus putting a ceiling on the maximum number.
3. Anticipated internal turnover:
This turnover of employees may be due to retirement, transfers, and promotions, termination of service or death.
Some of these numbers can be calculated to some extent accurately, in advance by taking information about
individuals. The turnover due to retirement and promotions can be more accurately forecast by preparing
profiles for personnel who may be up for retirement, promotion or transfer in the near future.
4. Introduction of new technology:
With continuous technological developments, innovation and automation, the personnel needs are constantly
changing. At many places, computers are either replacing workers or reducing their numbers. The type of new
technology introduced would determine the number as well as qualifications of the people that may be hired or
transferred.
5. Minority hiring goals:
The goals established by the organization about hiring minorities or the handicapped, as a part of the affirmative
action policies may affect the demand for the total number of employees, especially when it is difficult to match
the skills of such minority workers to the specific job requirements.
Forecasting Methods Used in Personnel Planning and Recruiting
by Christian Fisher

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 HR Metrics and Their Impact on Business
 The Role of Human Resource in the Evaluation of Strategies
 Human Resource Trends Affecting Organizations
 What Are the Various Roles HR Plays in Organizations?
Organizations look to their budgets, competitive needs and the pool of talent in the workforce as part of
personnel planning and recruiting. In 2014, 70 percent of 162 U.S. CEOs surveyed by PwC pointed to a
shortage of needed talent and skills as a major concern affecting the future of their organizations. Forecasting
methods help human resources departments assess and find the skill sets needed to meet their organizations’
current and future goals.
Looking at Today
Job analysis and skills assessment are methods that human resources professionals use to understand an
organization’s current talent base and how that base is changing. Observing and interviewing employees helps
human resources departments know what skills, traits and experience certain jobs entail. Performance
evaluations, questionnaires and the results of training and leadership programs also help human resources
departments assess growth potential of individuals within an organization’s ranks.
Looking at Tomorrow
Human resources departments analyze the demand for their organizations’ products and services to assess the
need to hire more people in various departments. The competition for top talent entering the workforce compels
some human resources departments to become much more proactive in recruiting. For example, as of
publication, technologies that analyze social media profiles, blogs and profession-specific networking sites are
being used in the recruitment process to let organizations identify and reach out to promising job candidates
before those candidates apply to competing companies.
Evaluating Investment
Some human resources departments combine workforce analysis and financial data analysis to determine and
anticipate how employees and managers contribute to saving money or increasing revenue within the
organization. For example, an organization can use data to determine why some employees succeed over others
in such areas as sales, leadership or productivity. This method helps organizations make clearer predictions
regarding training new hires and developing current employees.
Responding to Trends
Human resources departments integrate changing workplace demographics into their personnel planning.
Training managers in cultural and generational diversity and customizing compensation and benefit packages
are among the methods being used to attract and retain top talent, according to the Society for Human Resource
Management’s 2013 Workplace Forecast. Additionally, some human resources departments conduct studies
looking at what skills will be in short supply and need replenishing as more employees in the workforce retire.

State the advantages and disadvantages of job evaluation indetail

The advantages of job evaluation are:
1. Job evaluation is a logical and an objective method of ranking jobs relative to each other.It may thus help in
removing inequities in existing wage structures and in maintaining soundand consistent wage differences in a
plant or an industry.2. The method replaces accidental factors occurring in less systematic procedures of
wagebargaining by more impersonal and objective standards, thus establishing a clearer basis fornegotiation.3.
The method may lead to greater uniformity in wage rates and simplify the process ofwage administration.4.
Information collected in a process of job description and analysis can be used forimprovement of selection,
training, transfer and promotion, procedures on the basis of thecomparative job requirement.
The limitations of job evaluation are:
1. Methods of job evaluation are not considered to be completely objective as some amountof subjectivity is
involved in the selection of benchmarking jobs and key compensablefactors.

2. External factors of jobs are not considered in job evaluation. It would be difficult to fixanything less than the
prevailing wages even if job evaluation recommends so.3. Due to the faster pace of changes in the external
factors such as technology and labourmarket characteristics, job characteristics requirements undergo changes
in quicksuccession. This makes job evolution results relevant for a short period only.4. The determination of
employee compensation is often influenced by the bargaining powerof the employees and their unions.
However, the job evaluation process never considers thisfactor while deciding the pay scale for jobs.5. Since
job evaluation is a time consuming, complex and costly process, small and mediumorganisations give minimum
importance on pay scale fixing

What do you mean by Discipline? Describe

–
Disciplinaryactions and penalty in any industry
.
Discipline is employee self-control which prompts him/her to willingly cooperate with theorganisational
standards, rules, objectives, etc. Discipline is best defined as the observationof principles, rules or any other laid
down procedures, practices, written or otherwise in theorganisation by the employees or group of employees, to
whom these apply, for smooth andeffective functioning of the organisation.There are various panalities for first
, second and third offences of the same rule.following are the commonly practiced actions in business
orgination.1. Oral reprimand :The penalties are listed in the general order of severity, from mild tosevere. For
most cases, an oral reprimand is sufficient to achieve the desired result. Thesupervisor must know his or
her personnel in determining how to give a reprimand. For oneperson, a severe "session" may be necessary
in order to get attention and cooperation;another person may require only a casual mention of a deficiency. If
the offence is moreserious, the reprimand may be put in written form2. Written warning: When an oral warning
or counselling to the employee does not producethe desired result, the manager may issue a written warning
to the employee. The employeeis normally asked to acknowledge the receipt of written reprimand, irrespective
of whetherhe agrees with the content of the letter or not. Since a written reprimand is more permanentthan an
oral one, it is considered a more severe offence and the penalty levied accordingly3. Denial of increments,
promotions and pay hikes : On some incidents the managementmay refuse promotions, increments or pay hike
by blacklisting the employee for a specificperiod of time. This is usually treated as a punishment for a
certain period of time.4. Pay reductions and disciplinary demotions :This is usually more severe than the denial
ofpay hikes and promotions because the employee loses part of existing benefits andprivileges received by him
from the organisation5. Suspension6. Discharge or dismissal

Discuss about the Statutory welfare facilities.

Statutory welfare facilities are facilities offered by the organization compliance with thecentral and
state government regulations. The relevant provisions of various acts that dealswith employee welfare measures
are:Factories Act, 1948Contract Labour Act. 1970 The statutory welfare schemes include the following
provisions:1. Drinking water: At all working places safe hygienic drinking water should be provided.2.
Facilities for sitting: In every organisation, especially factories, suitable seatingarrangements are to be
provided.3. First aid appliances: First aid appliances are to be provided and should be readilyaccessible, so that
initial medication can be provided to the needed employee in case of anyminor accidents.4. Latrines and urinals:
Sufficient number of latrines and urinals are to be provided in theoffice and factory premises and are to be
maintained in a neat and clean condition.5. Canteen facilities: Cafeteria or canteens are to be provided by the
employer so as toprovide hygienic and nutritious food to the employees.6. Spittoons: In every work place, such
as warehouses, store places, dock area and officepremises spittoons are to be provided in convenient places and
are to be maintained in ahygienic condition. 7. Lighting: Proper and sufficient lights are to be provided for
employeesso that they can work safely during the night shifts.8. Washing places: Adequate washing places such
as bathrooms, wash basins with tap andtap on the stand pipe are to be provided in the port area in the vicinity
of the work places.9. Changing rooms: Adequate changing rooms are to be provided for workers to changetheir
clothes in the factory area and office premises. Adequate lockers are also to beprovided to the workers to
keep their clothes and belongings.10. Restroom: Adequate numbers of restrooms are provided to the workers
with provisionsof water supply , basin wash , toilets , bathrooms etc
INTERNATIONAL JOURNAL OF MANAGEMENT, BUSINESS, AND ADMINISTRATION VOLUME 15,
NUMBER 1, 2012 1 Human Resource Planning: Forecasting Demand and Supply Fred C. Lunenburg Sam
Houston State University
______________________________________________________________________________ Abstract
Human resource planning begins with a forecast of the number and types of employees needed to achieve the
organization’s objectives. Planning also involves job analysis, which consists of the preparation of job
descriptions and job specifications. Of particular concern for today’s executives is the growing body of laws
regulating the human resource management process.
______________________________________________________________________________ Human
Resource Management Process The overall human resource management process comprises the following
programs: human resource planning, recruitment, selection, professional development, performance appraisal,
and compensation. In this article, I examine one of the human resource management processes (human resource
planning), because it is such an important function that is often neglected. The planning function, in general,
involves defining an organization’s goals, establishing a strategy for achieving those goals, and developing a
comprehensive set of plans to integrate and coordinate activities (Robbins & Judge, 2013). The necessity of this
function follows from the nature of organizations as purposive (goal-seeking) entities (Gibson, Ivancevich,
Donnelly, & Konopaske, 2012). Planning activities can be complex or simple, implicit or explicit, impersonal or
personal. For example, a human resource manager forecasting demand for the firm’s human resources may rely
on complex econometric models or casual conversation with human resource personnel in the field. Good
human resource planning involves meeting current and future personnel needs. The manager ensures that
personnel needs are met through ongoing analysis of performance objectives, job requirements, and available
personnel, coupled with knowledge of employment laws. INTERNATIONAL JOURNAL OF
MANAGEMENT, BUSINESS, AND ADMINISTRATION
2____________________________________________________________________________________
Human Resource Planning Organizations typically plan their future needs for supplies, equipment, building
capacity, and financing. Organizations must also plan to ensure that their human resource needs are satisfied.
Human resource planning involves identifying staffing needs, forecasting available personnel, and determining
what additions or replacements are required to maintain a staff of the desired quantity and quality to achieve the
organization’s goals. The human resource planning function involves at least three different elements: job
analysis, forecasting demand and supply, and legal restraints. Job Analysis Company president, manager,
director of personnel, legal counsel, labor relations specialist, college president, dean, and professor are all jobs.
To recruit and select the appropriate personnel for specific jobs, it is necessary to know what the jobs entail. Job
analysis is the process of obtaining information about jobs through a systematic examination of job content
(U.S. Department of Labor, 2012). A job analysis usually consists of two parts: a job description and a job
specification. The job description is a written statement that outlines the duties and responsibilities expected of
a job incumbent. It usually includes a job title, the title of the incumbent’s immediate supervisor, a brief
statement of the job goal, and a list of duties and responsibilities. The job specification is a written document
that outlines the qualifications that a person needs in order to accomplish the duties and responsibilities set forth
in the job description. Job analysis provides valuable information for forecasting future staffing needs and other
personnel management functions. For example, the data produced by the job analysis can be used to develop
appropriate recruitment and selection methods to determine dimensions on which personnel should be
evaluated, to determine the worth of jobs for compensation purposes, and to develop training programs for
personnel. Job analysis techniques. A variety of techniques are available for conducting a job analysis. The
technique most appropriate for a given situation depends on a number of factors, such as the type of job being
analyzed, the resources available for doing a job analysis, the scope of the job, and the size of the organization.
Some of the most commonly used techniques for conducting a job analysis include observation, work sampling,
critical incidents, interviews, and questionnaires. Observation. The most straightforward method of job analysis
is observation of people performing the job. Observation can be a good way of examining jobs that consist
mainly of observable physical activity. Jobs such as maintenance worker, groundskeeper, and machine operator
are examples. Analyzing a job through observation is not appropriate where the job requires much abstract
thinking, planning, or decision making (e.g., company president, labor relations specialist, legal counsel). FRED
C. LUNENBURG
_____________________________________________________________________________________3
Work sampling. A variation of the observation technique is the work sampling approach. The job analyst
periodically samples employees’ activities and behavior on jobs that have long cycles, that have irregular
patterns of activity, or that require a variety of different tasks. For example, research on the administrative
demands of department heads consistently shows that they are fragmented and rapid fire. A personnel
administrator could examine the job activities of twenty-five or thirty company executives on a given day or
randomly select twenty-five or thirty days of the year and observe the job activities of five executives during
those days. This approach is similar to the one used by Henry Mintzberg (1998) when he undertook a careful
study of five executives to determine what they did on their jobs. On the basis of his observations, Mintzberg
concluded that company executives perform ten different, highly interrelated roles, which he divided into three
categories: figurehead, leader, liaison (interpersonal); monitor, disseminator, spokesperson, decisional
(informational); and entrepreneur, disturbance handler, resource allocator, negotiator (decisional). Mintzberg,
however, went well beyond the work sampling approach in his analysis of executives. He used a combination of
ethnographic techniques including observation, interviews, document analysis, and structured questionnaires to
obtain his data. Critical incidents. Another variation of the observation technique, known as critical incidents,
examines only those job activities leading to successful or unsuccessful performance. This approach is similar
to the trait approach used to identify effective and ineffective leaders. An outside consultant, an immediate
supervisor, or a job incumbent can conduct this technique. Direct observation and the two variations thereof are
frequently used in conjunction with interviewing. Interviews. Probably the most widely used technique for
determining what a job entails is the interview technique, and its wide use attests to its advantages. Observation
of an organization’s labor relations specialist, for example, would only reveal that the role incumbent conducts
research, handles conflicts, prepares proposals and counterproposals, confers with management, and negotiates
at the bargaining table. This method fails to identify other important aspects of the job, such as analytic thinking
and problem solving. Interviewing the labor relations specialist allows that person to describe important
activities of the job that might not be revealed through direct observation. Questionnaires. Many organizations
use job analysis questionnaires to elicit information concerning what a job entails. Such questionnaires have at
least two advantages. First, they can pool the responses of numerous job incumbents and compare job activities
across many jobs, using a standard set of common dimensions. Second, questionnaire can generate much
information quickly and inexpensively. For example, a job analyst could administer a questionnaire to 100 job
incumbents in less than it would take to observe a single job or interview one job occupant. The U.S. Air Force
has developed the Comprehensive Occupational Data Analysis Program (CODAP) (Christal & Weissmuller,
1977). It elicits data about hundreds of job tasks. Another popular, structured job analysis questionnaire is the
INTERNATIONAL JOURNAL OF MANAGEMENT, BUSINESS, AND ADMINISTRATION
4____________________________________________________________________________________
Position Analysis Questionnaire (PAQ) developed at Purdue University. It consists of 194 items designed to
assess six broad categories of work activity: information input, mental processes, work output, relationships
with others, job context, and other job characteristics such as working irregular hours (McCormick, Mecham, &
Jeanneret, 1972). The PAQ is inadequate for analyzing upper-level cognitive processes such as abstract thinking
and strategic planning. Well-known instruments designed to elicit information about upper-level administrative
jobs include the Management Position Description Questionnaire (MPDQ) and the Professional and Managerial
Position Questionnaire (PMPQ) (Tornow & Pinto, 1976; Mitchell & McCormick, 1979). Forecasting Demand
and Supply The second phase of human resource planning, forecasting demand and supply, involves using any
number of sophisticated statistical procedures based on analysis and projections. Such forecasting techniques
are beyond the scope of this discussion. At a more practical level, forecasting demand involves determining the
numbers and kinds of personnel that an organization will need at some point in the future. Most managers
consider several factors when forecasting future personnel needs. The demand for the organization’s product or
service is paramount. Thus, in a business, markets and sales figures are projected first. Then, the personnel
needed to serve the projected capacity is estimated. Other factors typically considered when forecasting the
demand for personnel include budget constraints; turnover due to resignations, terminations, transfers, and
retirement; new technology in the field; decisions to upgrade the quality of services provided; and minority
hiring goals (Noe, 2012). Forecasting supply involves determining what personnel will be available. The two
sources are internal and external: people already employed by the firm and those outside the organization.
Factors managers typically consider when forecasting the supply of personnel include promoting employees
from within the organization; identifying employees willing and able to be trained; availability of required
talent in local, regional, and national labor markets; competition for talent within the field; population trends
(such as movement of families in the United States from Northeast to the Southwest); and college and
university enrollment trends in the needed field (Ball, 2012; Henderson, 2010). Internal sources of employees to
fill projected vacancies must be monitored. This is facilitated by the use of the human resource audit, or the
systematic inventory of the qualifications of existing personnel. A human resource audit is simply an
organizational chart of a unit or entire organization with all positions (usually administrative) indicated and
keyed as to the “promotability” of each role incumbent. Figure 1 depicts a human resource audit, or inventory
chart, for a hypothetical firm. As Figure 1 indicates, the president can see where he or she stands with respect to
future staff actions. The president’s successor is probably the vice president for operations. This person has a
successor, operations manager, ready for promotion. Subordinates to the manager of operations are two
department heads who are promotable now, three who will be ready for promotion in one or two years, two who
are not promotable, and one who should be dismissed. FRED C. LUNENBURG
_____________________________________________________________________________________5 The
other subordinate to the vice president of operations, the sales manager, is satisfactory but not promotable. That
person has two department heads who are promotable now, one who will be promotable with further training,
and one who is satisfactory but not promotable. The vice president of finance requires further training before
being ready for promotion. Here is a person who knows the job of business management extremely well but
lacks training in other aspects of the presidency, such as operations, personnel administration, marketing, sales,
and the like. Some of the accountants reporting to the vice president for finance are promotable now, while
others either are not promotable or require additional training before being ready for promotion. The vice
president of personnel, while occupying a very specialized function, is promotable now. Subordinates to that
person occupy such specialized jobs that, although performing these roles satisfactorily, they require additional
training before being ready for promotion to vice president of personnel. The vice president of research and
development was a newly created position in this hypothetical organization. Because of the specialized nature
of the position, that person requires considerable training before being ready for promotion. Subordinates to that
position are designated similarly. Future needs and the potential of the existing administrative staff have been
identified, and weaknesses have been uncovered. These data can help administrators plan immediate
promotions for personnel from within the organization who are promotable, plan for appropriate training and
development of others, or dismiss those who are unsatisfactory. If there are an insufficient number of candidates
inside the firm to fill vacancies, staffing specialists typically analyze labor markets. INTERNATIONAL
JOURNAL OF MANAGEMENT, BUSINESS, AND ADMINISTRATION
6____________________________________________________________________________________
Figure 1. Human resource audit for administrative personnel. Legal Constraints Legislation designed to regulate
hiring practices affects nearly every aspect of employment—from human resource planning to compensation.
Our intent is not to make managers into attorneys but to examine the basic laws that relate to employment
decisions. Managers must avoid possible charges of discrimination on the basis of race, color, gender, national
origin, age, or disability (Cushway, 2011; Moran, 2011). Table 1 summarizes some of the major laws pertaining
to the personnel process. Operations Manager Sales Manager Accountants President Vice President of Research
and Development Vice President of Finance Vice President of Operations Vice President of Personnel
Department Head Department Head P. Lewis J. Bolado V. Tate B. Nash N. Ross P. Garcia D. Smith T. Huang
R. Brown L. Budd A. Katz E. Moss H. Mann M. Liu L. Black B. Rose J. Diaz K. Chen T. Wong V. Aries S.
Valle Key: Promotable now Promotable with training Not promotable To be dismissed FRED C.
LUNENBURG
_____________________________________________________________________________________7
Women and minorities. The landmark legislation designed to ensure equal employment opportunity is the Civil
Rights Act of 1964. In 1965, President Lyndon B. Johnson issued Executive Order 11246 (amended by
Executive Order 11375 in 1967). These executive orders obligated employers to go beyond the provisions of
nondiscrimination of the Civil Rights Act and to actively seek out women and minorities and hire, train,
develop, and promote them. In 1972, Congress established the Equal Employment Opportunity Commission
(EEOC) and passed the Equal Employment Opportunity Act. This amendment to the Civil Rights Act of 1964
extended the jurisdiction of the EEOC and gave it the power to initiate court action against noncomplying
organizations. Older workers. Congress passed the Age Discrimination in Employment Act in 1967. The act
originally prohibited discrimination in employment of those people forty to sixty-five years of age; the act was
amended in 1978 to move the top age from sixtyfive to seventy years; and in 1986 the upper age limit was
removed. In essence, the law prohibits discrimination in hiring, firing, compensating, or any other conditions of
work of any person forty years of age or over. Exceptions to the legislation include tenured faculty and some
high-salaried executives or for documented health- or performancerelated reasons. The handicapped. The
Vocational Rehabilitation Act was passed in 1973 and amended in 1978. The act requires employers who have a
contract with the federal government worth $2500 or more to take affirmative action to hire and promote
qualified handicapped persons. A handicapped person is defined as any individual with a physical or mental
disability that limits normal activities such as walking, seeing, speaking, or learning. The law stipulates that the
handicapped individual must be capable of performing the particular job for which she is being considered.
Veterans. The Vietnam Era Veterans’ Readjustment Act of 1974 requires employers with federal contracts to
take affirmative action to employ disabled veterans. The act also provides job assistance for Vietnam-era
veterans in the form of job counseling, training, and placement. Equal employment opportunity. Equal
employment opportunity (EEO) is the right of all persons to work and to advance on the basis of merit, ability,
and potential without regard to race, color, religion, gender, or national origin. Table 1 summarizes the primary
legal base for EEO and supporting legal activities. The provisions of these acts generally apply to all public and
private organizations employing fifteen or more people. The EEOC administers and federally enforces the
various equal employment opportunity acts. The EEOC provides assistance to employers in developing
affirmative action programs and in resolving discrimination complaints brought against employers.
INTERNATIONAL JOURNAL OF MANAGEMENT, BUSINESS, AND ADMINISTRATION
8____________________________________________________________________________________
Table 1 Major Laws Affecting Hiring Practices Affirmative Action Programs Whereas EEO legislation
prohibits discrimination in recruitment, hiring, promotion, compensation, discharge, affirmative action
programs are designed to increase employment opportunities for women and other minorities including
veterans, the aged, and the handicapped. Based on two executive orders, originally issued by President Johnson,
affirmative action requirements apply to public and private employers and educational institutions that either
have contracts with or receive monies from the federal government. The intent of the program is to ensure that
women and other minorities are represented in the organization in percentages similar to their percentage in the
labor market from which the organization draws personnel. For example, if the labor pool in a community is 15
percent black and 5 percent Hispanic, then 15 percent and 5 percent of the labor force of an organization
operating in that community should be black and Hispanic respectively. Law Basic Requirements Title VII of
the Civil Rights Act of 1964 (as amended) Prohibits discrimination in employment on the basis of race, color,
religion, gender, or national origin. Age Discrimination in Employment Act of 1968 (as amended) Prohibits
discrimination in employment against any person 40 years of age or over. Equal Pay Act of 1963 Prohibits
wage discrimination on the basis of gender; requires equal pay for equal work regardless of gender.
Rehabilitation Act of 1973 Requires employers to take affirmative action to employ and promote qualified
handicapped persons. Pregnancy Discrimination Act of 1978 Requires employers to treat pregnant women and
new mothers the same as other employees for all employment-related purposes. Vietnam Era Veterans’
Readjustment Act of 1974 Requires employers to take affirmative action to employ disabled Vietnam War
veterans. Occupational Safety and Health Act (OSHA) of 1970 Establishes mandatory safety and health
standards in organizations. FRED C. LUNENBURG
_____________________________________________________________________________________9 In
general, affirmative action programs should include the following (Kranz, 2012): (a) making concerted efforts
to recruit and promote women, minorities, the handicapped, and veterans, including recruiting through state
employment services and at minority and women’s colleges; (b) limiting the questions that can be asked in
employment applications and interviews; (c) determining available percentages of women, minorities, and the
handicapped in the labor market; (d) setting up goals and timetables for recruiting women, minorities, the
handicapped, and veterans; and (e) avoiding testing unless it meets established guidelines. Conclusion Human
resource planning begins with a forecast of the number and types of employees needed to achieve the
organization’s objectives. Planning also involves job analysis, which consists of the preparation of job
descriptions and job specifications. Of particular concern for today’s executives is the growing body of laws
regulating the human resource management process. References Ball, M. K. (2012). Supply and demand. New
York, NY: Rosen Publishing Group. Christal, R. E., & Weissmuller, J. J. (1977). New comprehensive data
analysis programs (CODAP) for analyzing task factor information. JSAS Catalog of Selected Documents in
Psychology, 7, 24-25. Cushway, B. (2011). The employer’s handbook: An essential guide to employment law:
Personnel policies and procedures. Milford, CT: Kogan Page. Gibson, J. L., Ivancevich, J. M., Donnelly, J. H.,
& Konopaske, R. (2012). Organizations: Behavior, structure, processes (14th ed.). New York, NY: McGraw-
Hill Irwin. Henderson, H. D. (2010). Supply and demand. Kila, MT: Kessinger Publishing. Kranz, R. (2012).
Affirmative action (rev. ed.). New York, NY: Facts on File. McCormick, E. J., Mecham, R. C., & Jeanneret
(1972). Technical manual for the position analysis questionnaire (PAQ). West Lafayette, IN: Department of
Psychological Services, Purdue University. Mintzberg, H. (1998). The nature of managerial work. Reading,
MA: Addison-Wesley. Mitchell, J. L., & McCormick, E. J. (1979). Development of PMPQ: A structured job
analysis questionnaire for the study of professional and managerial positions. West Lafayette, IN: Department
of Psychological Sciences, Purdue University. Moran, J. J. (2011). Employment law. Upper Saddle River, NJ:
Prentice Hall. Noe, R. A. (2012). Human resource management: Gaining a competitive advantage. New York,
NY: McGraw-Hill. Robbins, S. P., & Judge, T. A. (2011). Organizational behavior (14th ed.). Upper Saddle
River, NJ: Prentice Hall. INTERNATIONAL JOURNAL OF MANAGEMENT, BUSINESS, AND
ADMINISTRATION
10____________________________________________________________________________________
Tornow, W. W., & Pinto, P. R. (1976). The development of a managerial job taxonomy: A system for
describing, classifying, and evaluating executive positions. Journal of Applied Psychology, 61, 410-418. U.S.
Department of Labor. (2012). Handbook for job analysis. Washington, DC: U.S. Government Printing Office.
The right quality and quantity of human capital (employed) is a measure of an organisation's strength and
success. Where this optimum staff mix is not maintained, imbalances in surpluses or deficits of employees may
arise leading to unmanageable increases in personnel costs, inefficiency, absenteeism, turnover and productivity
problems. The determination of this optimum staff mix is subject to the application of certain methods. The
principal objective of this paper is to assess the potency of demand forecasting in the determination of employee
requirements. A hypothesis in line with this objective is drawn and tested based on the data generated through a
questionnaire. The survey investigation method was used in collecting the primary data for the study. The
sample consisted of 349 top, middle and low levels management staff of five public sector organisations in
Nigeria. The result shows that demand forecasting is not a potent tool in the estimation of employee
requirements in Nigerian public organisations. Based on the aforementioned, the paper concluded that although
widely varying approaches to forecasting the employees needs of an organization exist, demand forecasting
might not predict with certainty the exact employee needs of an organization. The paper recommends that
human capital planners should adopt a strategy of combining both qualitative and subjective methods in
forecasting the employee needs of an organization; Chief executive officers of organisations should make it
mandatory for human capital planners to employ scientific methods in forecasting; and the adoption of a
combination of the technical skills of experts from various fields in the forecasting efforts.
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: Demand Forecast -Inspectors

…

Regression line relationships between sales and employment size. Source: Francis, A (2004:176), Business
Mathematics and Statistics, London Bedford Row: Thomson Learning.
…

Chi-square (X 2 ) Table for Testing Hypothesis H 1

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Public Policy and Administration Review 1(1); June 2013 pp. 01-15 Wurim
© American Research Institute for Policy Development 1 www.aripd.org/ppar

Demand Forecasting and the Determination of Employee Requirements in Nigerian

Public Organisations

Wurim, Ben Pam Ph.D.

(Assistant Chief Accountant)
National Directorate of Employment
Plateau State, Nigeria.
Abstract

The right quality and quantity of human capital

(employed) is a measure of an organisation’s
strength and success. Where this optimum staff
mix is not maintained, imbalances in surpluses
or deficits of employees may arise leading to
unmanageable increases in personnel costs,
inefficiency, absenteeism, turnover and
productivity problems. The determination of this
optimum staff mix is subject to the application of
certain methods. The principal objective of this
paper is to assess the potency of demand
forecasting in the determination of employee
requirements. A hypothesis in line with this
objective is drawn and tested based on the data
generated through a questionnaire. The survey
investigation method was used in collecting the
primary data for the study. The sample
consisted of 349 top, middle and low levels
management staff of five public sector
organisations in Nigeria. The result shows that
demand forecasting is not a potent tool in the
estimation of employee requirements in
Nigerian public organisations. Based on the
aforementioned, the paper concluded that
although widely varying approaches to
forecasting the employees needs of an
organization exist, demand forecasting might
not predict with certainty the exact employee
needs of an organization. The paper
recommends that human capital planners
should adopt a strategy of combining both
qualitative and subjective methods in
forecasting the employee needs of an
organization;

Chief executive officers of organisations should

make it mandatory for human capital planners
to employ scientific methods in forecasting; and
the adoption of a combination of the technical
skills of experts from various fields in the
forecasting efforts.

Introduction

The further into the future it takes to plan

human capital, the greater will be the degree of
certainty of the number and types of employees
available for employment both within and
outside the organization. Effective workforce
planning for specific enterprises involves
determining which actions are needed to achieve
business objectives, identifying the types and
quantities of skills that are necessary to
accomplish those actions, determining how
those skills may vary from the skills that are
currently available, and developing strategies
for closing the gaps between today’s workforce
and the workforce needed to accomplish the
business objectives (Ward, 1996:1).

This brings to the fore the import of demand

forecasting. Armstrong (2003:371) defines
demand forecasting as the process of estimating
the future numbers of people required and the
likely skills and competences they will need.

Public Policy and Administration Review 1(1); June 2013 pp. 01-15 Wurim
© American Research Institute for Policy Development 2 www.aripd.org/ppar

The ideal basis of the forecast is an annual

budget and longer term business plan, translated
into activity levels for each function and
department or decisions on downsizing. The
information gathered from external
environmental scanning and assessment of
internal strengths and weaknesses is used to
predict or forecast human capital supply and
demand in the light of organizational objectives
and strategies.

Forecasting uses information from the past and

present to identify expected future conditions.
Projections for the future are, of course, subject
to error. Changes in the conditions on which the
projections are based might even completely
invalidate them, which is the chance forecasters
take. Usually, though, experienced people are
able to forecast with enough accuracy to benefit
organizational long-range planning (Gerhart et
al, 2000:803).

But what is the cost-benefit trade-off of the

rigorous activities involved in demand
forecasting? Why should organisations concern
themselves with demand forecasting? There are
several good reasons to conduct demand
forecasting. It can help: (i) quantify the jobs
necessary for producing a given number of
goods, or offering a given amount of services,
(ii) determine what staff-mix is desirable in the
future, (iii) assess appropriate staffing levels in
different parts of the organisation so as to avoid
unnecessary costs, (iv) prevent shortage of
people where and when they are needed most,
and (v) monitor compliance with legal
requirements with regard to reservation of jobs
(Aswathappa, 2005:74). In spite of the
numerous functions and advantages of demand
forecasting, most organisations are yet to take
advantage of this scientific way of estimating
employee needs.
The problem

The absence of effective and scientific demand

forecasting methods in most Nigerian public
organizations seems to be the main bane of
shortages and excesses in human resources
resulting to unmanageable and expensive
imbalances in the number and quality of
employees needed to optimally achieve
organizational objectives and plans. As a result,
public organizations’ scorecard has remained
excessive costs associated with excessive
turnover, absenteeism, stress, low morale, shift
work, healthcare services, low productivity and
internal market inefficiency.

Several demand forecasting techniques currently

exist. They vary from fairly simple qualitative
methods based on individual or group
judgements to highly complicated methods
involving sophisticated statistical
computerization. What is not yet very clear is
whether or not these forecasting methods are
used and further still which particular
techniques are used and what is the result of
such efforts? Are there benefits derivable from
such exercises?

Objectives of the study

The principal objective of the paper therefore, is

to assess the potency of demand forecasting in
the determination of employee requirements.
Specifically the paper seeks to assess the extent
to which demand forecasting techniques are
used in the determination of employee
requirements and to find out the degree to which
demand forecasting leads to the determination
of employee requirements.

Methodology

The research design used for the study is the

survey research method.

Public Policy and Administration Review 1(1); June 2013 pp. 01-15 Wurim
© American Research Institute for Policy Development 3 www.aripd.org/ppar

Primary data for the study were sourced from

five public sector organisations namely:
National Directorate of Employment (NDE),
Power Holding Company of Nigeria (PHCN),
Plateau State Water Board (PSWB),
Federal Ministry of Finance (FMF) and
Nigerian National Petroleum Corporation
(NNPC). The population of the study includes
all the 10,127 top, middle and lower
management staff of the five organisations.

Given that the population of the study is finite,

the Taro Yamane (1964) statistical formula for
selecting a sample was applied.
The formula is given as:
n = N
1 + N (e)2
Where: n = Sample size; N = Population; e = level of significance (or limit of tolerance error) in this
case 0.05; 1 = Constant value

This gives a sample size of 385.

For its data collection, a suitable Likert Scale (5

Points) questionnaire was designed and
developed. The data so collected was then
analyzed using the chi-square (x2) test statistic.

Theoretical considerations

Methods for forecasting human resources range

from a manager’s best guess to a rigorous and
complex computer simulation. Simple
assumptions may be sufficient in certain
instances, but complex models may be
necessary for others. However, it has been
observed that despite the availability of
sophisticated mathematical models and
techniques, forecasting is still a combination of
quantitative methods and subjective judgement.
In theory or in practice, the most commonly
used techniques in forecasting the demand for
human resources include the following:

Management / Executive Judgement

The simplest approach to manpower forecasting

is to prepare estimates of future needs based on
the individual opinions of departmental or line
managers. The technique may involve a bottom-
up approach by asking junior managers to sit
down, think about their future workloads and
decide how many people they need.
Alternatively, a “top downward” approach can
be used, in which company and departmental
forecasts are prepared by top management,
possibly based on the advice/information
available from the personnel, and organisation
and methods departments. The suggested
forecasts are circulated downwards for
discussions and therefore reviewed and agreed
with departmental managers (Sen, 2007:135).

Aswathappa (2005:74) indicates that in

“bottom-up” and “top-down’’ approaches,
departmental heads are provided with broad
guidelines. Armed with such guidelines, and in
consultation with the human resource section in
the human resource management department,
departmental managers can prepare forecasts for
their respective departments. Simultaneously,
top human resource managers prepare company
forecasts. A committee comprising departmental
managers and human resource managers will
review the two sets of forecasts; arrive at a
unanimity, which is then presented to top
managers for their approval. Needless to say,
this technique is used in smaller organisations or
in those companies where sufficient data-base is
not available.

Public Policy and Administration Review 1(1); June 2013 pp. 01-15 Wurim
© American Research Institute for Policy Development 4 www.aripd.org/ppar

Work Study Techniques

Work Study is as old as industry itself. In the

opinion of Currie (1972:22), work study is the
study of human work in the deepest sense and
dignity of the word, and not merely in the
special and more restricted meaning used in the
physical sciences. Even today it is not limited to
the shop floor, or even to manufacturing
industry. In one or another form it can be used
in any situation wherein human work is
performed. In the book “Introduction to work
study” (1983:29), the International Labour
Organisation (ILO) defines “work study” as a
generic term for such techniques, particularly,
method study and work measurement, as are
used in the examination of human work in all its
contexts and which leads systematically to the
investigation of all the factors that affect the
efficiency and economy of the situation being
reviewed in order to effect improvement”.

Work study, therefore, has a direct relationship

with productivity. It is most frequently used to
increase the amount produced from a given
quantity of resources with little or no further
capital investment.

Work study technique can be used when it is

possible to apply work measurement to calculate
how long operations should take and the number
of people required. Work study techniques for
direct workers can be combined with ratio trend
analysis to calculate the number of indirect
workers needed (Armstrong, 2003).

The starting point in a manufacturing company

is the production budget, prepared in terms of
volumes of saleable products of the company as
a whole, or volumes of output for individual
departments. The budgets of productive hours
are then compiled using standard hours for
direct labour. The standard hours per unit of
output are then multiplied by the planned
volume of units to give the total number of
planned hours for the period. This is then
divided by the number of actual working hours
for an individual operator to show the number of
operators required. Allowance will have to be
made for absenteeism and idle time. As already
stated, work study techniques for direct workers
can be combined with ratio-trend analysis to
forecast for indirect workers, establishing the
ratios between the two categories. The same
logic can be extended to any other category of
employees.

Ratio Trend Analysis

This is the quickest forecasting technique. The

technique involves studying past ratios, like the
number of workers involved in direct production
(direct hours) and sales in an organisation and
forecasting future ratios, making some
allowance for changes in the organisation or its
methods. Table1 shows how an analysis of
actual and forecast ratios, between the number
of routine proposals to be processed by an
insurance company underwriting department
and the number of underwriters employed could
be used to forecast future requirement
(Armstrong, 1988:209).
Public Policy and Administration Review 1(1); June 2013 pp. 01-15 Wurim
© American Research Institute for Policy Development 5 www.aripd.org/ppar

Table 1: Demand Forecast – Inspectors

Year No. of Employees Ratio

Inspectors :
Production
Production
Inspectors
Actual - 3
- 2 1500 150
1800 180 1 : 10
1 : 10
Last year
Next year 2000 180
2200* 200** 1 : 11
1 : 11
Forecast

+2
+ 3 2500* 210**
2750 230** 1 : 12
1 : 12
* Calculated by reference to forecast activity levels
**Calculated by applying forecast ratio to forecast activity levels.

Source: Armstrong (1988:209), A Hand book of Personnel Management, New Delhi: Kogan Page.

Delphi Technique – Expert Forecast

Named after the ancient Greek Oracle at the city

of Delphi, the Delphi technique is a subjective
method used to predict future personnel needs
of an organisation by “integrating the
independent opinions of experts”.

Schuler (1983:48) explains that the technique

involves a large number of experts who take
turns at presenting their forecasts and
assumptions. An intermediary passes each
expert’s forecast and assumptions to the others,
who then make revisions in their forecasts. This
process continues until a final forecast emerges.

The final forecast may represent specific

projections or a range of projections depending
on the position of the experts. Originally
developed as a method to facilitate group
decision making, it has also been used in
workforce forecasting. Experts are chosen on
the basis of their knowledge of internal factors
that might affect a business (e.g. projected
retirements), their knowledge of the general
business plans of the organisation, or their
knowledge of external factors that might affect
demand for the firm’s product or service and
hence its internal demand for labour.

Experts may range from first-line supervisors to

top-level managers. Sometimes experts internal
to the firm are used, but if the required expertise
is not available internally, then one or more
outside experts may be brought in to contribute
their opinions. To estimate the level of future
demand for labour, an organisation might select
as experts, for example, managers from
corporate planning, human resources,
marketing, production and sales department.

Face-to-face group discussion is avoided since

differences in job status among group members
may lead some individuals to avoid criticizing
others and to compromise on their good ideas.
To avoid these problems, an intermediary is
used. The intermediary’s job is to pool,
summarize, and then feed back to the experts
the information generated independently by all
the other experts during the first round of
forecasting. The cycle is then repeated, so that
the experts are given the opportunity to revise
their forecasts and the reasons behind their
revised forecasts. Successive rounds usually
lead to a convergence of expert opinion within
three to five rounds.

Public Policy and Administration Review 1(1); June 2013 pp. 01-15 Wurim
© American Research Institute for Policy Development 6 www.aripd.org/ppar

Process Analysis

The widespread interest in reengineering

activities has produced a hypothetical approach
to workforce demand forecasting based on
process analysis. Some articles on the topic
suggest businesses should develop a detailed
analysis of process components of work
activities and that predictive ratios could then be
designed to forecast the associated workload for
each unit level of process output (Ward,
1996:2). Data collection and analysis phase of a
process analysis approach according to Ward is
similar to the traditional historical ratio
approach.

Process steps are substituted for work activity

steps, so that the analysis is done at an
organizational level rather than a work group.
Ward goes further to observe that the bench
mark analysis showed some reengineered
companies have developed the traditional
historical ratio analysis described in section 3,
and have then adjusted those ratios for their
assumed productivity gains to be achieved via
process improvements. In theory, the positive
and negative aspects of this process would
mirror those described for historical ratios.

The concept seems fundamentally sound, but

the benchmarking efforts do not seem to find a
single case where this concept has been
translated into an operational model. In order for
the process to work as hypothesized, the work
load analysis should be incorporated within a
reengineering study. It might fairly be
questioned whether the extensive level of
analysis should become part of an annual
planning cycle or should only be done in
conjunction with a major reengineering effort.

Flow Model

Flow models are very frequently associated with

forecasting personnel needs. The simplest one is
called the Markov model. In this technique,
Rothwell (1988:175) outlines the activities to be
carried out by the forecasters as follows:

1. Determine the time that should be covered.

Shorter lengths of time are generally more
accurate than longer ones. However, the time
horizon depends on the length of the human
resource plan which, in turn, is determined by
the strategic plan of the organisation.

2. Establish categories, also called “states” to

which employees can be assigned. These
categories must not overlap and must take into
account every possible category to which an
individual can be assigned. The number of states
can neither be too large nor too small.

3. Count annual movements (also called

‘flows’) among states for several time periods.
These states are defined as ‘absorbing’ (gains or
losses to the company) or ‘non-absorbing’
(change in position levels or employment
status). Losses include death or disability,
absences, resignations and retirements. Gains
include hiring, retirements, transfer and
movement by position level.

4. Estimate the probability of transitions from

one state to another based on past trends.
Demand is a function of replacing those who
make a transition.

There are alternatives to the simple Markov

model. One, called ‘Semi-Markov’, takes into
account not just the category but also the tenure
of individuals in each category. After all,
likelihood of movement increases with tenure.
Another method is called the ‘Vacancy model’
which predicts probabilities of movement and
number of vacancies.

While the Semi-Markov model helps estimate

movement among those whose situations and
tenure are similar, the vacancy model produces
the best results for an organisation. Markov
analysis is advantageous because it makes sense
to decision makers. They can easily understand
its underlying assumptions. They are therefore,
likely to accept results.

Public Policy and Administration Review 1(1); June 2013 pp. 01-15 Wurim
© American Research Institute for Policy Development 7 www.aripd.org/ppar

The disadvantages include: (i) heavy reliance on

past oriented data, which may not be accurate in
periods of turbulent change, and (ii) accuracy in
forecasts about individuals is sacrificed to
achieve accuracy across groups.

Statistical techniques

The most commonly used statistical approaches

to human capital forecasting range from
methods of simple scatter diagram through
regression or correlation analysis, to economic
models. All of these methods depend, for their
validity, on the assumption that developments in
the future will exhibit some continuity with the
past. Simple extrapolation assumes that past
trends will continue, regression analysis
assumes that particular relationships will hold
firm and econometric models assume that the
basic inter-relationship between a whole range
of variables will be carried on into the future.

Regression and Correlation

This method seeks to provide a measure of the

extent to which movements in the values of two
or more variables – as for example, labour input
and sales are related (or correlated) with each
other. The aim is to predict changes in one
variable by reference to changes in the other or
others, where the future value of these other (or
explanatory) variables are already postulated.
Regression therefore, is a technique used to
describe a relationship between two or more
variables, in mathematical terms. Francis
(2004:173) asserts that regression is concerned
with obtaining a mathematical equation which
describes the relationship between two
variables. The equation can be used therefore
for comparison or estimation purposes. The
process of obtaining a linear regression
relationship for a given set of (bivariate) data is
often referred to as fitting a regression line.
Francis (2004:174) asserts that there are three
methods commonly used to fit a regression line
to a given set of bivariate data.

(a) Inspection

This method is the simplest and consists of

plotting a scatter diagram for the relevant data
and then drawing in the line that most suitably
fits the data. The main disadvantage of this
method is that different people would probably
draw different lines using the same data. It
sometimes helps to plot the mean point of the
data (that is, the mean of the x’s and y’s
respectively) and ensure the regression line
passes through this. In Figure 1, possible
relationships are examined to see whether they
might prove useful for forecasting. Francis goes
further to explain that for any set of bivariate
data, there are two regression lines which can be
obtained viz: i) The y on x regression line – that
regression line which is used for estimating y
given a value of x and ii) the x on y regression
line – that regression line which is used for
estimating x given a value of y. The two
regression lines are quite distinct.
(b) Semi – averages

The method of semi-averages according to

Francis is for obtaining the y on x regression
line using the following steps: STEP 1 – Sort
the (bivariate) data into size order by x-value.
STEP 2 – Split the data up into equal groups, a
lower half and an upper half (if there is an odd
number of items, ignore the central one). STEP
3 – Calculate the mean point for each group.
STEP 4 – Plot the above mean point on a graph
within suitably scaled. This method is
considered superior to the method of inspection.
However, a major drawback of the semi average
technique for obtaining a regression line is the
fact that it relies on only two points, both means
of the two respective data groups. If there are
extreme values present either or both of the
means are easily distorted, thus so is the
regression line.

Public Policy and Administration Review 1(1); June 2013 pp. 01-15 Wurim
© American Research Institute for Policy Development 8 www.aripd.org/ppar

200 -
-
180 -
-
160 -
-
140 -
-
120 -
-
100 -
-
80 -
18 20 22 24 26 28
Mid Point
Regression line
(by inspection
)
Sales
(’000’ N)
E
m
p
l
o
y
e
e

s
i
z
e
x
y
5
52
x
x
xxxx
xxx

Figure 2.8- Regression line relationships between sales and employment size.

Source: Francis, A (2004:176), Business Mathematics and Statistics, London Bedford Row: Thomson
Learning.

As already mentioned, an important use of regression lines is for estimating the value of one variable
given a value of the other.

(c) Conventional Statistical Technique –

Simple Linear Regression and Multiple
Regression (Least Square Method).

The least squares regression method can be used

to forecast direct labour employment needs of
an organisation. In simple linear regression
(least square method), a forecast of future
human capital demand is based on past
relationship between employment level and a
variable related to employment.
For example, the number of beneficiaries
supervised (x) determines the number of persons
needed for employment (i.e. internal demand),
y.
The least square method is considered to be the
standard method of obtaining a regression line.
The derivation of the technique has
mathematical base which involves all values and
is thus considered to be superior. (Francis,
2004:173-174).

Berenson et al (1985:587) assert that the

computation is represented by two
simultaneously solved equations given as:

Public Policy and Administration Review 1(1); June 2013 pp. 01-15 Wurim
© American Research Institute for Policy Development 9 www.aripd.org/ppar

n n n
n∑ Xi Yi - ( ∑ Xi) ( ∑Yi)
bi = i–1 i =1 i = 1___
n n
n∑ Xi 2 - ( ∑ Xi )2
i=1 i=1 .......................................1
bo = Y - bi X . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

Where: bo = Coefficient of y intercept, bi = the slope used in predicting Y, X=

number of beneficiaries selected, trained, placed and monitored/
Supervised ( i.e. the work load). Y = Manpower demand (number of
persons needed for employment), yi = Actual value of y for observation,

xi = Actual value of x,
n n
Y = ∑ yi; and X = ∑ xi
i = 1 i =1
n n
Examining the above equations, it is observed that there are five quantities that must be calculated in
order to determine bo and bi. These are n, the sample size; ∑Xi, the sum of the X values;
i=1
n n
∑ yi, sum of the Y values, ∑ Xi2 , the sum of the square of X values,
i = 1 i = 1
n
and ∑ Xi Yi, the sum of the cross product of X and Y.
i = 1

Where there are more than one independent

variables to be used for example, number of
beneficiaries, productivity, turnover,
absenteeism, etc, this method becomes
ineffective and gives room to “MULIPLE
REGRESSION MODEL” – One which could
utilize several explanatory variables (xi ,
x2,…………., xn) to predict a quantitative
dependent variable (y). If the least squares
method is utilized to compute the sample
regression coefficient (bo, b1 and b2) we will
have the following three normal equations
(Berenson, et al, 1985:650):

n n n
∑ yi = n bo + b1 ∑ x, i + b2 ∑ x2 i ………………………..3
i =1 i =1 i = 1

n n n n
∑x1i yi = bo ∑x1 i + b1 ∑ x2 i + b2 ∑ x1 i x2 i ................................4
i =1 i =1 i = 1 i = 1
n n n n
∑ x2 i yi = bo ∑x2 i + b1 ∑ x1 i x2 i ∑x2 i ………………………5
i =1 i =1 i = 1 i = 1

Public Policy and Administration Review 1(1); June 2013 pp. 01-15 Wurim
© American Research Institute for Policy Development 10 www.aripd.org/ppar

Standard Error of the Estimate

Although the least squares method results in the

line that fits the data with the minimum amount
of variation, the regression equation is not a
perfect predictor, especially when samples are
taken from a population, unless all the observed
data points fall within the predicted regression
line. Thus, the regression line serves only as an
approximate predictor of a y curve, for a given
value of x.

Therefore, the measure, of variability around the line of regression is called the standard error of the
estimate and is given by the symbol Syx and defined as:

n ^
∑ ( Yi - Yi )2
Syx = i = 1_____________
n–2

Where: Yi = Actual value of Y for a given Xi,

^
Y = Predicted value of Y for a given Xi.
In the final analysis, the standard error of the estimate Syx can thus be obtained using the following
computational formula:

n n n
∑ Yi 2 - bo ∑ Yi - b1 ∑ X i Y i
Syx i =1 i =1 i =1
n–2

Computer Simulations and Modeling

The most common packages available for use

when developing regression models for business
application are the statistical analysis system
(SAS) (Reference11 and 18), the statistical
package for the social sciences (SPSS)
(Reference 20), and Minitab (references 12 and
17) (Berenson, et al, 1985:711). Using any of
the three packages, the values of the three
sample regression coefficients in equations 3, 4
and 5 may be obtained. That is to say that the
computer can be used to effectively forecast
internal manpower demand even when there are
many dependent variables. To improve human
capital decision making, an organisation must
also be concerned with its external demand
conditions especially within the industry and in
the economy as a whole.
This can also be predicted by the use of the
Delphi and conventional statistical techniques,
and estimating the needs of other organisations
in the same industry, and the mass media.

Time Series Analysis

It is necessary to analyse past trends in human

capital activities and sift the significant points
while preparing a forecast. This requires an
understanding of the concept of the time series.
Francis (2004:214) asserts that a time series is
the name given to the values of some statistical
variables measured over a uniform set of time
points. A time series therefore, is a name given
to numerous data that is described over a
uniform set of time points-’data classified
chronologically’- for example, monthly
absenteeism rates.

Public Policy and Administration Review 1(1); June 2013 pp. 01-15 Wurim
© American Research Institute for Policy Development 11 www.aripd.org/ppar

The recording of such casual relationships

between different variables for example, is there
a positive correlation between absence and age
or length of service, or with prediction of
future?

Depending on the nature, complexity and extent

of the analysis required, there are various types
of models that can be used to describe time
series data. They include two models called
simple additive and multiplicative models. The
components that go to make up each value of a
time series are described in the following
definitions:

The time series additive model

y=t+s+r
Where: y = a given time series value, t = the trend component, s = the seasonal component and r =
the residual component.
The time series multiplicative model

y = t x s x R
Where: y = a given time series value, t = the trend component
s is the seasonal component, R is the residual component (Francis, 2004:215).

Trend (t) is the underlying, long-term tendency

of the data. Seasonal variations are short-term
cyclic fluctuations in the data about the trend
which take their name from standard business
quarters of the year. Season, however, can have
many different meanings, for example, daily,
monthly or quarterly seasons. Residual
variations include other factors not included in
trend or seasonal factors. Time series therefore,
is an alternative method that can be used to
analyse employment levels over a time and used
as a basis for forecasting human capital levels.
This means projecting the past into the future
and then allowing for any foreseen changes
resulting in a change in use of capital and
machinery, change in external economic
climate, internal problems within the
organisation and emergence of competitors.
Contrary to the three factors mentioned by
Francis, Lynch (1982:72) mentions four factors
or movements to be revealed by an analysis of a
time series as: (a) a long-term (basic) trend; (b)
seasonal fluctuations; (c) catastrophic
(abnormal) movement; and (d) residual (chance
movement).

Results

The questionnaire was distributed to 385 top,

middle and lower levels staff of the five selected
organisations but only 349 completed and
returned the questionnaire yielding an overall
response rate of 92%. We set out to provide the
necessary lead for empirical examination of the
degree to which demand forecasting leads to the
determination of employee requirements in
organisations. For this reason, hypothesis one
was formulated thus:

H1: Demand forecasting positively affect the

determination of employee requirements. Table

1 shows that 57.54% of the respondents agreed

that scientific calculation of the quality and
quantity of staff before recruitment leads to
proper estimations while 42.46% responded to
the contrary; 62% of the respondents agreed that
job analysis is made before a ‘fit’ person is
employed and that it leads to accurate
estimation of employee needs but 38%
disagreed.

Public Policy and Administration Review 1(1); June 2013 pp. 01-15 Wurim
© American Research Institute for Policy Development 12 www.aripd.org/ppar

Also, 66% of the respondents affirmed that the

total number and quality of workers in their
organisations is estimated based on their
organisation’s policies and objectives which
leads to accurate manpower needs

determination, while 34% disagreed; 64%

affirmed that the total number and quality of
workers is estimated based on their
organisation’s workload/sales or production
targets
Table 1: Opinion of Respondents on the Impact of Demand Forecasting on the Estimation of
Employee Requirements
S/no Description Response Frequency %
1 Scientific calculation and
evaluation of staff before
recruitment leads to proper
estimation
Agreement category 145
Disagreement category 107

57.54%
42.46
2 A clear analysis of the needs,
experience and expectations
of a particular job before
recruitment leads to proper
estimation
Agreement category 166
Disagreement category 100

62.41
37.59
3 Number and quality of
workers is estimated based on
my organization’s policies
and objectives
Agreement category 177
Disagreement category 91 66.05
33.95
4 Total number and quality of
workers is estimated based on
my organization’s workload/
sales or production targets an
Agreement category 185
Disagreement category 106

63.57
36.43
5 Subvention from Government
and /or internally generated
income determines the right
number and quality of
workers employed
Agreement category 204
Disagreement category 95 68.23
31.77

Source: Field Survey, 2012

Which leads to the accurate estimation of
personnel needs while 36% disagreed. Lastly,
68% of the respondents agreed that subvention
from government and internally generated
revenue determines the right number and quality
of workers employed but 34% of the
respondents disagreed.

The Chi-square (x2) test statistic was used to test

the hypothesis (H1). The theoretical frequency
for each cell in Table 1 was computed using the
formula: nRnc /n as shown in Table 2. The X2t 4
under 0.05 = 9.49 while the calculated X2c =
7.29.

Public Policy and Administration Review 1(1); June 2013 pp. 01-15 Wurim
© American Research Institute for Policy Development 13 www.aripd.org/ppar

Table 2 - Chi-square (X2) Table for Testing Hypothesis H1

Cell fo ft fo – ft (fo – ft)

2

f
t

1 145 161 –16 1.60

2 107 91 16 2.40
3 166 170 –4 0.09
4 100 96 4 0.17
5 177 171 6 0.20
6 91 97 –6 0.37
7 185 185 0 0
8 106 106 0 0
9 204 191 13 0.89
10 95 108 –13 1.57
Total 1376 1376 0 7.29

Source: Field survey, 2012

d.f. = (r – 1)(c – 1) = (5 – 1)(2 – 1) = (4)(1) = 4
X2t 4 under 0.05 = 9.49. But calculated Chi-square (X2c) = 7.29

Statistical Decision

Level of significance = 0.05, Sample size (n) =

349; Test statistic = x2. Decision rule: Accept
Ho if calculated value (X2c)  Chi-square (X2t),
if otherwise, reject the Ho and accept H1. Since
the calculated Chi-square (x2c) value falls within
the acceptance region (i.e. x2c = 7.29 < x2t =
9.49), we accepted the null hypothesis and
rejected the alternate and we thus concluded that
demand forecasting is not a potent tool in the
estimation of employee requirements in Nigeria
public organisations.

Discussion and Implications of Findings

Result of the test of the hypothesis indicate that
demand forecasting does not significantly affect
the estimation of employee needs in Nigerian
public organisations (α = 0.05, x2c = 7.29 < x2t =
9.49), we thus conclude that the two variables
are not associated: The result is contrary to
Karen Legge theory which states that demand
forecasting is a very potent tool in human
capital forecasting that yields accurate or precise
estimation of employee requirement in terms of
number and quality (Legge 1989: 36).

The result is also contrary to the findings of a

survey of 115 large organisations conducted
jointly by the American Management
Association and Creasp, McCormick and Paget
– which indicated that some firms particularly,
in stable businesses like utilities or insurance,
simply perfected requirements on the basis of
past growth or sales forecasts or company
budgets. The result is precision in the estimation
of employee requirements (Sen, 1987:20).
]
The weakness in the relationship between
human capital forecasting and employee
requirements as witnessed in the Nigerian
Public Sector Organisations could be as a result
of the lack of proper knowledge and expertise.
Bartholomew (1976: 67) asserts that human
capital forecasting requires the combined
technical skills of statisticians, economists and
behavioral scientist, managers and planners.

It is also possible that the inability of public

organisations in Nigeria to forecast with
precision its employee requirements could be as
a result of forecasting in isolation from other
sectors or departments of the organisation.

Public Policy and Administration Review 1(1); June 2013 pp. 01-15 Wurim
© American Research Institute for Policy Development 14 www.aripd.org/ppar

Bramham (1982: 22 – 23) strongly belief that

human capital forecasting cannot be done in
isolation from forecasting in other domains. To
him, having established a fund of knowledge on
all aspects of the firm’s business, it is possible
to move at attempts to indicate in which
direction human capital is going and the
direction it should take to meet organisational
objectives.

Also, the finding is unlike results from a

research conducted on some selected Indian
Public Sector organisations where human
capital forecasting gave precise estimation of
employee need requirements (Sen, 2005: 129 –
163). However, Sen goes on to conclude that
forecasting could be right or wrong.
Conclusion

Widely varying approaches to forecasting the

employee needs of an organization exist and
effective forecasting requires a combination of
quantitative methods and subjective judgement.
Where demand forecasting is conscientiously
pursued, imbalances in surpluses or deficits of
employees can be detected and handled before
they become unmanageable leading to decrease
in personnel costs.

Also, demand forecasting is an interdisciplinary

activity which requires the combined technical
skills of statisticians, economists, behavioural
scientists, together with the practical knowledge
of human capital managers. Lastly, forecasting
cannot tell what will happen, but only what
might happen under given conditions and
circumstances.

Recommendation

In view of the findings and conclusion above,

the following recommendations are hereby
submitted:

1. Human capital managers should adopt a

strategy of combining both quantitative methods
and subjective judgement in forecasting the
employee needs of organization.

2. Chief executive officers of public

organisations should make it mandatory for
human capital planners to employ scientific
methods in forecasting. This is with a view to
reducing personnel cost, accurate estimation of
employee requirements and the achievement of
organisational effectiveness and employee
productivity.

3. Since forecasting is an interdisciplinary

activity, there should be a combination of the
technical skills of statisticians, economists,
behavioural scientists and human capital
managers in planning the human capital in
public organisations.
Public Policy and Administration Review 1(1); June 2013 pp. 01-15 Wurim
© American Research Institute for Policy Development 15 www.aripd.org/ppar

References

Armstrong, M (1988), A Handbook of

Personnel Management Practice,
Sterling: Kogan Page.
Armstrong, M. (2003), A Handbook of Human
Resource Management Practice,
Sterling: Kogan Page.
Aswathappa, K. (2005), Human Resource &
Personnel Management, Kuala Lumpur:
Tata McGraw-Hill.
Berenson, M. L. and Levine, D. M. (1989),
Basic Business Statistics: Concepts and
Applications, New Jersey: Prentice-Hall.
Currie R. M. (1972), Work Study, Revised by
Joseph. E. Raraday, British Institute of
Management, Sterling: Pitman.
Francis, A. (2004), Business Mathematics and
Statistics. Bedford Row, Bedford Row:
Thomson Learning.
Gerhart, B. (2000), ‘Measuring Error in
Research on Human Resources’,
Personnel Psychology Journal.
Lynch, J.G. (1982), Making Manpower
Effective, Sterling: Pan Original
Macmillan.

Rothwell, S. (1988), Strategic Human Resource

Planning and Management, New Jersey:
Prentice Hall.
Schuler, R. S. (1983), Effective Personnel
Management, St. Paul: West Publishing
Company.
Sen, A. K. (2007), Human Resource
Development, Planning and Deployment
(Public Sector Perspective), Calcuta:
International Institute of Management
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Citations (0)
References (10)
 Measuring Error in Research on Human Resources
o Jan 1982
o B Gerhart

 Recruitment and Selection

Recruitment and Selection i About the Tutorial Recruitment and Selection is an important operation in HRM,
designed to maximize employee strength in order to meet the employer's strategic goals and objectives. It is a
process of sourcing, screening, shortlisting and selecting the right candidates for the required vacant positions.
This is a brief introductory tutorial that explains different methods of hiring and how to make effective and
efficient utilization of Recruitment and Selection. In addition, it also explains the best recruitment practices for
specific requirements. Audience This tutorial will be useful for students from management streams who aspire
to learn the basics of Recruitment and Selection. Professionals, especially HR managers, regardless of which
sector or industry they belong to, can use this tutorial to learn how to apply the most effective type of
Recruitment and Selection as per their specific requirement, in their respective project environments.
Prerequisites The readers of this tutorial are expected to have a basic understanding of the complexity of
Recruitment and Selection that an HR manager handles for hiring a right candidate for a required vacant
position. Copyright & Disclaimer © Copyright 2016 by Tutorials Point (I) Pvt. Ltd. All the content and graphics
published in this e-book are the property of Tutorials Point (I) Pvt. Ltd. The user of this e-book is prohibited to
reuse, retain, copy, distribute or republish any contents or a part of contents of this e-book in any manner
without written consent of the publisher. We strive to update the contents of our website and tutorials as timely
and as precisely as possible, however, the contents may contain inaccuracies or errors. Tutorials Point (I) Pvt.
Ltd. provides no guarantee regarding the accuracy, timeliness or completeness of our website or its contents
including this tutorial. If you discover any errors on our website or in this tutorial, please notify us at
contact@tutorialspoint.com. Recruitment and Selection ii Table of Contents About the Tutorial
.............................................................................................................................. i
Audience............................................................................................................................................ i
Prerequisites...................................................................................................................................... i Copyright &
Disclaimer...................................................................................................................... i Table of Contents
............................................................................................................................. ii 1. Recruitment and Selection –
Introduction ................................................................................... 1 The Scope of Recruitment and
Selection.........................................................................................1 Case Study: How to Improvise Recruitment
Process.......................................................................2 2. What is
Recruitment?..................................................................................................................... 5 3. Factors Affecting
Recruitment...................................................................................................... 7 Internal
Factors.................................................................................................................................7 External
Factors................................................................................................................................8 4. Recruitment
Process...................................................................................................................... 9 Recruitment Planning
.......................................................................................................................9 Recruitment
Strategy......................................................................................................................12 Searching the Right
Candidates.....................................................................................................12 Screening /
Shortlisting...................................................................................................................14 Evaluation and Control
...................................................................................................................15 5. Types of
Recruitment................................................................................................................... 16 Internal Sources of
Recruitment.....................................................................................................16 External Sources of
Recruitment....................................................................................................19 6. Recruitment Interviews
................................................................................................................ 22 How to Interview?
...........................................................................................................................23 Importance of Interview
..................................................................................................................24 Interview Process
...........................................................................................................................24 7. Types of Interviews
...................................................................................................................... 26 8. What is
Selection?........................................................................................................................ 28 Importance of
Selection..................................................................................................................29 Advantages of
Selection.................................................................................................................29 Selection Process and
Steps..........................................................................................................30 9. Salary Negotiations
...................................................................................................................... 31 10. Making a Job Offer
....................................................................................................................... 33 How to Make a Job
Offer?..............................................................................................................33 Preparing a Job Offer
Letter...........................................................................................................34 What Next after Issuing a Job
Offer? .............................................................................................35 Recruitment and Selection 1 Recruitment
and Selection is an important operation in HRM, designed to maximize employee strength in order to meet the
employer's strategic goals and objectives. In short, Recruitment and Selection is the process of sourcing,
screening, shortlisting and selecting the right candidates for the filling the required vacant positions. In this
tutorial, we will discuss the various aspects of Recruitment and Selection such as the recruitment process, the
factors affecting recruitment, recruitment planning, methods of recruitment, recruitment interviews, selection
process and making an offer. The Scope of Recruitment and Selection The scope of Recruitment and Selection
is very wide and it consists of a variety of operations. Resources are considered as most important asset to any
organization. Hence, hiring right resources is the most important aspect of Recruitment. Every company has its
own pattern of recruitment as per their recruitment policies and procedures. The scope of Recruitment and
Selection includes the following operations:  Dealing with the excess or shortage of resources  Preparing the
Recruitment policy for different categories of employees  Analyzing the recruitment policies, processes, and
procedures of the organization  Identifying the areas, where there could be a scope of improvement 
Streamlining the hiring process with suitable recommendations  Choosing the best suitable process of
recruitment for effective hiring of resources 1. Recruitment and Selection – Introduction Recruitment and
Selection 2 Any organization wants it future to be in good and safe hands. Hence, hiring the right resource is a
very important task for any organization. CaseStudy:HowtoImproviseRecruitmentProcess Let’s assume there is
a company called ABC Systems, which sells FMCG products. The company is lately suffering due to its high
attrition rates. In this case study, we will see how ABC Systems can improve its recruiting process and focus on
maintaining the efforts required for filling a job vacancy. We will also learn how the HR team of ABC Systems
can reduce the time and effort involved in sourcing good resources for the vacant positions. We suggest here
seven different steps that ABC Systems can utilize to resolve its problems. Step 1: Define the Problem First,
define the problem in exact terms and then, design a step-wise recruitment process that can be easily followed.
Recruitment Process Step Activity 1 Sending the resignation communication message to HR with request for
initiating the recruitment process 2 Manager-HR directs the hiring team to start the recruitment process 3
Logging into the employment website and contacting different recruiters 4 Sourcing, identifying, and collecting
the resumes of the candidates 5 Receiving relevant resumes 6 Shortlisting the resumes 8 Sending the shortlisted
resumes to the department manager 9 Schedule interview dates 10 Calling the candidates for interview 12
Interviewers complete the feedback form and the feedback is shared with the HR 13 This process repeats for
many candidates till the best candidates are finalized. 14 The HR team negotiates the package and
compensation 15 Final confirmation and agreements 17 Send offer letter 18 Offer accepted Step 2: Research the
Causes Analyze the root cause of the problem at hand. Why the attrition rate is so high? There are several ways
to arrive at the root cause behind a problem. In case of ABC Systems, it was observed that there is only a less
percent of candidates who are rejected in the process of review. Hence, there is a need to improve this process
by increasing the number of rejections with an efficient review process. Recruitment and Selection 3 Screening
of resumes must be very effective, because the selection of the candidates through resume screening has
maximum percentage of a positive outcome, which is explained below: Resume Selection Test Reviewer
Resumes Provided Resumes Selected Successful Selections* 1 10 8 4 2 10 5 2 3 10 7 2 Reviewers can use a set
of defined criteria to screen the resumes, which can then be compiled as shown below. Tabulation of Selection
Criteria Used Criteria Reviewer 1 Reviewer 2 Reviewer 3 1 X X X 2 X X X 3 X 4 X X 5 X X X 6 X X 7 X X 8
X X X Step 3: Countermeasure Ideas Generation It is mandatory to have a basis of standardization in selecting
the candidates. The shortlisting of the relevant criteria is done as shown in the following table: Selection
Criteria – Standardized Criteria Reviewer 1 Reviewer 2 Reviewer 3 Criteria to Keep 1 X X 2 X X X X 3 X X 4
X X 5 X X X X 6 X X X 7 X X X 8 X X X X The shortlisted list of candidates is reviewed by the department
heads and they can suggest modification which can then be incorporated as new criteria. Recruitment and
Selection 4 Step 4: Testing and Modifying the Ideas The next step is to test the defined set of criteria with three
batches. After the selections are done, the set of criteria is analyzed to see it was effective or not. Step 5:
Implementing the Ideas If found effective, then implement the new set of criteria for future recruitments. Step 6:
Standardize Procedures The next step is to standardize the procedure. First, make a note of the improvements
achieved recruitment efficiency. It can done as shown in the following tables: Improvements in Recruitment
Efficiency Before After Resumes 100 92 Selected 18 24 Interviews 170 142 Improvements in Recruitment
Efficiency Before After Percentage Improvement R/C 6.25 4.1 34 I/C 10 6 40 With the help of the above
processes, there will be a reduction of about 30%-40% in the hiring process in shortlisting, reviewing and
selecting the candidates for the right job positions. This process was standardized and adopted in the regular
practice. Step 7: Compiling the Quality Improvement Story At last, the improvised and the quality story is
compiled and presented to the senior management for a better recruitment process. Recruitment and Selection 5
Recruitment is a process of identifying, screening, shortlisting and hiring potential resource for filling up the
vacant positions in an organization. It is a core function of Human Resource Management. Recruitment is the
process of choosing the right person for the right position and at the right time. Recruitment also refers to the
process of attracting, selecting, and appointing potential candidates to meet the organization’s resource
requirements. The hiring of the candidates can be done internally i.e., within the organization, or from external
sources. And the process should be performed within a time constraint and it should be cost effective.
Importance of Recruitment Recruitment is one of the most fundamental activities of the HR team. If the
recruitment process is efficient, then –  The organization gets happier and more productive employees 
Attrition rate reduces.  It builds a good workplace environment with good employee relationships.  It results
in overall growth of the organization. 2. What is Recruitment? Recruitment and Selection 6 Here is a list that
shows the purpose and importance of Recruitment in an organization:  It determines the current and future job
requirement.  It increases the pool of job at the minimal cost.  It helps in increasing the success rate of
selecting the right candidates.  It helps in reducing the probability of short term employments.  It meets the
organization’s social and legal obligations with regards to the work force.  It helps in identifying the job
applicants and selecting the appropriate resources.  It helps in increasing organizational effectives for a short
and long term.  It helps in evaluating the effectiveness of the various recruitment techniques.  It attracts and
encourages the applicants to apply for the vacancies in an organization.  It determines the present futures
requirements of the organization and plan according.  It links the potential employees with the employers.  It
helps in increasing the success ratio of the selection process of prospective candidates.  It helps in creating a
talent pool of prospective candidates, which enables in selecting the right candidates for the right job as per the
organizational needs. Recruitment and Selection 7 Recruitment is an important function of the Human Resource
Management in an organization, and it is governed by a mixture of various factors. Proactive HR Professionals
should understand these factors influencing the recruitment and take necessary actions for the betterment of the
organization. When the market condition changes, the organization also needs to monitor these changes and
discover how it affects the resources and analyze these functions for making recruitment an effective process.
We have Internal Factors as well as External Factors that influence the recruitment process. In this chapter, we
will be discussing these factors in detail. Internal Factors Organizations have control over the internal factors
that affect their recruitment functions. The internal factors are:  Size of organization  Recruiting policy 
Image of organization  Image of job Size of Organization The size of the organization is one of the most
important factors affecting the recruitment process. To expand the business, recruitment planning is mandatory
for hiring more resources, which will be handling the future operations. Recruiting Policy Recruitment policy of
an organization, i.e., hiring from internal or external sources of organization is also a factor, which affects the
recruitment process. It specifies the objectives of the recruitment and provides a framework for the
implementation of recruitment programs. Image of Organization Organizations having a good positive image in
the market can easily attract competent resources. Maintaining good public relations, providing public services,
etc., definitely helps an organization in enhancing its reputation in the market, and thereby attract the best
possible resources. Image of Job Just like the image of organization, the image of a job plays a critical role in
recruitment. Jobs having a positive image in terms of better remuneration, promotions, recognition, good work
environment with career development opportunities are considered to be the characteristics to attract qualified
candidates. 3. Factors Affecting Recruitment Recruitment and Selection 8 External Factors External factors are
those that cannot be controlled by an organization. The external factors that affect the recruitment process
include the following:  Demographic factors – Demographic factors are related to the attributes of potential
employees such as their age, religion, literacy level, gender, occupation, economic status, etc.  Labor market –
Labor market controls the demand and supply of labor. For example, if the supply of people having a specific
skill is less than the demand, then the hiring will need more efforts. On the other hand, if the demand is less
than the supply, the hiring will be relative easier.  Unemployment rate – If the unemployment rate is high in a
specific area, hiring of resources will be simple and easier, as the number of applicants is very high. In contrast,
if the unemployment rate is low, then recruiting tends to be very difficult due to less number of resources. 
Labor laws – Labor laws reflect the social and political environment of a market, which are created by the
central and state governments. These laws dictate the compensation, working environment, safety and health
regulations, etc., for different types of employments. As the government changes, the laws too change.  Legal
considerations – Job reservations for different castes such as STs, SCs, OBCs are best examples of legal
considerations. These considerations, passed by government, will have a positive or negative impact on the
recruitment policies of the organizations.  Competitors – When organizations in the same industry are
competing for the best qualified resources, there is a need to analyze the competition and offer the resources
packages that are best in terms of industry standards. Recruitment and Selection 9 Recruitment is a process of
finding and attracting the potential resources for filling up the vacant positions in an organization. It sources the
candidates with the abilities and attitude, which are required for achieving the objectives of an organization.
Recruitment process is a process of identifying the jobs vacancy, analyzing the job requirements, reviewing
applications, screening, shortlisting and selecting the right candidate. To increase the efficiency of hiring, it is
recommended that the HR team of an organization follows the five best practices (as shown in the following
image). These five practices ensure successful recruitment without any interruptions. In addition, these practices
also ensure consistency and compliance in the recruitment process. Recruitment process is the first step in
creating a powerful resource base. The process undergoes a systematic procedure starting from sourcing the
resources to arranging and conducting interviews and finally selecting the right candidates. Recruitment
Planning Recruitment planning is the first step of the recruitment process, where the vacant positions are
analyzed and described. It includes job specifications and its nature, experience, qualifications and skills
required for the job, etc. A structured recruitment plan is mandatory to attract potential candidates from a pool
of candidates. The potential candidates should be qualified, experienced with a capability to take the
responsibilities required to achieve the objectives of the organization. 4. Recruitment Process Recruitment and
Selection 10 Identifying Vacancy The first and foremost process of recruitment plan is identifying the vacancy.
This process begins with receiving the requisition for recruitments from different department of the organization
to the HR Department, which contains:  Number of posts to be filled  Number of positions  Duties and
responsibilities to be performed  Qualification and experience required When a vacancy is identified, it the
responsibility of the sourcing manager to ascertain whether the position is required or not, permanent or
temporary, full-time or part-time, etc. These parameters should be evaluated before commencing recruitment.
Proper identifying, planning and evaluating leads to hiring of the right resource for the team and the
organization. Job Analysis Job analysis is a process of identifying, analyzing, and determining the duties,
responsibilities, skills, abilities, and work environment of a specific job. These factors help in identifying what a
job demands and what an employee must possess in performing a job productively. Job analysis helps in
understanding what tasks are important and how to perform them. Its purpose is to establish and document the
job relatedness of employment procedures such as selection, training, compensation, and performance appraisal.
The following steps are important in analyzing a job:  Recording and collecting job information  Accuracy in
checking the job information  Generating job description based on the information  Determining the skills,
knowledge and skills, which are required for the job The immediate products of job analysis are job descriptions
and job specifications. Recruitment and Selection 11 Job Description Job description is an important document,
which is descriptive in nature and contains the final statement of the job analysis. This description is very
important for a successful recruitment process. Job description provides information about the scope of job
roles, responsibilities and the positioning of the job in the organization. And this data gives the employer and
the organization a clear idea of what an employee must do to meet the requirement of his job responsibilities.
Job description is generated for fulfilling the following processes:  Classification and ranking of jobs  Placing
and orientation of new resources  Promotions and transfers  Describing the career path  Future development
of work standards A job description provides information on the following elements:  Job Title / Job
Identification / Organization Position  Job Location  Summary of Job  Job Duties  Machines, Materials and
Equipment  Process of Supervision  Working Conditions  Health Hazards Job Specification Job specification
focuses on the specifications of the candidate, whom the HR team is going to hire. The first step in job
specification is preparing the list of all jobs in the organization and its locations. The second step is to generate
the information of each job. This information about each job in an organization is as follows:  Physical
specifications  Mental specifications  Physical features  Emotional specifications  Behavioral specifications
A job specification document provides information on the following elements:  Qualification  Experiences 
Training and development Recruitment and Selection 12  Skills requirements  Work responsibilities 
Emotional characteristics  Planning of career Job Evaluation Job evaluation is a comparative process of
analyzing, assessing, and determining the relative value/worth of a job in relation to the other jobs in an
organization. The main objective of job evaluation is to analyze and determine which job commands how much
pay. There are several methods such as job grading, job classifications, job ranking, etc., which are involved in
job evaluation. Job evaluation forms the basis for salary and wage negotiations. Recruitment Strategy
Recruitment strategy is the second step of the recruitment process, where a strategy is prepared for hiring the
resources. After completing the preparation of job descriptions and job specifications, the next step is to decide
which strategy to adopt for recruiting the potential candidates for the organization. While preparing a
recruitment strategy, the HR team considers the following points:  Make or buy employees  Types of
recruitment  Geographical area  Recruitment sources The development of a recruitment strategy is a long
process, but having a right strategy is mandatory to attract the right candidates. The steps involved in
developing a recruitment strategy include:  Setting up a board team  Analyzing HR strategy  Collection of
available data  Analyzing the collected data  Setting the recruitment strategy Searchingthe Right Candidates
Searching is the process of recruitment where the resources are sourced depending upon the requirement of the
job. After the recruitment strategy is done, the searching of candidates will be initialized. This process consists
of two steps:  Source activation: Once the line manager verifies and permits the existence of the vacancy, the
search for candidates starts. Recruitment and Selection 13  Selling: Here, the organization selects the media
through which the communication of vacancies reaches the prospective candidates. Searching involves
attracting the job seekers to the vacancies. The sources are broadly divided into two categories: Internal Sources
and External Sources. Internal Sources Internal sources of recruitment refer to hiring employees within the
organization through:  Promotions  Transfers  Former Employees  Internal Advertisements (Job Posting) 
Employee Referrals  Previous Applicants External Sources External sources of recruitment refer to hiring
employees outside the organization through:  Direct Recruitment  Employment Exchanges  Employment
Agencies  Advertisements  Professional Associations  Campus Recruitment  Word of Mouth Recruitment
and Selection 14 Screening/Shortlisting Screening starts after completion of the process of sourcing the
candidates. Screening is the process of filtering the applications of the candidates for further selection process.
Screening is an integral part of recruitment process that helps in removing unqualified or irrelevant candidates,
which were received through sourcing. The screening process of recruitment consists of three steps: Reviewing
of Resumes and Cover Letters Reviewing is the first step of screening candidates. In this process, the resumes
of the candidates are reviewed and checked for the candidates’ education, work experience, and overall
background matching the requirement of the job. While reviewing the resumes, an HR executive must keep the
following points in mind, to ensure better screening of the potential candidates:  Reason for change of job 
Longevity with each organization  Long gaps in employment  Job-hopping  Lack of career progression
Conducting Telephonic or Video Interview Conducting telephonic or video interviews is the second step of
screening candidates. In this process, after the resumes are screened, the candidates are contacted through phone
or video by the hiring manager. This screening process has two outcomes:  It helps in verifying the candidates,
whether they are active and available.  It also helps in giving a quick insight about the candidate’s attitude,
ability to answer interview questions, and communication skills. Identifying the top candidates Identifying the
top candidates is the final step of screening the resumes/candidates. In this process, the cream/top layer of
resumes are shortlisted, which makes it easy for the hiring manager to take a decision. This process has the
following three outcomes:  Shortlisting 5 to 10 resumes for review by the hiring managers  Providing insights
and recommendations to the hiring manager  Helps the hiring managers to take a decision in hiring the right
candidate Recruitment and Selection 15 Evaluation and Control Evaluation and control is the last stage in the
process of recruitment. In this process, the effectiveness and the validity of the process and methods are
assessed. Recruitment is a costly process, hence it is important that the performance of the recruitment process
is thoroughly evaluated. The costs incurred in the recruitment process are to be evaluated and controlled
effectively. These include the following:  Salaries to the Recruiters  Advertisements cost and other costs
incurred in recruitment methods, i.e., agency fees.  Administrative expenses and Recruitment overheads 
Overtime and Outstanding costs, while the vacancies remain unfilled  Cost incurred in recruiting suitable
candidates for the final selection process  Time spent by the Management and the Professionals in preparing
job description, job specifications, and conducting interviews. Finally, the question that is to be asked is,
whether the recruitment methods used are valid or not? And whether the recruitment process itself is effective
or not? Statistical information on the costs incurred for the process of recruitment should be effective.
Recruitment and Selection 16 For any organization, recruitment is a crucial part of developing and maintaining
an effective and efficient team. A good recruitment strategy will cut down the wastage of time and money,
which would have incurred for extensive training and development of unqualified resources. Have you ever
thought of, how a recruiter finds the right candidates? Recruiters use different methods to source, screen,
shortlist, and select the resources as per the requirements of the organization. Recruitment types explain the
means by which an organization reaches potential job seekers. In this chapter, we will shed some light on the
secrets of hiring and recruiting methods, used by the recruiters. Recruitment is broadly classified into two
different categories − Internal Sources and External Sources. Internal Sourcesof Recruitment Internal sources of
recruitment refer to hiring employees within the organization internally. In other words, applicants seeking for
the different positions are those who are currently employed with the same organization. At the time
recruitment of employees, the initial consideration should be given to those employees who are currently
working within the organization. This is an important source of recruitment, which provides the opportunities
for the development and utilization of the existing resources within the organization. Internal sources of
recruitment are the best and the easiest way of selecting resources as performance of their work is already
known to the organization. Let us now discuss more on the various internal sources of recruitment. 5. Types of
Recruitment Recruitment and Selection 17 Promotions Promotion refers to upgrading the cadre of the
employees by evaluating their performance in the organization. It is the process of shifting an employee from a
lower position to a higher position with more responsibilities, remuneration, facilities, and status. Many
organizations fill the higher vacant positions with the process of promotions, internally. Transfers Transfer
refers to the process of interchanging from one job to another without any change in the rank and
responsibilities. It can also be the shifting of employees from one department to another department or one
location to another location, depending upon the requirement of the position. Let’s take an example to
understand how it works. Assume there is a finance company called ABC Ltd. Having two branches, Branch-A
and Branch-B, and an employee from Branch-A resigned from his job responsibilities. Hence, this position has
to be filled for the continuation of the project in Branch-A. In this scenario, instead of searching or sourcing
new candidates, which is time consuming and expensive, there is a possibility of shifting an employee from
Branch-B to Branch-A, depending upon the project requirements and the capabilities of that respective
employee. This internal shifting of an employee from one branch to another branch is called as Transfer.
Recruiting Former Employees Recruiting former employees is a process of internal sources of recruitment,
wherein the exemployees are called back depending upon the requirement of the position. This process is
costeffective and saves plenty of time. The other major benefit of recruiting former employees is that they are
very well versed with the roles and responsibilities of the job and the organization needs to spend less on their
training and development. Recruitment and Selection 18 Internal Advertisements (Job Posting) Internal
Advertisements is a process of posting/advertising jobs within the organization. This job posting is an open
invitation to all the employees inside the organization, where they can apply for the vacant positions. It provides
equal opportunities to all the employees working in the organization. Hence, the recruitment will be done from
within the organization and it saves a lot of cost. Employee Referrals Employee referrals is an effective way of
sourcing the right candidates at a low cost. It is the process of hiring new resources through the references of
employees, who are currently working with the organization. In this process, the present employees can refer
their friends and relatives for filling up the vacant positions. Organizations encourage employee referrals,
because it is cost effective and saves time as compared to hiring candidates from external sources. Most
organizations, in order to motivate their employees, go ahead and reward them with a referral bonus for a
successful hire. Previous Applicants Here, the hiring team checks the profiles of previous applicants from the
organizational recruitment database. These applicants are those who have applied for jobs in the past. These
resources can be easily approached and the response will be positive in most of the cases. It is also an
inexpensive way of filling up the vacant positions. Pros and Cons of Internal Sources of Recruitment Internal
sources of recruitment, i.e., hiring employees within the organization, has its own set of advantages and
disadvantages. The advantages are as follows:  It is simple, easy, quick, and cost effective.  No need of
induction and training, as the candidates already know their job and responsibilities.  It motivates the
employees to work hard, and increases the work relationship within the organization.  It helps in developing
employee loyalty towards the organization. The drawbacks of hiring candidates through internal sources are as
follows:  It prevents new hiring of potential resources. Sometimes, new resources bring innovative ideas and
new thinking onto the table.  It has limited scope because all the vacant positions cannot be filled.  There
could be issues in between the employees, who are promoted and who are not.  If an internal resource is
promoted or transferred, then that position will remain vacant.  Employees, who are not promoted, may end up
being unhappy and demotivated. Recruitment and Selection 19 External Sourcesof Recruitment External
sources of recruitment refer to hiring employees outside the organization externally. In other words, the
applicants seeking job opportunities in this case are those who are external to the organization. External
employees bring innovativeness and fresh thoughts to the organization. Although hiring through external
sources is a bit expensive and tough, it has tremendous potential of driving the organization forward in
achieving its goals. Let us now discuss in detail the various external sources of recruitment. Direct Recruitment
Direct recruitment refers to the external source of recruitment where the recruitment of qualified candidates are
done by placing a notice of vacancy on the notice board in the organization. This method of sourcing is also
called as factory gate recruitment, as the blue-collar and technical workers are hired through this process.
Employment Exchanges As per the law, for certain job vacancies, it is mandatory that the organization provides
details to the employment exchange. Employment exchange is a government entity, where the details of the job
seekers are stored and given to the employers for filling the vacant positions. This external recruitment is
helpful in hiring for unskilled, semi-skilled, and skilled workers. Employment Agencies Employment agencies
are a good external source of recruitment. Employment agencies are run by various sectors like private, public,
or government. It provides unskilled, semi-skilled and Recruitment and Selection 20 skilled resources as per the
requirements of the organization. These agencies hold a database of qualified candidates and organizations can
use their services at a cost. Advertisements Advertisements are the most popular and very much preferred
source of external source of recruitment. The job vacancy is announced through various print and electronic
media with a specific job description and specifications of the requirements. Using advertisements is the best
way to source candidates in a short span and it offers an efficient way of screening the candidates’ specific
requirements. Let’s take an example. Assume that there is a Sales Company called XYZ Ltd which has got a
new project of selling a product in a short span of time, as the competition is very high. In this scenario,
choosing the specific recruitment plays a vital role. Here the ideal type of recruitment which should be chosen is
Advertisement. Advertisement is the best suitable practice for this kind of hiring, because a large volume of
hiring in a short span can be done through Advertisement only. Advertisement is one of the costliest way to
recruit candidates, but when time and number are important, then advertisement is the best source of
recruitment. Professional Associations Professional associations can help an organization in hiring professional,
technical, and managerial personnel, however they specialize in sourcing mid-level and top-level resources.
There are many professional associations that act as a bridge between the organizations and the job-seekers.
Campus Recruitment Campus recruitment is an external source of recruitment, where the educational
institutions such as colleges and universities offers opportunities for hiring students. In this process, the
organizations visit technical, management, and professional institutions for recruiting students directly for the
new positions. Word of Mouth Advertising Word of mouth is an intangible way of sourcing the candidates for
filling up the vacant positions. There are many reputed organizations with good image in the market. Such
organizations only need a word-of-mouth advertising regarding a job vacancy to attract a large number of
candidates. Pros and Cons of External Sources of Recruitment External sources of recruitment, i.e., hiring
employees outside an organization, has both its benefits and drawbacks. The benefits are as follows:  It
encourages new opportunities for job seekers.  Organization branding increases through external sources. 
There will be no biasing or partiality between the employees. Recruitment and Selection 21  The scope for
selecting the right candidate is more, because of the large number candidates appearing. The disadvantages of
recruiting through external sources are as follows:  This process consumes more time, as the selection process
is very lengthy.  The cost incurred is very high when compared to recruiting through internal sources. 
External candidates demand more remuneration and benefits. To conclude, the HR department should be
flexible enough to choose between internal or external methods of recruitment, depending upon the requirement
of the organization. Recruitment and Selection 22 An interview is a purposeful exchange of ideas, the
answering of questions and communication between two or more persons. Generally, an interview is a process
of private meeting conversation between people, where questions are asked and answered, for obtaining
information about qualities, attitudes, prospectus etc. An interview refers to a conversation with one or more
persons acting as the role of an interviewer who ask questions and the person who answers the questions acts as
the role of an interviewee. The primary purpose of an interview is to transfer information from interviewee to
interviewer. Interviews can be either formal or informal, structured or unstructured. Interviews can be carried
out one-to-one or in groups; they can be conducted over telephone or via video conferencing. There are
different meanings of the word “interview”, as different scholars defined the term differently. However,
interviews have some basic objectives, which are as follows:  Through interviews, recruiters can verify the
information obtained through application forms and tests.  Recruiters can obtain additional information about
the candidates which are not mentioned in the application forms or resumes.  Interviews provides an applicant
the information and the necessary facts about the job and the organization.  Interviews establish a mutual
understanding between the applicant and the organization 6. Recruitment Interviews Recruitment and Selection
23 How to Interview? Various researches have proved that organizations that spend more time on recruitment
have benefitted greatly in long term. An important thing to do, when you are planning for an interview is to
think, whom you are interviewing and what kind of information you want from that person. Hence, you should
prepare a list of questions, which you want to ask, prior to conducting an interview. Interviewing is both an art
and a science. Hence, how to interview is a technique that every HR professional should learn and try to
implement. The following five P’s should be taken into consideration in order to ensure effective selection and
interviewing:  Prepare: Preparation is the first step of conducting an interview. Prior to interview, the
interviewer should make sure that he/she understands the key elements of the job. And the interviewer should
go through the resume of the candidate for understanding his/her qualities and efficiencies.  Purpose: The
interviewer should have knowledge about the purpose of the interview, why he/she is conducting it. The
interviewer should project the organization as the best place to work to the interviewee, which helps in selecting
the right candidate.  Performance: An interviewer must identify the attitude, attributes, knowledge and skills of
the applicants, who are needed for the success of the organization. If the requirement is about special education
and technical skills, then hiring high-performing applicants plays an important role.  People Skills: The
applicant, who comes for an interview, will not be completely transparent. Hence, it is the job of an interviewer
to un-mask the applicant and discover the inner qualities and skills during the interview. This good practice of
hiring will help in selecting the right candidate for the organization.  Process: Every interviewer should follow
a structured interview process to get better results. A structured process of interview avoids bias and gives equal
and fair chance to all the applicants. The best way for accomplishing this process is by using the behavioral
based questions and situational questions. Recruitment and Selection 24 Importance of Interview An interview
provides an organization the scope to learn more about the applicants, who come for an interview, while the
applicants get an opportunity to become more familiar with the demands of a given position. Interviews enable
both the parties to exchange information, ask questions and also help in evaluating the potential for establishing
a professional working relationship with the organization. Interviews help in gathering a wide range of
information about the applicants’ attitude, feelings and motivations, which in turn help in the decision-making
process to hire the right candidates. The following points explain the importance of conducting interviews: 
Interviews help in selecting the right candidate from a group of applicants, who applied for a job.  Interviews
are a medium to help collect useful information about potential candidates.  Information given in the
application form or resume is very less. Recruiters can ask the candidates to provide an elaborate explanation
during the interview.  A good interviewer gives good impression about the organization, which in turn
increases the goodwill of the organization.  Interviews also help in promotions and transfers of the candidates,
as per the requirements of the organization. Interview Process Interviewing candidates is the final stage in the
recruitment process. Hence, to find the right person for a specific position, there should be a proper process, that
has to be followed for the right results. Recruitment and Selection 25 An ideal interview process for selecting
the right candidates is as follows:  Determine the requirements of the job. Conduct a thorough job analysis. 
Prepare a specific job description and a job specification.  Make a plan − how and where to find qualified
candidates.  Collect and review applications and resumes and from them, select the most potential and
qualified candidates for further proceedings.  Interview the shortlisted candidates based upon the job
description and specification.  Verify the candidates’ background with the references provided by them.
Following such an interview process, the HR department can hire the best possible candidates for a vacant job
position. Recruitment and Selection 26 Depending up the requirements, situations, locations and time, the
interviews are broadly classified into ten different categories. Recruiters should be knowledgeable enough to
understand which type of interview should be used when. The ten different types of interviews are as follows: 1.
Structured Interview: In this type, the interview is designed and detailed in advance. A structured interview is
pre-planned, accurate, and consistent in hiring the candidates. 2. Unstructured Interview: This type of interview
is an unplanned one, where the interview questionnaire is not prepared. Here, the effectiveness of the interview
is very less and there is a tremendous waste of time and effort of both the interviewer and the interviewee. 3.
Group Interview: In this type of interview, all the candidates or a group of candidates are interviewed together.
Group interviews are conducted to save time when there is a large number of applications for a few job
vacancies. A topic will be given to discuss among the candidates and the interviewer judges the innovativeness
and behavior of each candidate in the group. 4. Depth Interview: Depth interview is a semi-structured interview,
where the candidates have to give a detailed information about their education background, work experience,
special interests, etc. And the interviewer takes a depth interview and tries in finding the expertise of the
candidate. 5. Stress Interview: Stress interviews are conducted to discover how a candidate behaves in stressful
conditions. In this type of interview, the interviewer will come to know whether the candidate can handle the
demands of a complex job. The candidate who maintains his composure during a stress interview is normally
the right person to handle a stressful job. 6. Individual Interview: In an individual interview, the interview takes
place one-on-one i.e., there will be a verbal and a visual interaction between two people, an interviewer and a
candidate. This is a two-way communication interview, which helps in finding the right candidate for a vacant
job position. 7. Informal Interview: Such interviews are conducted in an informal way, i.e., the interview will be
fixed without any written communication and can be arranged at any place. There is no procedure of asking
questions in this type of interview, hence it will be a friendly kind of interview. 8. Formal Interview: A formal
interview held in a formal way, i.e., the candidate will be intimated about the interview well in advance and the
interviewer plans and prepares questions for the interview. This is also called as a planned interview. 7. Types
of Interviews Recruitment and Selection 27 9. Panel Interview: Panel interview, as the name indicates, is being
conducted by a group of people. In this type of interview, three to five members of the selection committee will
be asking questions to the candidates on different aspects. The final decision will be taken by all the members of
the panel collectively. 10. Exit Interview: Exit interviews are conducted for those employees who want to leave
the organization. The importance of the exit interview is to discover why an employee wants to leave his job.
Example Suppose there is a software company Global Systems, which has an executive requirement for the
position CEO. This kind of position cannot be fulfilled in a short span. This kind of requirements need a keen
observation and a lot of planning. There are different types of interviews, which are explained in the above list.
The best type of interview suitable for hiring a CEO would be a “Structured Interview”. Hiring a CEO for an
organization is a big task and it can only be fulfilled with lots of planning. Hence the interview process needs to
be well structured and it has to be executed in a perfect way. Recruitment and Selection 28 Selection is the
process of picking or choosing the right candidate, who is most suitable for a vacant job position in an
organization. In others words, selection can also be explained as the process of interviewing the candidates and
evaluating their qualities, which are required for a specific job and then choosing the suitable candidate for the
position. The selection of a right applicant for a vacant position will be an asset to the organization, which will
be helping the organization in reaching its objectives. Different authors define Selection in different ways. Here
is a list of some of the definitions:  Employee selection is a process of putting a right applicant on a right job. 
Selection of an employee is a process of choosing the applicants, who have the qualifications to fill the vacant
job in an organization.  Selection is a process of identifying and hiring the applicants for filling the vacancies
in an organization.  Employee selection is a process of matching organization’s requirements with the skills
and the qualifications of individuals. A good selection process will ensure that the organization gets the right set
of employees with the right attitude. 8. What is Selection? Recruitment and Selection 29 Difference between
Recruitment and Selection The major differences between Recruitment and Selection are as follows:
Recruitment Selection Recruitment is defined as the process of identifying and making the potential candidates
to apply for the jobs Selection is defined as the process of choosing the right candidates for the vacant positions.
Recruitment is called as a positive process with its approach of attracting as many candidates as possible for the
vacant jobs Selection is called as a negative process with its elimination or rejection of as many candidates as
possible for identifying the right candidate for the position Both recruitment and selection work hand in hand
and both play a vital role in the overall growth of an organization. Importance of Selection Selection is an
important process because hiring good resources can help increase the overall performance of the organization.
In contrast, if there is bad hire with a bad selection process, then the work will be affected and the cost incurred
for replacing that bad resource will be high. The purpose of selection is to choose the most suitable candidate,
who can meet the requirements of the jobs in an organization, who will be a successful applicant. For meeting
the goals of the organization, it is important to evaluate various attributes of each candidate such as their
qualifications, skills, experiences, overall attitude, etc. In this process, the most suitable candidate is picked
after the elimination of the candidates, who are not suitable for the vacant job. The organization has to follow a
proper selection process or procedure, as a huge amount of money is spent for hiring a right candidate for a
position. If a selection is wrong, then the cost incurred in induction and training the wrong candidate will be a
huge loss to the employer in terms of money, effort, and also time. Hence, selection is very important and the
process should be perfect for the betterment of the organization. Advantages of Selection A good selection
process offers the following advantages:  It is cost-effective and reduces a lot of time and effort.  It helps
avoid any biasing while recruiting the right candidate.  It helps eliminate the candidates who are lacking in
knowledge, ability, and proficiency. Recruitment and Selection 30  It provides a guideline to evaluate the
candidates further through strict verification and reference-checking.  It helps in comparing the different
candidates in terms of their capabilities, knowledge, skills, experience, work attitude, etc. A good selection
process helps in selecting the best candidate for the requirement of a vacant position in an organization.
Selection Process and Steps As we have discussed that Selection is very important for any organization for
minimizing the losses and maximizing the profits. Hence the selection procedure should be perfect. A good
selection process should comprise the following steps:  Employment Interview: Employment interview is a
process in which one-on-one session in conducted with the applicant to know a candidate better. It helps the
interviewer to discover the inner qualities of the applicant and helps in taking a right decision.  Checking
References: Reference checking is a process of verifying the applicant’s qualifications and experiences with the
references provided by him. These reference checks help the interviewer understand the conduct, the attitude,
and the behavior of the candidate as an individual and also as a professional.  Medical Examination: Medical
examination is a process, in which the physical and the mental fitness of the applicants are checked to ensure
that the candidates are capable of performing a job or not. This examination helps the organization in choosing
the right candidates who are physically and mentally fit.  Final Selection: The final selection is the final
process which proves that the applicant has qualified in all the rounds of the selection process and will be issued
an appointment letter. A selection process with the above steps will help any organization in choosing and
selecting the right candidates for the right job. Recruitment and Selection 31 Salary negotiation is done ahead of
issuing an offer letter. This is the heart of recruitment and selection process, wherein the actual worth of a right
candidate will be evaluated. The remuneration offered should be balanced, acceptable and agreed by both the
parties – the employer and the employee. Some organizations have salary grades, which are already assigned for
each and every position, hence the new employee also receives the salary as per the grade for which the
candidate is qualified and selected for. A Win-Win Situation The negotiations should be a win-win situation,
where both the candidate and the employer should benefit. If the candidate expects and demands for a higher
salary than the offered salary, then the employer can raise the package (if the budget permits) in the following
cases:  The candidate is highly talented with a potential to deliver great results.  The candidate has
exceptional skills which are rare in the market. Sometimes there is high demand for a skill and the market does
not have sufficient supply of qualified candidates to fill the gap. In such cases, the HR team offers lucrative
packages in order to attract talented professionals. Hiring managers, most of the time, have a budget for each
position and they are under pressure to hire the right candidates without overshooting their assigned budget. 9.
Salary Negotiations Recruitment and Selection 32 Tips for Good Salary Negotiation Hiring managers should
keep the following points in mind while negotiating salary with a potential candidate:  Research about the job
posting well in advance and have a clear understanding of the demand and supply of skilled professionals in the
job market.  Make the candidates understand the break-up of the total package that is offered.  Do not let the
candidate know the maximum salary that can be offered.  Do not reject a candidate if his expectations are
beyond the budget, rather try to make them understand the fringe benefits that is being offered in the package.
Salary negotiation is extremely important, as it can either make or break a selection. Sometimes, hiring
managers tend to go overboard and offer an extraordinary package to attract a right candidate. At other times, a
potential candidate rejects the offer because it was not up to his expectation. Hence, it is very important to
maintain balance between hiring the right candidates and working within the boundaries of the assigned budget.
Recruitment and Selection 33 Making a job offer is the final stage of recruitment and selection. Once a
candidate is selected, he/she will be issued an offer letter, which describes the designation, job location, role,
responsibilities, remuneration, benefits, and a few terms related to the company policies. Most HR professionals
tend to believe that making an offer is a simple process, but in many cases, it is not so. Making an offer is a
crucial part of recruitment and selection, because it’s a stressful and demanding process until the candidate joins
the company, after issuing an offer. At this stage, a lot of responsibility lies on the shoulders of the HR with
regards to the process after making an offer. How to Make a Job Offer? Making a job offer is a delicate process
and it should be handled carefully. The outcome of this process can be one of the following:  the candidate
may accept and start working with the organization, or  the candidate may accept a better job offer from
another organization, if he gets one. Hence, the HR team should take quick action at his stage. The following
points should be kept in mind while making a job offer:  Do Not Delay: Issue an offer letter as soon as a
candidate is selected, especially if the resources are limited. 10. Making a Job Offer Recruitment and Selection
34  Put the job offer on the table: While issuing an offer letter, do not wait for the right time. Contact the
selected candidate over phone and give him a verbal confirmation that he/she is selected to fill the position
vacant.  Set a deadline to accept the offer: Once the offer is issued to the candidate, set a reasonable deadline to
accept the offer. Take a confirmation from the candidate that he/she should join as per the date of joining
mentioned in the offer letter.  Stay connected: Even after the offer is accepted by the candidate, it is the
responsibility of the hiring manager to be in touch with the selected candidate, till he/she joins the organization.
After finding the right resource for the vacant job in the organization, the offer is prepared and released to the
candidate. It is crucial at this stage to follow a correct process in order to close the deal and ensure that the
selected candidate joins the organization as per the terms issued in the offer letter. Preparing a Job Offer Letter
Once the salary negotiations are completed, the next step is preparing and issuing a job offer letter. During the
confirmation of the job offer through phone call or mail, it is best to make the initial offer and discuss about the
terms of the employment. A formal job offer should include the following:  Name of the employee  Title or
designation of the job  The remuneration or salary offered  Employment commencement date  Roles and
responsibilities of the job  Terms and conditions (contract/temporary/permanent) of the job  Compensations
and benefits  Conditions during the probationary period  Additional condition, which includes legal,
background verification etc. Recruitment and Selection 35 Once the offer letter is prepared and issued to the
selected candidate, ask the candidate to send a signed copy of the offer letter, as a token of acceptance of the job
offer. The process of recruitment and selection starts right from understanding the requirements, sourcing,
scheduling, shortlisting, interviewing, selecting and finally issuing the offer letter. The process is not over till
the candidate joins. What Next after Issuing a Job Offer? Employees usually have to serve a notice period
before switching jobs. So, there is a time-gap of one month or so after a candidate accepts the Offer Letter till
the time he joins the organization. During this time-gap, the role of a recruiter is important because the
candidate may or may not join, even after accepting the offer letter! Hence, the recruiter should be in touch with
the candidate through mails/messages/calls till he/she joins the company. This communication and the
relationship between the recruiter and the candidate will help the process to complete and reduce the risks of the
candidate not joining the company. Hence, communication plays a vital role in the process of recruitment and
selection. The following steps are important after a candidate accepts the Job Offer:  Documentation process:
This process includes collecting documents such as educational certificates, id proof, address proof, previous
company offer letter, relieving letters, etc. If a candidate responds positively, then it is an indicator that he/she is
actually interested in joining the organization.  Employment verification process: Collecting an employment
verification document, which consists of the details of the previous employers and their references. It provides
information regarding the behavior and attitude of the candidate.  Contacting the candidates: Be in contact with
the candidate through calls or mails or messages, which helps in building a relationship between the recruiter
and a potential employee. It also helps in knowing the status of the candidate joining the organization. 
Resignation from current employment: As soon as an offer letter is issued to the candidate, make sure that the
candidate resigns his current job and shares a copy of the resignation document/mail. Later on, do follow up
with regards to the resignation acceptance document/mail from the current employer.  Following up for the
joining date: Finally, keep following up with the candidate about the joining date, because it will help in
knowing the status of the candidate joining the organization as per the joining date mentioned in the offer letter.
All the above points help the employer in identifying the interest and the seriousness of a candidate in joining
the organization.
Recruitment and Selection Process in HRM
September 26, 2015 by Umar Farooq
Recruitment and Selection Process
Recruitment and Selection process is defined as the process through which the best individuals are selected
among a pool of applicants for particular positions of job. Mostly managers consider selection process as one of
their critical decision functions in the organization. In selection process, the managers actually try to match
knowledge, skills & abilities of the applicants with the requirements of the jobs. There is no single selection
process that can be considered as standard one for all the organizations. Rather the steps & procedure of
selection process varies from organization to organization.
Factors Effecting Recruitment and Selection Process
Recruitment and Selection Process is supported by a standard & permanent process of screening. However in
some cases the screening process cannot simplify the selection process because there are certain other factors
that influence the selection process. These factors are the environmental factors & are as follow.
01- Legal Considerations
02- Speed of Decision Making
03- Organizational Hierarchy
04- Applicant Pool
05- Types of Organization
06- Probationary Period
07- Selection Criteria:
1. Legal Considerations
Human Resource Management is influenced by the court decisions, executive orders & legislation. The
management of the organization should use the legally defensive selection tools in the selection process.
2. Speed of Decision Making
The recruitment and selection process is directly influenced by the available time to make the decision of
selection. In general cases the selection process is followed by the specified policies & procedures to protect the
organization from legal issues. But in certain situations there is much pressure on the organization that leads the
management to follow the exceptional selection process.
3. Organizational Hierarchy
Recruitment and selection process varies according to the filling posts of different levels of hierarchy in the
organizational structure.
4. Applicant Pool
The recruitment and selection process is also influenced by the number of applicants for a particular job. In case
of many qualified applicants for a particular post, the selection process becomes selective. For this purpose,
selection ratio is ascertained by comparing the number of selected applicants to the number of applicants in a
pool.
5. Type of Organization
The type of the organization like government organization, private or non-profit organization etc, also affects
the selection process for the hiring individuals.
6. Probationary Period
Certain organization adopts the procedure of probation period in the selection process to check the potential of
the individual on the basis of his performance. This may take the form of either validity check on the selection
process or as a substitute of some steps of the selection process.
7. Selection Criteria:
In most of the cases the applicants are selected on the basis of following factors or criterion.
 Education
 Competence
 Experience
 Skills & Abilities
  Personal Characteristics
In way the applicant that best fits the above criterion is selected rather than the one that has extraordinary skills
or over as well as under qualified because in such case the later selected person would not properly adjust in the
organization.
Steps Involved in Recruitment and Selection Process in HRM
In typical cases, the selection process starts with the preliminary interview after which the applications for the
employment are filled by the candidates. The candidates pass through a number of selection tests, interviews of
employment and background check & references. The candidates that are successful in all the previous steps get
physical examination test by the company and if the results are satisfactory, they are selected. There are several
internal & external forces that influence the selection process & therefore the managers must consider these
factors before making a final decision of selection. Following are the standardized steps of the selection process
but some organizations may alter some of these steps in their selection process.
01- Initial Screening
02- Application blank
03- Pre-employment Testing
04- Interview
05- Background Checks
06- Conditional Job Offer
07- Drug Test/Medical Exam
08- Final Selection Decision
Now each step is discussed one by one.
1. Initial Screening:
Generally the Selection and the Recruitment Process starts with the initial screening of applicants so that the
unqualified ones are drop out at the initial stage. Initial screening is helpful to save the time, cost & effort of the
selection committee in the following steps of the selection process. In this step certain general questions are
asked from the applicants. There are chances that the some applicants would be unqualified for the job but some
of them would be qualified. So the main purpose of screening of applicants is to reduce the number of
applicants available in the selection process.
Sources used in the Screening Effort
The main source of initial screening is the curriculum vitae of the applicant along with the job application.
Following information is included in the above mentioned documents.
 Education & employment History
 Evaluation of character
 Evaluation of job performance
Screening Interviews
Screening interviews are employed to
  To verify the accuracy & validity of the information given in the curriculum vitae of the applicant.
 The duration of these interviews is quite short.
Advantages of Successful Screening
When the initial screening step become successful, the removing applicants don not proceed to the next step of
the selection process because they do not meet the minimum requirements. Secondly the selection costs of the
organization are much reduced through proper screening of the applicants.
2. Application Blank
The person’s application for employment is formally recorded in the shape of application blank. In the next step
of the selection process, an application form for the employment is completed by the prospective applicant. The
information contained in the application blank differ from one organization to another organization and in job
posts, it may vary even within the same organization. But generally the informational needs and the
requirements of EEO are covered in the application blank. The historical data from the candidate can be quickly
collected through the application blanks so that further verification about the accuracy of the data is carried out.
3. Pre-employment Test
The physical & mental abilities, knowledge, skills, personal characteristics & other aspects of behavior can be
effectively measured through the pre-employment tests. For this purpose there are hundreds of test that can
measure the different aspects of human behavior. With the passage of time, the application of pre-employment
test is growing at a fast rate in the selection process because they can explain the qualities & skills of applicant
clearly. These tests are more used in the large & public sector organizations.
The advantage of application of tests in the selection process is that it can ensure the potential & qualified
candidate selection from a pool of applicants for a job.
Characteristics of Well Designed Test
A well designed selection test has the following characteristics.
 Standardization
 Objectivity
 Norms
 Reliability
 Validity
Kinds of Pre-employment Tests:
As individuals varies on the basis of cognitive abilities, job knowledge, vocational interests, psycho-motor
abilities & personality etc. So, all these factors are measured through a set of different pre-employment tests
which are as follow.
Cognitive Aptitude tests
In this test the ability to learn & perform a job by an individual is judged. The abilities related to job are as
follow.
 Verbal
 Reasoning
  Numerical
 Perceptual Speed
 Spatial
Psycho – motor Abilities Test
In this test, the coordination, strength & dexterity of an individual is judged. Other abilities related to routine
office jobs & production jobs can also be measured through these tests.
Job knowledge Tests
This test is used to measure the knowledge of the person about the duties of a particular job.
Work Sample Tests
A set of tasks that represent a job are identified in this test through which the productivity level, ability to face
adverse conditions by the applicants are judged.
Vocational Interest test
This test identifies the occupations that are preferred by the candidate & that can provide him maximum
satisfaction.
Personality Tests
These tests are not considered to be so reliable & valid as compared to other pre-employment tests because
these tests require external psychologist who interprets the results of the tests subjectively.
Drug & Alcohol Tests
For the security, productivity & safety of the workplace drug testing programs are used as pre-employment
tests.
4. Job Interviews
In the interview, the interviewer & applicant exchange information in order to achieve a goal through
conversation. The employment interviews are conducted during the selection process through proper planning.
The pleasant location of the interviewing place is selected and the interviewer has the good personality with
empathy & ability to communicate & listen effectively. A job profile must be prepared on the basis of job
description before conducting interview.
Contents of the Interview
Although the contents of the employment interview varies from one organization to another & also according to
the nature of job but still following are the essential contents of the interview.
 Occupational Experience
 Academic Achievement
 Interpersonal Skills
 Personal Qualities
 Organizational Fit
Types of Interviews
The interviews are generally categorized into the following three types.
1. Unstructured Interview
In unstructured interviews open ended questions are asked from the applicant in order to perform probing. It is
generally non-directive in nature and applicant is encouraged to give lengthy answers.
1. Structured Interview
In structured interview, a list of job related questions associated to particular job are asked from each applicant
in a consistent manner. It is directive or patterned in nature and includes the following four kinds of questions.
 Situational Questions
 Job Knowledge Questions
 Job-sample simulation Questions
 Worker Requirement Questions
1. Mixed Interview
It is a special kind of structured interview in which specially designed questions are asked from the applicant to
probe his past behavior in specific situations. It does not include the self-evaluative & hypothetical questions &
inhibits to judge the personality of the applicant. The candidates are rated on the basis of their responses in the
light of the bench-marked answer of successful employees.
Methods of Interviewing
Following are the main ways of conducting interviews.
01- One-on-One Interview
02- Group Interview
03- Board Interview
04- Stress Interview
5. Back Ground Checks
The accuracy of the application form of the candidate is verified through references & former employer. The
educational, criminal record & legal status to work are verified. Personal references of applicant are contacted
to confirm the validity & accuracy of the provided information. Effort is made to know the past behavior of the
employees to that the future behavior can be predicted from it. Background checks assist the selection
committee in dropping the applicants that have past insubordination issues, attendance problem, theft or special
behavioral problems. The level of responsibility of the new job directs the intensity of the background
investigation.
6. Conditional Job Offer
After going through all the previous steps of selection process, there comes the most important step of the
selection process in which the decision of hiring is made. The applicant that best meets the requirements of the
job is selected. At start conditional job letter is issued which must be followed by medical exam.
7. Medical Exam
When the conditional job letter is issued the next step of the selection process starts in which the
physical/medical examination of the selected candidate is conducted. The medical exam of the candidate is
essential to check either he takes the drugs or not. If he passes the exam, he would be finally selected for the
job.
8. Final Selection Decision
After passing the medical exam by the candidate, the final offer for the job is made to the candidate by the
relative department.
Human resource management (HRM) is nothing but the strategic and coherent approach towards the
administration of an organisation’s largely valued assets – the people. The Human resource management main
role is to sustain employees of an industry is to make sure that the adequate employees levels by means of the
right skills, correctly compensated and encouraged. All the activities of an organization are done effectively by
the Human resource panel. Staffing purpose of an organization is done by Human resource management. It
comprises of the activities of human resources planning, recruitment, selection, orientation and training.
Nowadays numerous businesses are ramping towards Human Resources Outsourcing (HRO) since it removes
the load of administration as well as changing their focus again to before the individual’s policies. Their main
goal is to reduce the expenses and at the same time, organisations are also looking before the Human Resource
Management to offer first-rate service to their employees. Below are some of the efforts of the HRM played in
most of the organizations?
Considerable cost savings
Functioning efficiency
Industry leading expertise
Outstanding service to the customers
To a certain extent HRM tries to save the cost of the organization or we can say HRM plays an important role in
cost cutting; HRM glance at every level of the organisation from the holistic point of analysis. HRM looks at an
organisation where it could be extra capable, in which the organization can be able to work better. HRM helps
employees to be more engages and productive by providing various kind of trainings, learning and development
as per the requirement. We can say HRM main objective is to make organization work better at a lower cost.
Recruitment Definition
In simple words Recruitment process indicates hiring of a person or group for a particular position, it can also
be said as activity that creates a link between employer and job seeker. Generally HR department team in the
company looks to evaluate the logical, analytical, critical, commitment and responsibilities when searching for
the candidates in the candidates while selection. Recruitment process can also be identified as bringing together
the applications from the job seekers and selecting the best candidate for the role of the job identified. Actually
it can be said the process of hiring employees. It can also be said as performing action of seeking fresh
employees or members within the organization. Recruitment plays an important role for any organization to
continue its efforts to make the organisation the finest organization.
Recruitment needs can be of three categories
Planned: The need of occurring since amendment in organization and retirement policy.
Anticipated: These needs are of those types in which movements can be forecasted by going through the
movement in internal and external environment.
Unexpected: The need can arise when resignation, termination, illness or death of the employee
For recruiting the right persons following procedure should be improved and then needs to be followed.
How to advance ability for drawing the correct candidate
Which recruitment way and performance will get the largely competent candidates
How to strengthen as well as attribute as an employer
How to simplify the screening process
How to perform a reasonable and systematic application process
Recruitment Process
Recruitment refers to the process of recognizing and drawing job seekers so that to construct a group of job
applicants. The main goal of the recruiter is to identify the right person for the said job and the recruiters can
achieve their target by 5 important guidelines.
Planning
Strategic expansion
Searching or probing
Selection
Assessing and organizing
In most of the organizations, recruitment process operates various channels: But in most of the organizations
companies will agree to the existing employee’s applications before trying to bring from the external resource.
The main types of recruitment process are.
Internal Recruitment
Generally, as soon as a position opens in an organization, the HRM panel would normally place the vacancy
under the company’s intranet as well as in familiar spot, such as cafeterias, break rooms, lifts and departmental
information boards. If member of the organization gets attracted in the position, they will usually required to go
through a related process same as external candidates interview. The employees will have to submit their CV to
HR team, if they get selected they would have to go with number of rounds and finally with the hiring manager.
External Recruitment
In this case the company generally places the position on various external resources for e.g. Internets,
newspaper, consultancies, educational institutes or campus selection and bring a friend referral to the employees
then the HR panel would select the CV of candidates who have applied for the position. But in this case lot of
time and money is spent. Generally, the interview and testing is determined as per the company’s guidelines
plus procedures. Several candidates will be selected and shortlisted on a phone with human resource team and
then they are asked take assessments, it can be personality, technical aptitude or academic assessments
depending upon the job required.
Factors affecting internal recruitment
Recruitment policy
Human resource planning
Size of the firm
Cost
Growth and expansion
Factors affecting external recruitment
Supply and demand
Labour Market
Image/ Goodwill
Political Social and Legal Environment
Unemployment Rate
Competitors
Selection
Selection means selecting the right person for the right kind of a job according to the company demand and
person’s ability. It is the process of opting within the scores of job seekers with necessary qualification as well
as competence to fill the position in the organization. Few of the selection process could be applied within the
organization as a part of promoting and transferring. In selection criteria the candidates are cautiously picked up
as per their ability.
Staffs play an important function in the achievement of any company. When an organization wants to achieve
their goals and target in simple words if the organization wants to be successful and wants to win the race
against the competitors, they need to hire the best of the individuals who can work effectively and efficiently.
Thus a wrong person selected can cause a reputation loss or failure in meeting the goals. A cautious approach
needs to be taken while selecting the candidate to be more successful in the market.
Selection process
It means the combination of measure taken, or procedure used as per the basis of some employment judgment.
In selection process short listing is done as per the ability and performance of the candidate.
Below are the various stages in selection process,
Application: Applicants are welcomed by e-mail or telephone by the Human Resources team.
Selection Methods: Selection system will be carried out to make a decision by the HRM team for the selected
candidates by the below stages.
Panel interview
Presentation
Selection tests
During the course of selection all the academic and experience of the candidate is verified by the Human
Resource team to ensure that they meet the compliance and integrity of the organization as well as to suit for the
post of the job. Usually in External Selection phase this kind of procedure is followed. While during Internal
selection, all the employees who are shortlisted and interviewed for the position if they meet up the important
criteria for the job. During the internal selection employees if the employ is selected they are promoted or at
least get a hike in their salary.
Equally recruitment and selection is the two segment of an employment procedure. The main distinction
between the two is as follows:
The recruitment can be the course of looking for the candidate for the employment and invigorating them to be
valid for the job, whereas selection engage in the various stages through which the candidate is selected as per
the ability.
The essential intention of recruitment is to develop a flair of candidates who are talented enough to be able to
get selected in the organization. While in selection the most important aim is to select the right candidate to fill
the a range of positions in the organization.
Recruitment is always a optimistic process, encouraging many candidates to submit an application for the
position whereas selection is a pessimistic approach in which it entails the elimination of the incompatible
candidates.
Recruitment is apprehensive about the rhythm of human resource, while selection is concerned about the
selecting the best candidate in the course of a range of interviews and assessments.
Recruitment creates no agreement, whereas in selection we can find consequence in a agreement between
service provider and the job seeker.
Recruitment and Selection process interact with other systems
Equally recruitment and selection process are correlated for the success of the organization, as per the planning
and strategic approach pursued by the Human Resource Management. Every organization believes that if the
best of the candidates are selected for the given job then obviously the organization yield profit and at the same
time customer satisfaction can also be achieved. Effective and Efficient employees plays an important role for
the success of any organization and they can be selected only by the recruitment and selection system.
Employees can also be trained or developed by means of various procedures like training and learning and
development. The organization should create a effective procedure to select the best candidates for the position
which needs to be filled as it helps to obtain the right employees which will yield the increase in productivity
and thus they can produce the better quality products or services. To achieve the said goal selection of the
candidate should be done and at the same time they should be given the benefits so that they work for a longer
period of time in the organization which will automatically reduce the cost of hiring.
Recruitment and Selection process is implicated in every part of the organization. Every department in the
organization needs employees thus recruitment and selection play an important role for the success of the
organization.
HR implemented plans provides input to organization in all functions
HR has to play plan their strategies for the recruitment and selection in such a way that they provide a platform
for the success of the organization. They need to find out the key areas through which capable candidates are
selected. HR should be able to identify which candidate can perform the job in a best possible way. If in case
their plans are not carried out correctly, it will affect the whole performance of the organization. Thus it will
increase the expenses of the labour cost which is not a good sign for any organization.
HR team needs to put an additional crack for the development and implementation for the recruiting and
selecting process. They need to be thoroughly approached for assessing the candidate to fill up the particular job
for which the candidate should have the ability and potential. They should be fair enough while recruiting and
selecting as they have the responsibility to make sure that no ill feeling occurs in the mind of the candidate as
some time they feel they were discriminated inappropriately, which can turmoil the reputation of the
organization.
Conclusion
During current circumstances, organizations are no more competing with their competitors, price, packaging
and product. Their main competition is to look for the most excellent talent existing in the market. Nowadays
companies with the best talent available in the market prevails for example HSBC bank has the load of talented
people working that’s why during recession their layoff rate was so low in that scenario also as they knew with
the talent in their employees they have still they can excel in the market. We can say recruitment and selection
process plays an important role for the good hiring and bad hiring of the employees.
Recruitment and Selection process should be introduced in such a way that an organization achieved the goals
and aims like group discussion, online interview. If we see the history most of the companies have decided on
budding and convalescing the selection process for the job.
Rapidly varying economic surroundings, considered by such phenomena in the organization as well as
customer’s weights and ever rising competition among the competitors is making the human resource to
improve their performance. For improving the recruitment and selection procedures organizations has to en
route for determining the performance of the managers, they should be remunerated as per the selection
performance. During decision building, uniformity always enhanced the comparable category of capable
employees and they are occupied by each phase of the selection process. Organizations should believe in
expenditure which is acquired for recruitment and selection process as expenses but not as investment.
One of the significant roles of HRM is to select suitable staff and decide to hire right professionals or
employees to fill recruitment needs, and provide training the best employees and, make certain that these
selected candidates can give better performance, deal with performance issues and follow the rules to diverse
system. Recruitment is of the fundamental job of Human Resource management. Fundamentally, recruitment is
the process of attracting, assessing, and hiring employees for companies. Once HRM requirements are
understood, the next step of HRM is to employ workers. Recruiting and staffing is a complicated activity in
competitive business surroundings. Earlier, HRM employees were dependent on recommendation from existing
employees. At present, the major challenge is to fill suitable positions and equal employment opportunity which
requires more complicated procedures to distinguish and select potential employees. There is difference in
enrolment and selection practices reflecting an organizations strategies and perspective to manage workforce.
Talented employees represent the core workforce of organization. Applicants are employed on the basis of their
ethical level and skills (Guest, 1989). In many organizations, skill framework have been developed and utilized
to recognize the talent and qualities essential from potential employees (Roberts, 1997). Such criteria are
important to implement many recruitment and selection procedures to classify and select suitable people.
There are many definitions of recruitment and selection stated by theorists. Recruitment performs the necessary
function of drawing an important resource of human capital into the organization (Barber, 1998). Barber
explained that Recruitment includes those practices and activities carried on by the organization with the
primary purpose of identifying and attracting potential employees. Another theorist, Newell and Shackleton
(2000) refer to recruitment as "the process of attracting people who might make a contribution to the particular
organization". Recruitment is intended to attract individuals to an organization whereas selection is to identify
the most capable from among those individuals. Bratton and Gold (2003) describe selection as "the process by
which managers and others use specific instruments to choose from a pool of applicants a person or persons
most likely to succeed in the job(s), given management goals and legal requirements".
The recruitment and selections are complicated procedures. Presently, there is a trend to sign a positive
psychological contract with employees which provides the basis for a positive outcome in terms of
organizational pledge and enthusiasm. Recruitment and selection are essential means in the development of the
expectations that form such a contract. In order to make two way flow of communication, workers choose an
organization that offers soothing working conditions and incentives for bright career. According to Armstrong
(2009), recruitment and selection process comprises of four stages: defining requirements, attracting candidates,
selecting candidates and placing them on the job. Respectively, Robertson and Smith (2001) maintained similar
outlook as Armstrong's viewpoint and added personality assessment to the lists guided by tests and interviews.
Another theorist, Rynes (1990) proposed that recruitment includes all organizational practices and decisions that
influence either the number, or types, of individuals who are willing to apply for, or to accept, a given vacancy.
Torrington and Hall (1991) distinguished three components in a recruitment procedure. First is the job analysis
which is done in order to collect all relevant information about the job demands and to set the hiring standards.
The second component is associated with the recruitment strategy to spread all pertinent information among the
possible set of candidates. The third component is the selection method which aims to screen the applicants'
abilities and traits in order to assess the degree of success and compatibility of the individual in the
organization.
There is a great significance of recruitment and selection as a human resource function in organization. In
complicated marketplace, recruitment and selection is effective tool for organizations to achieve their current
strategic direction and to maintain innovation. Recruitment and selection is important to deliver behaviours seen
as necessary to support organizational strategies (Iles, 2001). Kilibarda and Fonda (1997) stated that good
recruitment and selection practices can reduce the risks of failing to achieve the business strategy. Successful
recruitment and selection can also provide considerable improvements in productivity and employee morale and
allow organizations to build personnel of more able employees who collectively provide a superior product or
service (Robertson, et al., 1996). There are numerous important factors that can lead to successful recruitment
and selection. For example, personality is important as a supplementary forecaster of job performance. Despite
the fact that the use of personality tests have witnessed an increase in recruitment and selection between the late
1980s and beginning of 1990s, the role of personality testing in managerial selection has not been
acknowledged. During this period, the evidence for predictive validity of personality tests is normally
overstated and imperfectly assessed. Personality is only a relative minor determinant of managerial performance
(Dakin et al, 1994). However, there have been major changes over the past decade.
The recruitment and selection process can occur any time in organization when there is a need of personnel,
when a current incumbent leaves the position or being promoted to another position and when a current
incumbent takes an extended leave such as for maternity leave. Recruiting activities can be performed with
internal efforts or, college hiring fairs, technical and vocational events, and conventional newspaper
advertisements. It is based on the current openings in organization and forecasts for future needs. Hiring
manager will need direct efforts toward the best option for recruiting the right candidates. The recruitment
process follows on from the process of establishing staffing needs.

usual strategic recruitment process

Recruitment and selection is the first step to develop the competitive strength of organisations. Recruitment
process involves a systematic procedure from sourcing the candidates to arranging and conducting the
interviews and requires many resources and time. Consequently, recruitment and selection are visualized as the
processes by which organizations solicit and get in touch with (Sisson, 1994). Recruitment and selection are the
two phases of the employment process. The recruitment is the process of searching the candidates for
employment and stimulating them to apply for jobs in the organisation whereas selection involves the series of
steps by which the candidates are screened for choosing the most suitable persons for vacant posts.
Correspondingly, the basic principle of recruitments is to create talented candidates to enable the selection of
best candidates for the organisation, by attracting more and more employees to apply in the organisation
whereas the basic purpose of selection process is to choose the right candidate to fill the various positions in the
organisation. The recruitment process is directly followed by the selection process, which is the final interviews
and the decision making, conveying the decision and the appointment formalities. A good recruitment and
selection policy ensures consistency in hiring staff and reduces the risk of bias or favouritism.
In technical advancement period, the use of online recruitment has been increased internationally. Technology
has facilitated communication through official corporation website or job referral site. Galanaki (2002) said that
online recruitment or internet recruiting implies the formal sourcing of job information online. Online
recruitment can reduce costs considerably.

Benefit and limitations of online recruitment

It is observed that online recruitment is not suitable for all organizations.
To summarize, the key objective of recruitment and selection in organization is to fill the vacancy effectively. A
policy of recruitment must be coordinated with human resource strategies as a positive contribution to the
overall outcome of company. Through the recruitment and selection process, an organization get the quality and
quantity of employees which are required to fulfil the targeted goals. Human resource sees recruitment process
is costly but it is essential part of any business. New methods of recruitment and selection have helped in
managing quality of new hires. Through appropriate strategy and assessment tools for candidates' selection
process, the recruiters need to obtain complete information of their past behaviours which truly reflect the
demonstrated competencies of the candidates. Overall, the recruitment and selection process facilitates firms in
making realistic decisions about a prospective candidate. It also provides the organization with the knowledge
of sources of potential recruits. Experts state that the process should be clear and should ensure confidentiality
and observance of equal opportunity legislation.
Recruitment and selection – The most important HR function

Recruitment is a key responsibility of the HR department. While HR works in many areas including employee
engagement, employee development, statutory compliance, data management and many others, one of the key
areas of focus for HR is to attract, select and onboard suitable candidates for the organization.
Why do we need an appropriate Recruitment and Selection process?
Recruitment is the process of attracting qualified candidates for a job role and Selection is the process of
identifying and selecting the right candidate for that job.
The contributions of each employee play a pivotal role in the sustenance and growth of a business. Hence it is
extremely important to select the right person for the job. The same way as a square peg does not fit in a round
hole, a bad hire can affect the overall business outcomes.
The impact to your business when you hire the wrong candidate is often much more than not hiring a person at
all! Recruitment is not only an operational activity but a key strategic activity for the business.
Hence there is a need for developing a strong recruitment and selection process.
The right process reflects on your company’s professionalism and portrays your organization’s maturity
in attracting and hiring the right talent. An effective process helps in creation of a talent pool in a proactive
manner, thus assisting in meeting the medium-term and long-term business objectives.
Recruiting involves multiple stakeholders including senior level employees in your company and can cost a lot
in terms of time and money. Hence one needs to ensure that the process is well defined and optimized to meet
the needs of all stakeholders.

Enablers of a good Recruitment Process

A few things to keep in mind to enable a smooth hiring experience:
Integrate job postings with job description
Create a database of job postings and link vacancies to well defined job descriptions and skills. This makes it
easier for the recruiter, the hiring manager and even the candidate.
Simplify the application process
You want to excite a candidate and sell the job to them. A complex application process puts off most
candidates. The application process should work on all devices including mobiles, allow a seamless experience
and candidates should be able to register once and submit their resumes to multiple positions.
Display job postings on your website
Publish the jobs on the career page of your website along with postings on other social platforms. You want to
be visible everywhere – especially the social sites where a majority of your prospective hires spend their time.
Manage previously submitted resumes
Old submissions often get lost. Build a database that allows easy tagging and searching. Keep track of
applicants and inform them of new positions.
Manage your candidates effectively
Assign interviewers to shortlisted candidates and automated reminders to candidates and interviewers.
Streamline the applicant tracking process
Allow recruiters to accept, review and manage resumes at a single location.
Maintain touchpoints with candidates
It is important to remain in touch with candidates on a periodic basis. They may not have succeeded in the
existing job position they applied for but may be suitable in the future. Keeping in touch with them often builds
relationships and can reduce the time-to-hire for future recruitments both for these candidate as also their
referrals.
Have a robust onboarding process
Improve day-one readiness of new hires by seamlessly onboarding new employees.
Maintain data on the recruitment process
To iteratively improve the recruitment and selection process, meticulously maintain data related to different
parts of the process. Different recruitment metrics that you can manage include resumes received, resumes
shortlisted, interviews, no-shows, offers, accepts, time-to-hire, time-to-fill and so on.
Concluding thoughts
Selecting the right employee is an important goal for the recruitment team and establishing the correct process
can enhance the experience of the Candidate, Interviewer, Hiring Manager and the HR Department. It can also
help increase the effectiveness of your business.
HR professionals should ensure that they follow the correct Recruitment and Selection processes and attract the
best workforce for their organization.
Recruitment and selection

Recruitment refers to the process of finding possible candidates for a job or function, undertaken by recruiters.
It may be undertaken by an employment agency or a member of staff at the business or organization looking for
recruits. Advertising is commonly part of the recruiting process, and can occur through several means: through
newspapers, using newspaper dedicated to job advertisement, through

professional publication, using advertisements placed in windows, through a job center, through campus
interviews, etc.

Suitability for a job is typically assessed by looking for skills, e.g. communication skills, typing skills, computer
skills. Evidence for skills required for a job may be provided in the form of qualifications (educational or
professional), experience in a job requiring the relevant skills or the testimony of references. Employment
agencies may also give computerized tests to assess an individual's "off-hand" knowledge of software packages
or typing skills. At a more basic level written tests may be given to assess numeracy and literacy. A candidate
may also be assessed on the basis of an interview. Sometimes candidates will be requested to provide a résumé
(also known as a CV) or to complete an application form to provide this evidence.
RECRUITMENT PROCEDURE:

Before going to recruitment, careful study is needed about jobs which are to be kept under recruitment. Careful
study is nothing but doing Job analysis which is otherwise called as collection of every information about the
job so as to figure out exact candidate needed to perform said job.

HR manager needs careful attention and should be diligent while going for recruitment of human resource,
since it grabs attention of prospective employees at large. However it is not so easy to find out skilled people.
Hence various tests in selection process helps to identify potential candidate needed for an organisation.
Coming to procedure for recruitment, it depends on nature and size of organisation. But concept of recruitment
is one and same. Recruitment does in various modes which are basically categorised into two, out of that first
one is internal recruitment and external recruitment, which are elaborately explained in detailed below.
Whatever the mode of recruitment preferred by an organisation, it should be clear in what an organisation needs
and easily understandable by prospective employees at large so as to avoid frivolous and unsolicited
applications which will consume lot of time for an organisation to identify them. Hence organisation should be
clear and thoroughly check before posting recruitment.

Factors that should be considered for recruitment

1. The first step of recruitment is Identification of number of posts lying vacant.
2. Rule of reservation: identification of posts which will fall under which category of reservation.
3. Following rosters: roster points should be followed to come to conclusion that how many posts should
be notified under which category of reservation.
4. Deciding the qualifications necessary for every post or job which is going to be notified.
5. Designing selection procedure for each category of job or post
6. Fixing the remuneration or scale of pay.
7. Deciding the promotional channel for each category of post.

Basic contents of Recruitment notification;

1. It contains brief about an organisation which is recruiting.

2. Contains number of posts/jobs lying vacant in an organisation.
3. Contains number of jobs in reserved category. (especially in government organisation jobs are allotted
to reserved category).
4. Contains information about gender needed for the jobs. (For example: Male or female)
5. Contains information about educational qualification needed to qualify for applying to job.
 6. Contains information about work experience needed. (points from 2 to 6 are nothing but called as Job
specifications, it is a statement that describes about specifications needed by a candidate to have
qualified for a applying said job)
7. It contains most important information that is, Job description, which is the statement of information
about duties and responsibilities of the job.
8. Contains information about salary particulars, employee benefits and other allowances to be provided.
9. Selection tests which must be passed by candidates so as to have job.
10. Terms and conditions if any.

Recruiting Agency Can't Be Compelled To Fill Available Posts Even When Persons Of Desired Merit Are Not
Available: Supreme Court of India [Read Judgment]

Supreme Court has re-iterated that the recruiting agency cannot be compelled to fill up all available posts even
if the persons of the desired merit are not available.

The Supreme Court has allowed an appeal filed by Municipal Corporation of Delhi (MCD) and has held that it
was at liberty to set minimum qualifying cut-off marks in exam for appointment of Assistant Teacher (Primary).

The factual matrix herein was that Delhi Subordinate Services Selection Board (DSSSB) had issued a
notification for appointment of Assistant Teacher (Primary) in the schools of MCD. The said notification, by
virtue of Clause 25, conferred discretion to DSSSB to fix the minimum qualifying marks for selection, in order
to pick the best talent available. Further, Clause 26 provided that the marks obtained by a candidate in the
written examination shall not be disclosed.

Subsequently, the Respondents herein did not qualify the exam and filed a writ petition before learned Single
Judge of the Delhi High Court to quash Clauses 25 and 26 on grounds of arbitrariness. The writ petition filed by
the Respondents was dismissed and was challenged by them before a division bench of the same court. The
appeal succeeded and hence the Appellant herein pursued the present appeal.

The arguments made by Respondents in the original writ petition were that:

1) DSSSB was merely an agency to conduct the interviews/tests and prepare the panel. It was not empowered to
lay down its own criteria for scrutinizing the eligible candidates by fixing minimum qualifying marks and was
bound to follow the requisition given by MCD for undertaking selection process.

2) The action of DSSSB to refuse to give any details about the minimum marks which had been fixed by them
unilaterally was arbitrary and discriminatory.

3) In view of the minimum marks cut-off criteria, the result of only 1638 out of the total 2348 advertised posts
was declared. It was submitted that this process adopted by the DSSSB was contrary to the directions issued in
the case of Kuldeep Singh and Ors. v. DSSSB & Anr., W.P.(C) Nos.5650-51/2004, wherein it was held that
the number of posts that are vacant against every category, and all of them should normally be filled up from
the eligible candidates according to their standing. In that light, a direction was sought to the DSSSB to consider
the case of the Respondents against the remaining vacancies without fixing minimum qualifying marks for
selection.

The Appellant herein had contended that:

1) The method of recruitment, laying down the eligibility criteria, etc. were matters relating to the executive
policy decisions and in the absence of any statutory rules/laws, the executive decisions were sustainable.
Further, when MCD had no objection to the method adopted by DSSSB, the objections raised by the
Respondent would be unsustainable.

2) The allegations of discrimination were not sustainable in as much as the Respondents had not demonstrated
as to how the criteria of fixing the cutoff
percentage was arbitrary when it was uniformly applied to all the candidates.

3) The decision in the case of Kuldeep Singh was sought to be distinguished andreliance was placed on State of
Haryana v. Subhash Chandra Marwah & Ors., AIR 1973SC 2216, to contend that it was open to the
Government to fix a score which was higher than the one required for eligibility for the post with a view to
maintain the highstandard of competition.

The bench comprised by Justice R. Banumathi and Justice A. S. Bopanna found merit in the arguments raised
by the Appellant. Addressing the first contention, it was held that DSSSB had been specially created by the
executive for the purpose of selecting the appropriate candidates to fill up the vacancies in the User Department
and it was bound to discharge its obligation by fixing the criteria for declaring successful candidates. "Any
undue sympathy shown to the private respondents herein so as to direct their selection despite not possessing
the desired merit would amount to
interference with the right of the employer to have suitable candidates”, the bench said.

On the second contention, the bench agreed with the decision taken by Single Judge of the high court that even
if the criteria fixed was defective, the Courts were ordinarily not required to interfere as long as the same
standard/yardstick had been applied to all the candidates and did not prejudice any particular candidate.

On the last contention, the court relied on Ashwani Kumar Singh v. U.P. Public Service Commission &
Ors., (2003) 11 SCC 584, wherein it was held that it was not a rule of universal application that whenever
vacancies exist, persons who were in the merit list per force had to be appointed.

It was further held that when the Respondents appeared for the examination they were fully aware of Clause 25
pertaining to minimum qualifying marks and despite that they participated in the process by appearing for the
examination. Hence it washeld that any grievance raised now would not merit consideration.
"DSSSB and the appellant herein were concerned with the quality of teachers to be recruited and had fixed a
merit bar to indicate that the persons obtaining the percentage of marks above such bar only would be selected,
the employer cannot be forced to lower the bar and recruit teachers who do not possesses the knowledge to the
desired extent merely because certain posts had remained vacant which in any event would be carried over to
the next recruitment", the bench said.

https://www.livelaw.in/top-stories/recruiting-agency-cant-be-forced-to-fill-up-vacancy-by-lowering-bar-146896
Selection

Selection is the process used to identify and hire individuals or groups of individuals to fill vacancies within an
organization. Often based on an initial job analysis, the ultimate goal of personnel selection is to ensure an
adequate return on investment--in other words, to make sure the productivity of the new hire warrants the costs
spent on recruiting and training that hire.

Several screening methods exist that may be used in personnel selection. Examples include the use of minimum
or desired qualifications, resume/application review, oral interviews, work performance measures (e.g., writing
samples), and traditional tests (e.g., of job knowledge).

The field of personnel selection has a long history and is associated with several fields of research and
application, including human resources and industrial psychology.
Easily the most important job of human resources is recruitment and selection.

HR departments can even improve their employee retention rate if their recruitment and selection methods are
performed efficiently since hiring the right employee for the right position can reduce the rate of employee
turnover and improve morale by promoting from within when appropriate. There are many steps in the
recruitment and selection process, but they're necessary for ensuring that the ideal candidate is hired for the
position.
Recruitment and Selection Definition
When discussing the importance of the recruitment and selection process in human resource management, it's
important to first establish what these processes actually mean to a business. The simplest recruitment and
selection definition is the process of identifying and filling a position. But the process is a lot more
complicated than it sounds.
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In order to properly recruit candidates, you must recognize that a position is available, research and document
what the job entails and determine what ideal qualifications a candidate should have. Then, decide where and
how to recruit for the position and encourage people to apply.
Whereas recruiting involves trying to attract a large pool of qualified candidates, selection involves trying
to filter out those applicants until you find the one person you actually want to fill the position. In order to do
this, you need to go through the applications to find candidates who best meet your requirements.
You'll then conduct interviews with these prospects, short list the most qualified applicants and eventually
narrow down the pool of applicants until you choose the right person.
Recruitment and Selection Objectives
It's important to recognize that the ultimate goal of the recruitment and selection process isn't just to
hire someone to do the job but to hire the right person. That means not just finding someone with the abilities
and knowledge to fill the vacancy but someone who can also do it with a good attitude and fit in with his
coworkers and the overall company culture.
Failing to consider these important goals may leave you trying to fill the same position over and over until you
actually find someone who has a good attitude and fits in.
If you have a super laid-back company culture where everyone is expected to leave at 5 p.m. and not take their
work home with them, a highly motivated worker who wants to stay on the clock 24/7 will be miserable, just as
an employee who wants a well-defined distinction between her work and private life will be unhappy working
at a company that wants her to be available at all times.
Aside from helping you to find the right candidate, there are other things you may accomplish through a
thorough recruitment and selection process as well. These may include:
 Creating a large talent pool of potential employees that you may be able to pull from in the future.
 Meeting your diversity objectives by hiring based solely on ability and how someone fits into the
company culture.
 Building a reputation for fair, unbiased hiring practices.
 Making the recruitment and selection process faster and more efficient in the future.
Identify Your Hiring Needs
Before you go about hiring someone, you need to know that there's actually a position for them to fill. That's
why the first step of recruitment is to recognize that there's either a vacant position at the company or you need
to create a new position.
In large companies, this may begin with a requisition for recruitment being filed by a manager who needs a new
employee.
This document will detail the required duties, responsibilities, qualifications and desired experience related to
the position. The sourcing manager will then determine if the position is actually necessary and if it is, whether
it should be full or part time and permanent or temporary. In smaller companies, the owner or department head
may simply tell the HR manager that he'd like to hire for a position and if he has any specific requirements for
the position or the potential job candidate.
Analyze the Position
While a requisition for recruitment may have some details about the position and the desired candidate, it's
important to know the full extent of everything required for the job.
That's where the job analysis comes in. This process should look at similar positions at other companies, past
job analysis for the business and information from former employee's exit interviews in order to know what
work environment, duties, responsibilities, skills, abilities and experience are necessary for the position.
You'll need these details to create the job description, person specs, recruitment methods and interview
questions, as well as to decide on the proper pay, benefits and training program for the employee. It can even be
used for performance appraisals in the years to come.
Evaluation, Description and Person Specs
Once you have the job analysis, you can use this information for your evaluation, description and person specs,
which are all necessary before you can create a job listing. The job evaluation requires looking at similar
positions in your company and at similar local jobs in the area to come up with a fair pay range and benefits
package.
The job description should cover everything a person needs to do and what tools they'll use to perform their
duties.
This should include the job title, location, a simplified summary of the responsibilities and specific duties. You
may also choose to include details about special machines, materials, working conditions, equipment or health
hazards that are associated with the position as well as who the new recruit will be reporting to.
The person specs are to the new employee what the job description is to the vacancy. In other words, it lays
out everything you hope to see in an ideal prospective applicant. This should include a candidate's
qualifications, work experience, skills, education, training and even traits that could make them fit in well, such
as a good personality, positive outlook, ability to handle stress, etc.
Develop a Recruitment Strategy
Your recruitment strategy is how and where you plan to source applicants for the position, starting with whether
you'd like to hire internally or externally.
Internal sourcing involves recruiting from former employees, applicants and employee referrals, or promoting
or transferring current employees. The majority of positions are filled through external recruiting sources, such
as job sites, employment agencies, headhunters, job fairs, professional associations, etc.
There are benefits to both internal and external recruiting, and which option is best will vary by situation.
Internal recruitment can result in increased loyalty and morale among employees, as well as the knowledge that
your new hire will already be familiar with company culture and policies.
Unfortunately, if you promote or transfer an existing employee, you'll also have to fill her former position, and
by only looking at internal sources, you may be limiting your applicant pool and miss the opportunity to find a
truly outstanding employee.
Public recruitment strategies can open you up to the largest candidate pool, but you may end up with far more
unqualified applicants.
Therefore, you'll need to do more work to create an intriguing and interesting job listing that includes the
information from your job description and person specs. It's critical that you have someone proofread your ads
to make sure they're grammatically and factually correct as well as free from anything that could be interpreted
as discriminatory, especially if you wrote your listing in a unique or fun way.
Whether you recruit publicly or privately, internally or externally, it's also of the utmost importance that your
recruitment strategy is fair, professional and unbiased.
Go Through The Applications
Once you start getting applications, you need to start thinning out the pool of applicants, which means you've
entered the selection phase of the process.
It can be very time consuming to manually review each application to see if they meet your mandatory skills,
education and experience, or even just to briefly review that they meet the minimum requirements, which is
why many companies use software that automatically reviews resumes for keywords associated with the
vacancy.
If you just quickly scanned the resumes or used a keyword scanner, you'll then need to further review the
resumes, cover letters and applications that made it through your first review. Be sure to look for disqualifying
factors, such as unexplained gaps in employment history, insufficient qualifications, poor grammar or spelling,
etc.
You may choose to verify your applicant's references at this point, or you may choose to wait until you have
short-listed the candidates in order to call as few people as possible.
Conduct Interviews and Tests
When you've eliminated the majority of applications, it's time to schedule interviews with the remaining
candidates.
The initial interviews should ideally be conducted over the phone or through a video chat service in order to
minimize the impact on your applicants since this is only the first round. This interview should be quick and
merely verify your prospect's credentials, ability to speak professionally and their continued availability.
You can also easily determine whether you like an applicant's attitude and his ability to answer questions about
the position during the call.
While not all positions or companies require pre-employment skills tests, if you want to conduct such tests, you
should wait until after the initial interview and only test those who passed.
Conduct a Final Interview
Once the initial interview and any pre-employment tests are complete, you should have the information you
need to shortlist the top candidates for the position. This list should ideally have around five to 10 people,
although it's OK if you have only two or three standout candidates you feel very confident in.
After you've finished your shortlist, schedule interviews with these top prospects. These should ideally be in
person, although extenuating circumstances may require a video interview in some cases. The hiring manager,
department manager and anyone the employee may work particularly closely with should be present.
Everyone involved should be able to ask questions and submit their notes and recommendations to the hiring
manager after all interviews are completed.
Finish the Hiring Process
The hiring manager or department head should make the final choice on who to hire based on the prospect's
resume, cover letter, application, initial interview, pre-employment tests, final interviews, references and any
other relevant information.
Once the selection has been made, the new hire should be asked to perform any pre-employment clearance tests,
such as drug tests or physicals. As long as everything works out, the candidate can be sent a job offer and he
may accept and set a start date or begin salary negotiations. At this point, the new hire process begins, and the
recruitment and selection process is nearly closed.
Evaluate the Process
Before recruitment and selection is fully complete, it's important to evaluate the effectiveness of your current
process.
You should consider how long the position was open and the time and costs of filling the vacancy, including
any payments you made to recruiters, agencies or advertising costs. It's critical you determine if the process
could be made more effective or less expensive because recruitment is notably time consuming and costly, so
your experience can help you when you need to hire another employee.
Difference Between Recruitment and Selection
Last updated on July 26, 2018 by Surbhi S

Recruitment is a
process of searching out the potential applicants and inspiring them to apply for the actual or anticipated
vacancy. On the other hand, Selection is a process of hiring employees among the shortlisted candidates and
providing them a job in the organization.
Due to increase in population, getting a good job is not an easy task. Employers want the right candidate for the
concerned position. The large supply of workforce has given them the opportunity to select the best talent.
Nowadays, there is a very lengthy procedure for appointment of an employee to a post. There are two major
stages which may be heard by you hundreds and hundreds of times; they are recruitment and selection. Most of
us view them as the same thing. But, they are quite different in meaning and behaviour. Read the article
provided below that explains the difference between recruitment and selection in human resource management
(HRM) in tabular form.
Content: Recruitment Vs Selection
1. Comparison Chart
2. Definition
3. Key Differences
4. Conclusion
Comparison Chart
 BASIS FOR
RECRUITMENT SELECTION
COMPARISON

Meaning Recruitment is an activity of Selection refers to the process of

searching candidates and selecting the best candidates and
encouraging them apply for it. offering them job.

Approach Positive Negative

Objective Inviting more and more candidates Picking up the most suitable
to apply for the vacant post. candidate and rejecting the rest.

Key Factor Advertising the job Appointment of the candidate

Sequence First Second

Process Vacancies are notified by the firm The firm makes applicant pass
through various sources and through various levels like
application form is made available to submitting form, written test,
the candidate. interview, medical test and so on.

Contractual As recruitment only implies the Selection involves the creation of

Relation communication of vacancies, no contractual relation between the
contractual relation is established. employer and employee.

Method Economical Expensive

Definition of Recruitment
Recruitment is a process of finding out the prospective applicants and stimulating them to apply for the
vacancy. It is a long process which involves a series of activities that starts with analysing the job requirements
and ends on the appointment of the employee. The activities involved in the recruitment of employees are as
under:
 Analysing job requirement
 Advertising the vacancy
 Attracting candidates to apply for the job
 Managing response
 Scrutiny of applications
 Shortlisting candidates
The recruitment is done by the Human Resource managers either internally or externally. The sources of
internal recruitment are promotion, transfers, retrenched employees, contact or references, ex-employees, retired
employees, etc. On the other hand, sources of external recruitment are recruitment through advertisement,
campus recruitment, recruitment by employment exchanges, recruitment by third parties (recruitment agencies),
internet recruiting, unsolicited applicants, etc.
Definition of Selection
Selection is an activity in which the organisation selects a fixed number of candidates from a large number of
applicants. It involves the actual appointment of the employee for filling up the vacancies of the enterprise. The
term selection means the placement of the right man at the right job. We all know that a lot of people apply for a
single job at the time of recruitment, in which the recruiters have to decide which candidate fits the best for the
job.
The selection also involves a set of activities which are given as under:
 Screening
 Eliminating unsuitable candidates
 Conducting the examination like aptitude test, intelligence test, performance test, personality test, etc.
 Interview
 Checking References
 Medical Test
The process of selection is a time-consuming one because the HR managers have to identify the eligibility of
every candidate for the post. Besides this, the educational qualification, background, age, etc. are also some of
the most important factors in which they have to pay more attention. After this, the written examination and
interview is also a very tough task.
Key Differences Between Recruitment and Selection
The following points are substantial so far as the difference between recruitment and selection is concerned:
1. Recruitment is the process of finding candidates for the vacant position and stimulating them to apply
for it. The selection means picking up the best candidate from the list of applicants and offering them
the job.
2. Recruitment is a positive process as it attracts more and more job seekers to apply for the post.
Conversely, Selection is a negative process as it rejects all the unfit candidates.
3. Recruitment aims at inviting more and more candidates to apply for the vacant position. On the contrary,
selection aims at rejecting unsuitable candidates and appointing the right candidates at the job.
4. The activity of recruitment is quite simple because in this the recruiter does not have to pay more
attention to scrutinising the candidate, whereas selection is a complex activity because in this the
employer wants to know every minute detail about each candidate so that he can choose the perfect
match for the job which requires thorough investigation.
5. Recruitment consumes less time as it only involves identifying the needs of the job and stimulating
candidates to apply for the same. Conversely, selection involves a wide range of activities, right from
shortlisting the candidates to appointing them.
 6. In recruitment, the firm notifies the candidates regarding vacancy through different sources such as the
internet, newspaper, magazines, etc. and distributes the form to the candidates so that they can easily
apply. As against this, in the process of selection, the firm makes sure that candidate passes through
various stages such as form submission, written exam, interview, medical exam, etc.
7. In recruitment, no contractual relation is created between the employer and employee. Unlike selection,
where both employer and employee are bound by the contract of employment.
8. Recruitment is an economical process while the selection is an expensive process.
Conclusion
The success of any company depends on upon its employees. If the employee is perfect for a job, then the whole
organisation will enjoy the benefits of its unbeatable success. Recruitment and selection help in choosing the
right candidate for the right post. It helps in reducing losses of an organisation.
 Training and Development
Training and Development
Posted in Human Resources Terms, Total Reads: 41387
Definition: Training and Development
Training and Development is a subsystem of an organization which emphasize on the improvement of the
performance of individuals and groups. Training is an educational process which involves the sharpening of
skills, concepts, changing of attitude and gaining more knowledge to enhance the performance of the
employees. Good & efficient training of employees helps in their skills & knowledge development, which
eventually helps a company improve.
Read Next
 Training Needs Analysis
 Training Levy

Training is about knowing where you are in the present and after some time where will you reach with your
abilities. By training, people can learn new information, new methodology and refresh their existing knowledge
and skills. Due to this there is much improvement and adds up the effectiveness at work. The motive behind
giving the training is to create an impact that lasts beyond the end time of the training itself and employee gets
updated with the new phenomenon. Training can be offered as skill development for individuals and groups.

Organizational Development is a process that “strives to build the capacity to achieve and sustain a new desired
state that benefits the organization or community and the world around them.” (From the Organizational
Development Network website).
Relation between Training and Development
There is a relation between training and development, and there is clear difference between the two based on
goals to be achieved. Development is made to answer the training problems:

TRAINING DEVELOPMENT

Training is meant for operatives Development is meant for executives

It is reactive process It is pro- active process

AIM: To develop additional skills AIM: To develop the total personality

It is short term process It is continuous process

OBJECTIVE: To meet the present need of OBJECTIVE: To meet the future need of an
an employee employee

Initiative is taken by the management Initiative is taken by an individual.

Importance of Training and Development
For companies to keep improving, it is important for organizations to have continuous training and development
programs for their employees. Competition and the business environment keeps changing, and hence it is
critical to keep learning and pick up new skills. The importance of training and development is as follows:
• Optimum utilization of Human resources
• Development of skills like time management, leadership, team management etc
• To increase the productivity and enhance employee motivation
• To provide the zeal of team spirit
• For improvement of organization culture
• To improve quality, safety
• To increase profitability
• Improve the morale and corporate image

Need for Training and Development

Training and development of employees is a costly activity as it requires a lot quality inputs from trainers as
well as employees. But it is essential that the company revises its goals and efficiencies with the changing
environment. Here are a few critical reasons why the company endorses training and development sessions.
• When management thinks that there is a need to improve the performances of employees
• To set up the benchmark of improvement so far in the performance improvement effort
• To train about the specific job responsibility and skills like communication management, team management
etc
• To test the new methodology for increasing the productivity

Advantages of training and development

Training and development has a cost attached to it. However, since it is beneficial for companies in the long
run, they ensure employees are trained regularly. Some advantages are:
1. Helps employees develop new skills and increases their knowledge.
2. Improves efficiency and productivity of the individuals as well as the teams.
3. Proper training and development can remove bottle-necks in operations.
4. New & improved job positions can be created to make the organization leaner.
5. Keeps employees motivated and refreshes their goals, ambitions and contribution levels.

Disadvantages of training and development

Even though there are several advantages, some drawbacks of training and development are mentioned below:
1. It is an expensive process which includes arranging the correct trainers and engaging employees for non-
revenue activities.
2. There is a risk that after the training and development session, the employee can quit the job.

Training and Development Process

Training and development is a continuous process as the skills, knowledge and quality of work needs constant
improvement. Since businesses are changing rapidly, it is critical that companies focus on training their
employees after constantly monitoring them & developing their overall personality.
Steps for training and development processes are:
1. Determine the need of training and development for individuals or teams
2. Establish specific objectives & goals which need to be achieved
3. Select the methods of training
4. Conduct and implement the programs for employees
5. Evaluate the output and performance post the training and development sessions.
6. Keep monitoring and evaluating the performances and again see if more training is required.
Hence, this concludes the definition of Training and Development along with its overview.
Browse the definition and meaning of more terms similar to Training and Development. The Management
Dictionary covers over 7000 business concepts from 6 categories.
Training and Development - Meaning, its Need and Importance
Training and development is vital part of the human resource development. It is assuming ever important
role in wake of the advancement of technology which has resulted in ever increasing competition, rise in
customer’s expectation of quality and service and a subsequent need to lower costs. It is also become more
important globally in order to prepare workers for new jobs. In the current write up, we will focus more on the
emerging need of training and development, its implications upon individuals and the employers.
Noted management author Peter Drucker said that the fastest growing industry would be training and
development as a result of replacement of industrial workers with knowledge workers. In United States, for
example, according to one estimate technology is de-skilling 75 % of the population. This is true for the
developing nations and for those who are on the threshold of development. In Japan for example, with
increasing number of women joining traditionally male jobs, training is required not only to impart necessary
job skills but also for preparing them for the physically demanding jobs. They are trained in everything from
sexual harassment policies to the necessary job skills.
The need for Training and Development
Before we say that technology is responsible for increased need of training inputs to employees, it is important
to understand that there are other factors too that contribute to the latter. Training is also necessary for the
individual development and progress of the employee, which motivates him to work for a certain organisation
apart from just money. We also require training update employees of the market trends, the change in the
employment policies and other things.
The following are the two biggest factors that contribute to the increased need to training and development in
organisations:
1. Change: The word change encapsulates almost everything. It is one of the biggest factors that contribute
to the need of training and development. There is in fact a direct relationship between the two. Change
leads to the need for training and development and training and development leads to individual and
organisational change, and the cycle goes on and on. More specifically it is the technology that is
driving the need; changing the way how businesses function, compete and deliver.
2. Development: It is again one the strong reasons for training and development becoming all the more
important. Money is not the sole motivator at work and this is especially very true for the 21st century.
People who work with organisations seek more than just employment out of their work; they look at
holistic development of self. Spirituality and self awareness for example are gaining momentum world
over. People seek happiness at jobs which may not be possible unless an individual is aware of the self.
At ford, for example, an individual can enrol himself / herself in a course on ‘self awareness’, which
apparently seems inconsequential to ones performance at work but contributes to the spiritual well being
of an individual which is all the more important.
The critical question however remains the implications and the contribution of training and development to the
bottom line of organisations performance. To assume a leadership position in the market space, an organisation
will need to emphasise on the kind of programs they use to improvise performance and productivity and not just
how much they simply spend on learning!

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Training & Development

 Training and Development - Introduction
 Training & Development and HRD
 Systems View of Training
 Training Needs Analysis
 Collecting Data for Needs Assessment
 Development of a Training Program
 Designing Effective Training Programs
 What are Employee Training Manuals ?
 Efficient Transfer of Learning
 Preventing Relapse in Training
 Cost Benefit Analysis for Training
 Training Evaluation
 Kirkpatrick’s Model of Training Evaluation
 Special Training Programs
 Informational Training Methods
 Experiential Training Methods
  Types of Management Training Programs
 Ways to Improve Employee Training
 Train the Trainers - Need for Training the Trainers
 Systematic Approach to Training

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5. Training and Development - A Key HR Function

Training and Development - A Key HR Function
Training and development is one of the key HR functions. Most organisations look at training and
development as an integral part of the human resource development activity. The turn of the century has seen
increased focus on the same in organisations globally. Many organisations have mandated training hours per
year for employees keeping in consideration the fact that technology is deskilling the employees at a very fast
rate.
So what is training and development then? Is it really that important to organisational survival or they can
survive without the former? Are training and development one and the same thing or are they different?
Training may be described as an endeavour aimed to improve or develop additional competency or skills in an
employee on the job one currently holds in order to increase the performance or productivity.
Technically training involves change in attitude, skills or knowledge of a person with the resultant improvement
in the behaviour. For training to be effective it has to be a planned activity conducted after a thorough need
analysis and target at certain competencies, most important it is to be conducted in a learning atmosphere.
While designing the training program it has to be kept in mind that both the individual goals and organisational
goals are kept in mind. Although it may not be entirely possible to ensure a sync, but competencies are chosen
in a way that a win-win is created for the employee and the organisation.
Typically organisations prepare their training calendars at the beginning of the financial year where training
needs are identified for the employees. This need identification called as ‘training need analysis’ is a part of the
performance appraisal process. After need analysis the number of training hours, along with the training
intervention are decided and the same is spread strategically over the next year.
Development
Lots of time training is confused with development, both are different in certain respects yet components of the
same system. Development implies opportunities created to help employees grow. It is more of long term or
futuristic in nature as opposed to training, which focus on the current job. It also is not limited to the job
avenues in the current organisation but may focus on other development aspects also.
At Goodyear, for example, employees are expected to mandatorily attend training program on presentation
skills however they are also free to choose a course on ‘perspectives in leadership through literature’. Whereas
the presentation skills program helps them on job, the literature based program may or may not help them
directly.
Similarly many organisations choose certain employees preferentially for programs to develop them for future
positions. This is done on the basis of existing attitude, skills and abilities, knowledge and performance of the
employee. Most of the leadership programs tend to be of this nature with a vision of creating and nurturing
leaders for tomorrow.
The major difference between training and development therefore is that while training focuses often on the
current employee needs or competency gaps, development concerns itself with preparing people for future
assignments and responsibilities.
With technology creating more deskilled workers and with industrial workers being replaced by
knowledge workers, training and development is at the forefront of HRD. The onus is now on the human
development department to take a proactive leadership role in responding to training and business needs.

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Training & Development

 Training and Development - Introduction
 Training & Development and HRD
 Systems View of Training
 Training Needs Analysis
 Collecting Data for Needs Assessment
 Development of a Training Program
 Designing Effective Training Programs
 What are Employee Training Manuals ?
 Efficient Transfer of Learning
 Preventing Relapse in Training
 Cost Benefit Analysis for Training
 Training Evaluation
 Kirkpatrick’s Model of Training Evaluation
 Special Training Programs
 Informational Training Methods
 Experiential Training Methods
  Types of Management Training Programs
 Ways to Improve Employee Training
 Train the Trainers - Need for Training the Trainers
 Systematic Approach to Training

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5. Systems View of Training - Stages in a Training Program

Systems View of Training - Stages in a Training Program
The success of a training program is evaluated in terms of the end result or the increase in the work ability, skill
or competency in the trainee. For any training program to be successful it is very essential to follow a certain
process.
The basic process as illustrated in the figure below consists of four stages which are assessment,
development, delivery and evaluation.
  The process of training begins with the needs assessment stage. The aim of the assessment stage is to
understand whether or not training is required. If the answer is yes; the next step is determining
competency or skills gaps and the appropriate training intervention required. The training intervention is
essentially decided in terms of attitude, knowledge and skill (ASK), the combination of which is called
as competency. The assessment also called as the ‘training needs analysis’ is undertaken at three levels,
the job, the individual and organisational analysis.
 Once the training needs analysis is complete, the next stage is that of Development. This stage involves
the development of content and the training material. Right from designing the appropriate environment
to deciding the various tools, everything is taken care of in the development stage. Games, A/V’s, Case
Studies, Class room intervention are various means that may be decided upon apart from the content
delivered. For example, in behavioural training emotional intelligence, teamwork, listening are examples
of competencies that are required to perform superior work. The same may be transferred into the
trainees through any of the above means depending upon various factors like demographics, job nature
etc which are taken care of in the first stage.
 The most important stage and perhaps the least talked upon from the training process is the delivery.
Once the development stage is over it is time to conduct the training. Factors like time and venue of
delivery are already decided in the earlier stages. There are various factors that determine the process of
delivery like the participant demographics, the training intervention, the individual style of the trainer
etc. This brings in a lot of diversity to the training programs.
 Evaluation is the last stage in the training process and more important from the perspective of
evaluation of the effectiveness of training. Needless to say, it is aimed at analysing whether or not the
training has been effective in achieving the objective (bridging the competency gap, changing the
attitude, developing new skills etc). There are various ways in which the effectiveness of training
programs can be evaluated but not many are able to answer in terms of ROI. The most effective tool for
evaluation of training is the Kirk Patrick Model of Evaluation.
In order for the evaluation to be effective the both the criteria and design for training program is decided so that
there is no discrepancy and the participants are able to evaluate the benefits effectively for themselves. The
evaluation is made on the basis of participant reaction to the training, their learning and the change in
behaviour. This feedback is then reused in the first step ‘training needs analysis’ for making future training
more effective.

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Training & Development

 Training and Development - Introduction
 Training & Development and HRD
 Systems View of Training
 Training Needs Analysis
 Collecting Data for Needs Assessment
 Development of a Training Program
 Designing Effective Training Programs
 What are Employee Training Manuals ?
 Efficient Transfer of Learning
  Preventing Relapse in Training
 Cost Benefit Analysis for Training
 Training Evaluation
 Kirkpatrick’s Model of Training Evaluation
 Special Training Programs
 Informational Training Methods
 Experiential Training Methods
 Types of Management Training Programs
 Ways to Improve Employee Training
 Train the Trainers - Need for Training the Trainers
 Systematic Approach to Training

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5. Training Needs Analysis

Training Needs Analysis
Training is an expensive process not only in terms of the money spent on it but also the time and the other
resources spent on the same. The most important question therefore is determining whether or not a need for
training actually exists and whether the intervention will contribute to the achievement of organisational goal
directly or indirectly? The answer to the above mentioned question lies in ‘training needs analysis’ which is the
first step in the entire process of training and development.
Training needs analysis is a systematic process of understanding training requirements. It is conducted at
three stages - at the level of organisation, individual and the job, each of which is called as the
organisational, individual and job analysis. Once these analyses are over, the results are collated to arrive
upon the objectives of the training program.
Another view of the training need is that, it is the discrepancy between ‘what is’ and ‘what should be’. Taking
cues from this the world bank conducted a needs analysis and arrived upon the conclusion that many of its units
in eastern regions of Europe required transformation from state owned business to self sustaining organisations.
A number of universities were then contacted to develop the necessary modules and conduct the training upon
the same.
Although each step in the entire training process is unique in its own, needs analysis is special in that it lays the
foundation for the kind of training required. The assessment gives insight into what kind of intervention is
required, knowledge or skill or both. In certain cases where both of these are present and the performance is still
missing then the problem may be motivational in nature. It thus highlights the need and the appropriate
intervention which is essential to make the training effective.
As mentioned earlier, the needs analysis / assessment is carried out at three levels - organisational, Individual
and Job. We now take up each one of them in detail.
Organisational Analysis
The organisational analysis is aimed at short listing the focus areas for training within the organisation and the
factors that may affect the same. Organisational mission, vision, goals, people inventories, processes,
performance data are all studied. The study gives cues about the kind of learning environment required for the
training. Motorola and IBM for example, conduct surveys every year keeping in view the short term and long
term goals of the organisation.
Job Analysis
The job analysis of the needs assessment survey aims at understanding the ‘what’ of the training development
stage. The kind of intervention needed is what is decided upon in the job analysis. It is an objective assessment
of the job wherein both the worker oriented - approach as well as the task - oriented approach is taken into
consideration. The worker approach identifies key behaviours and ASK for a certain job and the task - oriented
approach identifies the activities to be performed in a certain job. The former is useful in deciding the
intervention and the latter in content development and program evaluation.
Individual Analysis
As evident from the name itself, the individual analysis is concerned with who in the organisation needs the
training and in which particular area. Here performance is taken out from the performance appraisal data and
the same is compared with the expected level or standard of performance. The individual analysis is also
conducted through questionnaires, 360 feedback, personal interviews etc. Likewise, many organisation use
competency ratings to rate their managers; these ratings may come from their subordinates, customers, peers,
bosses etc. Apart from the above mentioned organisations also make use of attitude surveys, critical Incidents
and Assessment surveys to understand training needs which will be discussed in detail in other articles.

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Training & Development

 Training and Development - Introduction
 Training & Development and HRD
 Systems View of Training
 Training Needs Analysis
 Collecting Data for Needs Assessment
 Development of a Training Program
 Designing Effective Training Programs
  What are Employee Training Manuals ?
 Efficient Transfer of Learning
 Preventing Relapse in Training
 Cost Benefit Analysis for Training
 Training Evaluation
 Kirkpatrick’s Model of Training Evaluation
 Special Training Programs
 Informational Training Methods
 Experiential Training Methods
 Types of Management Training Programs
 Ways to Improve Employee Training
 Train the Trainers - Need for Training the Trainers
 Systematic Approach to Training

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5. Techniques for Collecting Data for Training Needs Assessment

Techniques for Collecting Data for Training Needs Assessment
The process of needs assessment happens at three stages or levels, the organisational, the job and the person or
the individual. This is the basis for any needs assessment survey and remains the same more or less in all
organisations around the globe. There are however many techniques for collecting the data for training need
analysis. This article discusses some of the methods used for the same.
The needs assessment conducted at various stages tries to answer a different set of questions. Organisational
analysis, for example, aims at the ‘where in the organisation’ of the training. Person analysis similarly attempts
to decipher the question of ‘Whom in the organisation’. There are therefore various instruments or techniques
that are used to collect data for the analysis at each stage.
Techniques for Collecting data at Organisational Level
As discussed already, in organisational analysis we try to ascertain the areas in the organisation that require
training interventions. For example, among the various kinds of interventions that organisations chose it was
found out managerial training is picking up fast among corporations and also that managerial competencies
amount for 98% of success in the jobs.
Personnel and skill inventories, organisational climate and efficiency indices, Management requests, Exit
interviews, management by objectives (MBO) are the various kinds of techniques that are used at the level of
organisational analysis for collecting data for training needs analysis.
Essentially all these tools collect data that is inferential in nature, but does not give a clear picture of the training
needs. For example, the above mentioned tools may lead an organisation to deduce that ‘there is a need for
aligning the work processes with the organisational goals / objectives’, which is not very rich diagnostically. It
may require further analysis, which is done with the help of tools at the level of Job or the task.
The techniques for data collection at the level of the job include job description, performance standards,
work sampling, job specifications, job literature analysis, and analysis of operational problems among
others. These techniques are aimed at extracting data for understanding the target of training i.e. what exactly
should be taught in training. Time management may be may be one critical intervention in project handling /
management.
These techniques at the level of job are useful but yet not sufficient in helping understand who requires training
and when. Taking the above example further, time management may be a critical intervention for Projects
people, but there may already be some who are very efficient in time management and may require the
intervention at other level, which is only possible to ascertain with the help of techniques used at the level of the
individual or the person.
Training may prove worthless if it is conducted without studying individual data. Every member in a team
is unique and works as well as performs at a certain level (n). There may be others who are at (n+1) or (n-1) or
more. Thus, the same intervention may halt the progress of a certain individual and finally the organisation.
There are therefore certain tools that help in deciding interventions at the individual level. Performance
appraisal data, questionnaires, attitude surveys, 360 degree feedback, assessment centres, critical incidents are
some techniques that are employed to a good benefit.
All these techniques are integral to the success of any training program. Although each one of these may be
used independently but the combined use offers a holistic view of training within an organisation!

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Training & Development

 Training and Development - Introduction
 Training & Development and HRD
 Systems View of Training
 Training Needs Analysis
 Collecting Data for Needs Assessment
 Development of a Training Program
 Designing Effective Training Programs
 What are Employee Training Manuals ?
 Efficient Transfer of Learning
  Preventing Relapse in Training
 Cost Benefit Analysis for Training
 Training Evaluation
 Kirkpatrick’s Model of Training Evaluation
 Special Training Programs
 Informational Training Methods
 Experiential Training Methods
 Types of Management Training Programs
 Ways to Improve Employee Training
 Train the Trainers - Need for Training the Trainers
 Systematic Approach to Training

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5. Development of a Training Program

Development of a Training Program
Development of a training program is the next step after the training need analysis has been conducted
and there is a clear consensus on the need of training within the organisation. The next vital question to
answer is whether the training should be conducted by an in house expert or from a consultant outside.
Many of the fortune 500 organisations around the world have their in house learning centers and many have
even gone ahead to have their own training universities where they train people onboard and those who aspire to
join in the future. Companies like Xerox, Good Year Tyres, Kodak, Mahindra and Mahindra, Birla etc have
such setups for generating prospective employees with the requisite skills and also for training the existing
employees. There are other organisations too that have tie ups with the best academic institutions for employee
exchange programmes.
Nevertheless the prerequisites for development of a training program remain the same. We start with the
development of a conducive learning environment, followed by a choice of the training methods and
techniques.
Designing the Environment - every individual is unique. One style of learning may not be applicable to each
of the participants in a training program. Therefore ‘how do various individuals learn’ is what should be kept in
mind while designing the training program. There are certain who learn the experiential way by doing and yet
there are many who like the lecture based learning method. There are however pros and cons of both and the
appropriate learning style is generally the discretion of the trainer / facilitator.
Establishing the Variables - trainability is one factor that must be taken into consideration before developing
any training program. It is the duty of the trainer to ensure that the employees are actually willing to sit and
learn something in the training program. This is especially very true of sensitivity training that is not viewed
positively by many. Trainabality also implies that the employee is sufficiently motivated to learn apart from just
the ability to do so. Before any training program sets off, it is the responsibility of the trainer to build hype
about the event and such that it attracts all types of employees from target audience within the organisation.
There are both formal and informal ways of doing the same. Formal ways would be by sending mails to the
employees who are supposed to attend the program. Informal ways would be just creating conditions for
discussion in the cafeteria or the lounge where employees sit together, discuss and hear things on the grapevine.
Finally, once the training program has been delivered the evaluation of the same provides inputs for improving
the process of training. These are called as the ‘post learning inputs’. This evaluation which is conducted at
various levels may be utilised accordingly. Most of the organisations evaluate training on the basis of Kirk
Patrick Model. The feedback at each level - learning, reaction, behaviour and results can be used for effective
design of training in future.
Training and Development
Training and Development is one of the main functions of the human resource management department.
Training refers to a systematic setup where employees are instructed and taught matters of technical knowledge
related to their jobs. It focuses on teaching employees how to use particular machines or how to do specific
tasks to increase efficiency.
Whereas, Development refers to the overall holistic and educational growth and maturity of people
in managerial positions. The process of development is in relation to insights, attitudes,
adaptability, leadership and human relations.
Suggested Video

Training

Development and Objectives of Development

Methods of Training
Training and Development Programmes
Training and development programmes are designed according to the requirements of the organisation, the type
and skills of employees being trained, the end goals of the training and the job profile of the employees. These
programmes are generally classified into two types: (i) on the job programmes, and (ii)off the job programmes.

(source-miningreview)
Different training is given to employees at different levels. The following training methods are used For the
training of skilled workers and operators- Specific job training programmes, Technical training at a training
with live demos, Internship training, Training via the process of rotation of job.
Training given to people in a supervisory or managerial capacity is – Lectures, Group Discussions, Case
studies, Role-playing, Conferences etc.
People in managerial programmes are given this type of training- Management Games to develop decision
making, Programmes to identify potential executives, Sensitivity training to understand and influence employee
behaviour, Simulation and role-playing, Programmes for improving communication, human relations and
managerial skills.
Other Training Programmes
Technical Training – Technical training is that type of training that is aimed at teaching employees how a
particular technology or a machine.
Quality Training – Quality training is usually performed in companies who physically produce a product.
Quality training teaches employees to identify faulty products and only allow perfect products to go out to the
markets.
Skills Training – Skills training refers to training given to employees so as to perform their particular jobs. For
e.g. A receptionist would be specifically taught to answer calls and handle the answering machine.
Soft Skills – Soft skills training includes personality development, being welcoming and friendly to clients,
building rapport, training on sexual harassment etc.
Professional Training – Professional Training is done for jobs that have constantly changing and evolving
work like the field of medicine and research. People working in these sectors have to be regularly updated on
matters of the industry.
Team Training – Team training establishes a level of trust and synchronicity between team members for
increased efficiency.

(source-fhlb.com)
Benefits of Training
1. Training improves the quantity and quality of the workforce. It increases the skills and knowledge base
of the employees.
2. It improves upon the time and money required to reach the company’s goals. For e.g. Trained salesmen
achieve and exceed their targets faster than inexperienced and untrained salesmen.
3. Training helps to identify the highly skilled and talented employees and the company can give them jobs
of higher responsibilities.
4. Trained employees are highly efficient in comparison to untrained ones.
5. Reduces the need to constantly supervise and overlook the employees.
6. Improves job satisfaction and thus boosts morale.
Benefits of Development
1. Exposes executives to the latest techniques and trends in their professional fields.
 2. Ensures that the company has an adequate number of managers with knowledge and skill at any given
point.
3. Helps in the long-term growth and survival of the company.
4. Creates an effective team of managers who can handle the company issues without fail.
5. Ensures that the employees utilise their managerial and leadership skills in particular to the fullest.
Solved Question for you
Q: List at least four benefits of training employees for any organisation.
Answer – Four benefits of training employees for any organisation in brief are
1. Training helps to identify the highly skilled and talented employees and so the company can give them
jobs of higher responsibilities.
2. Trained employees are highly efficient in comparison to untrained ones.
3. Ensures that the company has an adequate number of managers with knowledge and skill at any given
point and thus, adequately staffed.
4. Ensures that the employees utilise their managerial and leadership skills to the fullest.
Training and Development is a structured program with different methods designed by professionals in particular job. It
organisation for updating skills and knowledge of employees in accordance with changing environment. Optimisation of
need for every organisation which will be possible only by way of improving efficiency and productivity of employees,
training and development conditioned to that it should be provided by professionals.

What is the difference between training and development?

Training is the process of improving and polishing the required Skills to an employee in order to make him/her skilled an
Training is purely job focused but development is psychology and soft skills oriented.

Previously many authors have defined the difference between training and development, but still there is little confusion
organisations are using term "training and development" as one and same. Mostly we hear the term "training" for the pur
employees. Both training and development are continuous and core tasks of organisation, but employee training will be
particular job for a particular period and will be given periodically whenever updating of skills needed for performing pa
purpose of development of technicality among employees. Training is mainly provided for making employee aware on
for doing particular task or function in the organisation. ultimately training of employees will be by way of teaching by t
technicality to develop skill. In many and large organisations even in governmental organisations financial budgeting pro
training as a key overhead which has been not ignored ever. Because employee training is very expensive, especially if w
large amounts for providing training to their employees and frequency of training is high because change of technology
make aware of new technology and update their skills in accordance with new technology, training of employees is more

Coming to employee development we don't hear or see as that of employee training program in the organisation. Employ
provided for people who deals with managerial tasks. As compared to technical staff, managerial staff will be very low i
efficiency can manage more number of people which is a real manager capability, but coming to technical jobs cannot b
labour if there is need for high or large production. ultimately development of employees is by way of learning by way
is also provided for management level personnel to understand technicalities involved and nature of work done by the st

Traditional And Modern Approach Of Training And Development

Traditional Approach – Most of the organizations before never used to believe in training. They were holding the traditio
were also some views that training is a very costly affair and not worth. Organizations used to believe more in executive
changing.

Modern approach of training and development is that Indian Organizations have realized the importance of corporate tra
tool than a cost. The training system in Indian Industry has been changed to create a smarter workforce and yield the bes

The HR Training and Development Manager is responsible for the organization's staff training requirements, programs
training staff, plan and administer training seminars, and manage conflict resolution, team building, and employee skill

The HR Training and Development Specialist plans, produces and administers staff and management training programs
accordance with organization practices and policies. Additionally, they research and evaluate training resources, as we

The Chief Learning Officer is a relatively new executive level position. The CLO is in charge of employee training, educ
well as providing the expertise to ensure everyone has access to the intellectual tools, information and data they need. Th
learning into a strategic business asset.

"The way to activate the seeds of your creation is by making choices about the results you want to create. When you mak
resources, which otherwise go untapped."
- Robert Fritz.
An example of importance of training employees

On a recent flight, the managing director of an international broking firm was sitting next to Journalist. With two hours o
handled losses in his business. "Recently, one of my employees made a calculation mistake and we lost $250,000 at the
I asked him. "Of course not!" he said, "I paid $250,000 for his training. Why would I fire him?"

His answer left me dumfounded and taught me a great lesson in handling people who goof up. Firing the man is not the o

To expect flawless execution from team members and colleagues would be quite unreal. People do make errors based on
simply, wrong judgment. But to terminate someone's services or take severe irrevocable action against them, would be a
you are faced with a loss, on someone else's erroneous execution.

TRAINING AND DEVELOPMENT OBJECTIVES

The principal objective of training and development division is to make sure the availability of a skilled and willing wor
four other objectives: Individual, Organizational, Functional, and Societal.
 Individual Objectives – help employees in achieving their personal goals, which in turn, enhances the individua
 Organizational Objectives – assist the organization with its primary objective by bringing individual effectiven
 Functional Objectives – maintain the department’s contribution at a level suitable to the organization’s needs.
 Societal Objectives – ensure that an organization is ethically and socially responsible to the needs and challenge
In the field of human resource management, training and development is the field concerned with organizational activi
and groups in organizational settings. It has been known by several names, including employee development, human r
development.
Training and development encompasses three main activities: training, education, and development. Garavan, Costine, a
Development, note that these ideas are often considered to be synonymous. However, to practitioners, they encompass th
Training
This activity is both focused upon, and evaluated against, the job that an individual currently holds.
Education
This activity focuses upon the jobs that an individual may potentially hold in the future, and is evaluated against those jo
Development
This activity focuses upon the activities that the organization employing the individual, or that the individual is part of, m
evaluate.
The "stakeholders" in training and development are categorized into several classes. The sponsors of training and develo
and development are business planners. Line managers are responsible for coaching, resources, and performance. The pa
processes. The facilitators are Human Resource Management staff. And the providers are specialists in the field. Each of
which sometimes conflict with the agendas and motivations of the others.

Facts [+]

The American Society for Training and Development (ASTD) held its first annual conference in 1944. ASTD is the w
learning and performance professionals. ASTD has 70,000 members and associates from more than 100 countries, repre
academia, consulting firms, and product and service suppliers.

Training and development

From Wikipedia, the free encyclopedia
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Training and development involves improving the effectiveness of organizations and the individuals and
teams within them.[1] Training may be viewed as related to immediate changes in organizational
effectiveness via organized instruction, while development is related to the progress of longer-term
organizational and employee goals. While training and development technically have differing definitions, the
two are oftentimes used interchangeably and/or together. Training and development has historically been a topic
within applied psychology but has within the last two decades become closely associated with human resources
management, talent management, human resources development, instructional design, human factors,
and knowledge management.[1]

Contents
 1History
 2Practice
 3Benefits
 4Occupation
 5See also
 6References
 7Further reading
History[edit]
The first training-related article was published in 1918 in the Journal of Applied Psychology. This article
explored an undergraduate curriculum designed for applied psychologists.[2] World War II influenced the focus
of applied psychology research to be on effectiveness of training programs, particularly in military contexts. By
the 1960s and 70s, the field began developing theories and conducting theory-based research because up until
that point, the field had been rooted in trial-and-error intervention research.[2] This era also brought along the
development of new training methods such as the use of computers, television, case studies, and role
playing.[2][3] The scope of training and development also expanded to include cross-cultural training, focus on
the development of the individual employee, and the use of new organization development literature to frame
training programs.[3] The 1980s marked a shift to focus on how employees were receiving and implementing
training programs, and encouraged the collection of data for evaluation purposes, particularly management
training programs.[4] The development piece of training and development became increasingly popular in the
1980s and 90s, with employees more frequently being influenced by the concept of "lifelong learning".[5] It was
in this decade that research revealing the impact and importance of fostering a training and development-
positive culture (including management and co-worker) was first conducted.[5] The turn of the century brought
more research in topics such as team-training, for example cross-training.[6] Cross-training emphasizes training
in coworkers' responsibilities.[6]
Practice[edit]
Training and development encompasses three main activities: training, education, and development.[7][8][9]
The "stakeholders" in training and development are categorized into several classes. The sponsors of training
and development are senior managers. The clients of training and development are business planners. Line
managers are responsible for coaching, resources, and performance. The participants are those who actually
undergo the processes. The facilitators are Human Resource Management staff. And the providers are
specialists in the field. Each of these groups has its own agenda and motivations, which sometimes conflict with
the agendas and motivations of the others.[10]
Especially in the last couple decades, training has become more trainee-focused, which allows those being
trained more flexibility and active learning opportunities.[11] For example, these active learning techniques
include exploratory/discovery learning,[12] error management training,[13] guided exploration,[14] and mastery
training.[11] Typical projects in the field include executive and supervisory/management development, new-
employee orientation, professional-skills training, technical/job training, customer-service training, sales-and-
marketing training, and health-and-safety training. Training is particularly critical in high-reliability
organizations, which rely on high safety standards in order to prevent catastrophic damage to employees,
equipment, or the environment (e.g. nuclear power plants, operating rooms).[15]
Benefits[edit]
Training has been used in organizations for the past several decades. Although training and development
requires investments of many types, there are cited benefits to integrating training and development into
organizations:
 Increased productivity and job performance [1]
 Skills development [1]
 Team development [1][16]
 Decreasing safety-related accidents [17]
However, if the training and development is not strategic and pointed at specific goals, it can lead to more harm
than good.[18] Needs assessments, especially when the training is being conducted on a large-scale, are
frequently conducted in order to gauge what needs to be trained, how it should be trained, and how
extensively.[19] Needs assessments in the training and development context often reveal employee and
management-specific skills to develop (e.g. for new employees), organizational-wide problems to address (e.g.
performance issues), adaptations needed to suit changing environments (e.g. new technology), or employee
development needs (e.g. career planning). The degree of effectiveness of training and development programs
can be predicted by the needs assessment and how closely the needs were met, the execution of the training (i.e.
how effective the trainer was), and trainee characteristics (e.g. motivation, cognitive abilities).[20] Effectiveness
of training is typically done on an individual or team-level, with few studies investigating the impacts on
organizations.[1]
Occupation[edit]
The Occupational Information Network (O*NET) cites training and development specialists as having a bright
outlook, meaning that the occupation will grow rapidly or have several job openings in the next few
years.[21] Related professions include training and development managers, (chief) learning officers, industrial-
organizational psychologists, and organization development consultants. Training and development specialists
are equipped with the tools to conduct needs analyses, build training programs to suit the needs of the
organization by using a variety of training techniques, create training materials, and execute and guide training
programs.
What Is Human Resource Development (HRD)?
Internal Training Can Work Most Effectively
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BY SUSAN M. HEATHFIELD

Updated May 07, 2019

Human Resource Development (HRD) is the framework for helping employees develop their personal and
organizational skills, knowledge, and abilities.
HRD is one of the most significant opportunities that employees seek when they consider you as an employer.
The ability, and encouragement, to continue to develop their skills help you to retain and motivate employees.
What Is Human Resource Development?
Human Resource Development includes such opportunities as employee training, employee career
development, performance management and development, coaching, mentoring, succession planning, key
employee identification, tuition assistance, and organization development.
The focus of all aspects of Human Resource Development is on developing the most superior workforce so that
the organization and individual employees can accomplish their work goals in service to customers.
Organizations have many opportunities for human resources or employee development, both within and outside
of the workplace.
Human Resource Development can be formal such as in classroom training, a college course, or an
organizational planned change effort.
These are the options that you have for developing your employees. Formal training can add value in your
workplace.
Or, Human Resource Development can be informal as in employee coaching by a manager or internal training
and development classes taught by internal staff or a consultant. Mentoring by more experienced employees is
also recommended for employee development.
It is especially useful as employees become more senior within your organization. Traditionally, executive
leaders and senior managers are resistant to training classes and conference educational sessions.
Healthy organizations believe in Human Resource Development and cover all of these bases. One option that is
recommended, in preference to many other ways in which organizations develop employees, is to provide
internal training either with internal staff or a paid facilitator or consultant. There are advantages to internal
employee development.
Tips for Internal Training

The Balance
Management training develops employee strengths and their ability to contribute in your organization. A variety
of management training is available to organizations—choices are endless.
The management training can include internally supplied, customized for your company, management
development sessions.
Internal management development is also provided through book clubs at work, challenging work assignments,
and coaching from the manager's boss. Many options in management training are identified through
the performance development planning process. Options include classes, internal work assignments, field trips,
and self-study. Approach management training with openness and a creative mindset.
Ideas about topics for management training are as diverse as management jobs. Choose the management
training most suitable to your management career from these suggested options.
When you approach providing internal training, a recommended way to offer the developmental sessions is to
have a facilitator or presenter meet with employees in a group weekly for a two-hour training session. These
sessions can last for several years although you will want to limit the frequency over time.
The key to the success of the training sessions is that the time together, the discussion, the shared training
topics, the new information, and the shared reading both educate and build the team.
With the appropriate facilitator who is tuned in to the language and culture of your organization, these sessions
provide an effective approach to learning and employee development.
Additionally, learning comes in bites small enough to practice and participants are not overwhelmed with
information. They also have the chance to discuss what worked for them of the lessons they applied in the
workplace at the next training session.
Consistent feedback from the planned weekly interaction is that the managers or the departments are pleased
and found the training process invaluable wherein a strong, effective team was built.
When I have worked with companies outside of a 90-minute drive or outside of my state, I have limited the
training sessions to a couple of times a month. I have found that less frequency interferes with the team building
aspects of the meetings, although not with the educational component of the training sessions.
So, if you're looking for a way to develop your internal staff that involves an external consultant, or even an
internal manager or HR staff person, this is an effective way to offer training and build the team at the same
time.
Your options for management development and employee training are limited only by your imagination—and
by the imagination of your employees. Why not try out various options to find out which work best for your
organization.
The Importance of Employee Training and Development in HR Management
Written by Veronika Mazour On 23 June 2016 - Business Solutions 11
According to a survey conducted by Office Team in 2015, 38% of HR professionals consider training and
developing employees their greatest staffing concern. Of course, companies that manage to train and develop
their employees win the jackpot.
Training programs boost employee satisfaction and improve employee retention
Employees appreciate being able to build new skills, improve their job performance and potentially evolve
towards more challenging roles. It is interesting to note that ongoing education is valued by employees from all
age groups as key to staying relevant in the job market.
Even more importantly, supporting and providing ongoing training opportunities show a company’s
commitment to its employees’ growth. Employees feel their value to a company where employee education is
promoted.
Finally, ongoing training opportunities can be publicized since they are an important perk in a company’s
compensation programs. However, and unlike many other perks, ongoing education can cost very little.
Developing talent is the best and cheapest way to staff
From the HR perspective, developing talent is the best way to staff a company’s roles.
First, it is always cheaper to source skills internally. The more junior the position, the lower the recruiting
costs, so hiring from more junior positions within the company automatically lowers the overall recruiting costs
for the position, even after accounting for the replacement of the junior position.
Second, it is usually simpler and quicker to bring an internal hire up to speed – as the newbie already knows
everything there is to know about the company. There are no precise statistics on the subject, but the idea that
homegrown executives on average perform better than external hires is firmly shared by most managers.
Finally, promoting internal mobility through training leads to a more engaged and loyal workforce. While
new blood remains necessary, ideally it should not represent the majority of the staff.
Overall, developing talent to staff ever-changing company needs is such a holistic circle that volumes have been
written on the subject of employee training. Introducing learning opportunities through a digital workplace will
maximize the value of all of your training programs.
Develop a culture of teaching and learning
One of the greatest ways to study is to learn from peers and managers. Unfortunately, that is also the most
complicated learning method to establish throughout the company. However, it is not enough to engage a
training consultant to provide a couple of one-off courses. We are talking about every day on-the-job learning.
The kind of culture where managers want to develop their team members and are valued for that effort, and
where all employees are encouraged to learn new skills and share them, is not easy to create. And, as with all
other corporate initiatives, the company internet is a great tool to promote this culture and elicit the desired
behaviors.
Learning by collaborating and interacting with peers
Digital workplaces provide ways for employees to collaborate on work projects and interact with each other
regardless of their location.
Social collaboration tools help in searching for answers, sourcing skills and experience, and interacting with
peers throughout the company.
Create, maintain and enrich the company knowledge base
Perhaps the greatest benefit of a digital workplace for employee training lies in its knowledge management
capabilities.
Training materials, like documents, presentations and recorded training sessions, can be stored in a dedicated
workspace in your company intranet, making them accessible to immediate search, access and use by
employees.
More importantly, in the same manner, the company’s knowledge can be encapsulated in documents, forums,
wiki pages, blogs and conversations, and then stored in a searchable database that an employee can access and
learn from as needed.
Communication tools for coaching opportunities
Communications channels in a digital workplace that are synchronous (like chats and video-conferencing) or
asynchronous (like activity streams conversations and forums) can be used to enhance the training and coaching
experience for all employees, whatever their location.
Detect training needs
A company intranet will allow you to survey employees and managers and identify the gaps in employee skills.
For example, if all your employees need basic Excel skills, the easiest way to identify the gap between the
reality and the expectation is to conduct an anonymous self-assessment (or an assessment by team leaders) and
consolidate the results at department level.
 Performance Management and Appraisal: Methods and Processes
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A Definitive Guide to Employee Performance Appraisal Methods

Kissflow
April 9th, 2019 • Performance Management
The employee performance appraisal process is crucial for organizations to boost employee productivity and
improve their outcomes. But although performance management is super important, it’s rarely put to good use.
Many companies don’t put in their best effort to pick the best perfect performance appraisal method, which is
why only 55 percent of employees believe theirs is effective.
A growing number of HR professionals report that existing performance appraisal methods fail to internalize
employee performance results. In fact, performance appraisals are nothing more than an empty buzzword in
some industries–just a formal way for companies to show that they have a standard procedure in place to
measure individual competitiveness.
What are performance appraisals?
Performance appraisals are an annual process that involves evaluating employee’s performance and productivity
against the pre-determined set of objectives for that year. It also helps to evaluate employee’s skills, strength
and shortcomings. The results of this performance appraisal process determines the employees wage raise and
promotion.
The objectives of performance appraisal varies from company to company and depending on the
industry/company size, the appraisal method varies.
The need for modern performance appraisal methods
Traditional methods of performance appraisals such as annual performance reviews suffer from major
limitations since they focus more on measuring past performance rather than improving future work. But on the
contrary modern performance appraisal methods helps:
 Define goals clearly
 Provide real-time feedback
 Enhance employee performance
 Spot training and development needs
 Offer insights on counter-productive tasks
 Improve employee engagement and retention
 Align individual performance with business goals
 Transform the workforce into a strategic advantage
Traditional and modern performance appraisal methods
Although there is no such thing as universally accepted performance appraisal method, most organizations
accept the Strauss and Sayles classification. George Strauss and Leonard R. Sayles classify performance
appraisal methods into two categories: traditional and modern.
Listed below are the various methods that belong in those two categories:
Traditional performance appraisal methods like appraisal templates, ranking, checklists, critical incidents, and
more take a goal-oriented approach and evaluate work results. Modern methods focus on individual’s
personality traits (creativity, integrity, goal-oriented approach, leadership qualities) and tend to be more
objective.
Six modern performance appraisal methods
With the right performance appraisal method, organizations can enhance employee performance within the
organization. A good employee performance review method can make the whole experience effective and
rewarding. Now that the drawbacks of traditional methods are clear.
Here’s a close look at the six most-used modern performance methods:
1. Management by Objectives (MBO)
Management by objectives (MBO) is the appraisal method where managers and employees together identify,
plan, organize, and communicate goals. After setting clear goals, managers and subordinates periodically
discuss the progress made to control and debate on the feasibility.
This process usually lays more stress on tangible work or career-oriented goals. So, intangible aspects like
interpersonal skills, job commitment, etc. are often brushed under the rug. This method is slightly expensive and
time-intensive.
2. 360-Degree Feedback

Once-in-a-year performance appraisals are lackadaisical and don’t work. Workers need ongoing communication
with team leaders and managers. A continuous process, like 360-degree feedback, can help employees stay
motivated. This is one of the most widely used appraisal methods.
In 360-degree feedback, every employee in an organization appraises his/her managers, peers, customers,
suppliers, and also does a self-evaluation. This method ensures effective performance analysis and Total
Employee Involved (TEI). If not handled properly, this method can also suffer from the subjectivity of the
appraiser.
3. Assessment Centre Method
The assessment centre method tests employees in a social-related situation. This concept was introduced way
back in 1930 by the German Army but it has been polished and tailored to fit today’s environment. Employees
are asked to take part in situation exercises like in-basket exercises, work groups, simulations, and role-playing
exercises that ensure success in a role.
While it gives an insight of the employee’s personality (ethics, tolerance, problem-solving skill,
introversion/extroversion, adaptability, etc.), it can also breed unhealthy competition among the workers and
bears adverse effects on low performers.
4. Behaviorally Anchored Rating Scale (BARS)
Behaviorally anchored rating scales (BARS) bring out both the qualitative and quantitative benefits in a
performance appraisal process. BARS compares employee performance with specific behavioral examples that
are anchored to numerical ratings.
This performance appraisal method is said to be better than the traditional methods. BARS provides clear
standards, improved feedback, accurate performance analysis, and consistent evaluation. However, when done
manually it suffers from the usual distortions that are inherent in most review methodologies.
5. Psychological Appraisals
Psychological appraisals come in handy to determine the hidden potential of employees. This method focuses
on analyzing an employee’s future performance rather than their past work.
Qualified psychologists conduct a variety of tests (in-depth interviews, psychological tests, discussions, and
more) to identify an employee’s emotional, intellectual, and other related traits. However, it is a rather slow and
complex process and the quality of results is highly dependent on the psychologist who administers the
procedure.
6. Human-Resource (Cost) Accounting Method
Human resource (cost) accounting method analyses an employee’s performance through the monetary benefits
he/she yields to the company. It is obtained by comparing the cost of retaining an employee (cost to company)
and the monetary benefits (contributions) an organization has ascertained from that specific employee.
When an employee’s performance is evaluated based on cost accounting methods, factors like unit-wise average
service value, quality, overhead cost, interpersonal relationships, and more are taken into account. Its high-
dependency on the cost and benefit analysis and the memory power of the reviewer is the drawback of human
resources accounting method.

How to improve your performance appraisal method

Whether you’re going to give workers a score, detailed feedback, or specific tips on how to succeed at their
jobs, you need to narrow down on one approach that can help you achieve all these goals.
To make the most of your current performance appraisal methods, consider the following points:
1. Zero in on goals
You should design your performance management method based on what organizational goals you want to
achieve. Even the best performance appraisal methods fail when they aren’t geared towards the core needs of a
business. Similarly, the company goals and the rationale behind conducting performance appraisal shouldn’t be
a secret to employees.
This way, they can clearly understand how their professional goals and contributions can be aligned well with
the company objectives. They will also have a better sense of assessment that they go through and its impact on
their long-term success.
2. Structure the information
Formalize the topics that you plan to discuss during the performance assessment. A standard structure makes it
easier to ensure fairness and give employees valuable information.
A well-sketched performance assessment should include an overview of accomplishments, ways in which the
employee could improve in the future, what type of skills they need to gain to better their performance, how
progress is being made on specific goals, and what professional development opportunities may become
available in the future.
3. Collect information in advance
Getting feedback from team members and supervisors will make your performance appraisal method much
more valuable. Use digital forms to document employee feedback and automate the process so that you don’t
have to revisit the step time and again. Instead, you can set the data to flow smoothly and route it through
relevant stakeholders who are supposed to review the information.
Performance appraisal raw facts
Typically, the HR department runs an employee appraisal process to figure out how well employees are
engaged with their work and what perks can better the chances their success.
These numbers paint a rather convincing picture about the importance of performance appraisals. In order to
benefit from all of its positive impacts, however, a company will have to do employee appraisal in the correct
way.
A future-focused employee performance appraisal method
Performance tracking in recent years has become intelligent in many ways. Automated HR software allows HR
leaders to roll out a modern performance appraisal method in a few minutes. Furthermore, all-in-one HR tools
like Kissflow HR Cloud enables businesses to ensure global consistency in performance appraisals while
offering room for local and role-specific variations.
With Kissflow HR Cloud, businesses can eliminate critical performance gaps and prepare their organization for
the future of work. Best of all, it enables organizations to address pressing issues like high employee turnover
rates, low engagement, absenteeism, and a low overall ROI. Employee performance management can be even
more exciting and valuable with an adequate solution and the right performance appraisal method.
Sign up for a free demo of Ki
Performance Appraisal Methods
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Performance Appraisal Methods
“It is a systematic evaluation of an individual with respect to performance on the job and individual’s potential
for development.”
Definition 2: Formal System, Reasons and Measures of future performance
“It is formal, structured system of measuring, evaluating job related behaviors and outcomes to discover reasons
of performance and how to perform effectively in future so that employee, organization and society all
benefits.”
Meaning of Performance Appraisals
Performance Appraisals is the assessment of individual’s performance in a systematic way. It is a
developmental tool used for all round development of the employee and the organization. The performance is
measured against such factors as job knowledge, quality and quantity of output, initiative, leadership abilities,
supervision, dependability, co-operation, judgment, versatility and health. Assessment should be confined to
past as well as potential performance also. The second definition is more focused on behaviors as a part of
assessment because behaviors do affect job results.
Performance Appraisals and Job Analysis Relationship

Job Analysis à Performance Standards à Performance Appraisals

Describe the work and Translate job requirements Describe the job relevant
personnel requirement of a into levels of acceptable or strengths and weaknesses
particular job. unacceptable performance of each individual.

Objectives of Performance Appraisals

Use of Performance Appraisals
1. Promotions
2. Confirmations
3. Training and Development
4. Compensation reviews
5. Competency building
6. Improve communication
7. Evaluation of HR Programs
8. Feedback & Grievances
4 Goals of Performance Appraisals

General Goals Specific Goals

Developmental Use Individual needs

Performance feedback
Transfers and Placements
Strengths and Development needs

Administrative Decisions / Uses Salary

Promotion
Retention / Termination
Recognition
Lay offs
Poor Performers identification

Organizational Maintenance HR Planning

Training Needs
Organizational Goal achievements
Goal Identification
HR Systems Evaluation
Reinforcement of organizational needs

Documentation Validation Research

For HR Decisions
Legal Requirements

Performance Appraisal Process

1. Objectives definition of appraisal
2. Job expectations establishment
3. Design an appraisal program
4. Appraise the performance
5. Performance Interviews
6. Use data for appropriate purposes
7. Identify opportunities variables
8. Using social processes, physical processes, human and computer assistance
Difference between Traditional and Modern (Systems) approach to Appraisals

Categories Traditional Appraisals Modern, Systems

Appraisals

Guiding Values Individualistic, Control Systematic,

oriented, Documentary Developmental, Problem
solving

Leadership Styles Directional, Evaluative Facilitative, Coaching

Frequency Occasional Frequent

Formalities High Low

Rewards Individualistic Grouped, Organizational

TECHNIQUES / METHODS OF PERFORMANCE APPRAISALS

Numerous methods have been devised to measure the quantity and quality of performance appraisals. Each of
the methods is effective for some purposes for some organizations only. None should be dismissed or accepted
as appropriate except as they relate to the particular needs of the organization or an employee.
Broadly all methods of appraisals can be divided into two different categories.
 Past Oriented Methods
 Future Oriented Methods
Past Oriented Methods
1. Rating Scales: Rating scales consists of several numerical scales representing job related performance
criterions such as dependability, initiative, output, attendance, attitude etc. Each scales ranges from excellent to
poor. The total numerical scores are computed and final conclusions are derived. Advantages – Adaptability,
easy to use, low cost, every type of job can be evaluated, large number of employees covered, no formal
training required. Disadvantages – Rater’s biases
2. Checklist: Under this method, checklist of statements of traits of employee in the form of Yes or No based
questions is prepared. Here the rater only does the reporting or checking and HR department does the actual
evaluation. Advantages – economy, ease of administration, limited training required, standardization.
Disadvantages – Raters biases, use of improper weighs by HR, does not allow rater to give relative ratings
3. Forced Choice Method: The series of statements arranged in the blocks of two or more are given and the
rater indicates which statement is true or false. The rater is forced to make a choice. HR department does actual
assessment. Advantages – Absence of personal biases because of forced choice. Disadvantages – Statements
may be wrongly framed.
4. Forced Distribution Method: here employees are clustered around a high point on a rating scale. Rater is
compelled to distribute the employees on all points on the scale. It is assumed that the performance is
conformed to normal distribution. Advantages – Eliminates Disadvantages – Assumption of normal distribution,
unrealistic, errors of central tendency.
5. Critical Incidents Method: The approach is focused on certain critical behaviors of employee that makes
all the difference in the performance. Supervisors as and when they occur record such incidents. Advantages –
Evaluations are based on actual job behaviors, ratings are supported by descriptions, feedback is easy, reduces
recency biases, chances of subordinate improvement are high. Disadvantages – Negative incidents can be
prioritized, forgetting incidents, overly close supervision; feedback may be too much and may appear to be
punishment.
6. Behaviorally Anchored Rating Scales: statements of effective and ineffective behaviors determine the
points. They are said to be behaviorally anchored. The rater is supposed to say, which behavior describes the
employee performance. Advantages – helps overcome rating errors. Disadvantages – Suffers from distortions
inherent in most rating techniques.
7. Field Review Method: This is an appraisal done by someone outside employees’ own department usually
from corporate or HR department. Advantages – Useful for managerial level promotions, when comparable
information is needed, Disadvantages – Outsider is generally not familiar with employees work environment,
Observation of actual behaviors not possible.
8. Performance Tests & Observations: This is based on the test of knowledge or skills. The tests may be
written or an actual presentation of skills. Tests must be reliable and validated to be useful. Advantage – Tests
may be apt to measure potential more than actual performance. Disadvantages – Tests may suffer if costs of test
development or administration are high.
9. Confidential Records: Mostly used by government departments, however its application in industry is not
ruled out. Here the report is given in the form of Annual Confidentiality Report (ACR) and may record ratings
with respect to following items; attendance, self expression, team work, leadership, initiative, technical ability,
reasoning ability, originality and resourcefulness etc. The system is highly secretive and confidential. Feedback
to the assessee is given only in case of an adverse entry. Disadvantage is that it is highly subjective and ratings
can be manipulated because the evaluations are linked to HR actions like promotions etc.
10. Essay Method: In this method the rater writes down the employee description in detail within a number of
broad categories like, overall impression of performance, promoteability of employee, existing capabilities and
qualifications of performing jobs, strengths and weaknesses and training needs of the employee. Advantage – It
is extremely useful in filing information gaps about the employees that often occur in a better-structured
checklist. Disadvantages – It its highly dependent upon the writing skills of rater and most of them are not good
writers. They may get confused success depends on the memory power of raters.
11. Cost Accounting Method: Here performance is evaluated from the monetary returns yields to his or her
organization. Cost to keep employee, and benefit the organization derives is ascertained. Hence it is more
dependent upon cost and benefit analysis.
12. Comparative Evaluation Method (Ranking & Paired Comparisons): These are collection of different
methods that compare performance with that of other co-workers. The usual techniques used may be ranking
methods and paired comparison method.
 Ranking Methods: Superior ranks his worker based on merit, from best to worst. However how best
and why best are not elaborated in this method. It is easy to administer and explanation.
  Paired Comparison Methods: In this method each employee is rated with another employee in the
form of pairs. The number of comparisons may be calculated with the help of a formula as under.
N x (N-1) / 2
Future Oriented Methods
1. Management By Objectives: It means management by objectives and the performance is rated against the
achievement of objectives stated by the management. MBO process goes as under.
 Establish goals and desired outcomes for each subordinate
 Setting performance standards
 Comparison of actual goals with goals attained by the employee
 Establish new goals and new strategies for goals not achieved in previous year.
Advantage – It is more useful for managerial positions.
Disadvantages – Not applicable to all jobs, allocation of merit pay may result in setting short-term goals rather
than important and long-term goals etc.
2. Psychological Appraisals: These appraisals are more directed to assess employees potential for future
performance rather than the past one. It is done in the form of in-depth interviews, psychological tests, and
discussion with supervisors and review of other evaluations. It is more focused on employees emotional,
intellectual, and motivational and other personal characteristics affecting his performance. This approach is
slow and costly and may be useful for bright young members who may have considerable potential. However
quality of these appraisals largely depend upon the skills of psychologists who perform the evaluation.
3. Assessment Centers: This technique was first developed in USA and UK in 1943. An assessment center is
a central location where managers may come together to have their participation in job related exercises
evaluated by trained observers. It is more focused on observation of behaviors across a series of select exercises
or work samples. Assessees are requested to participate in in-basket exercises, work groups, computer
simulations, role playing and other similar activities which require same attributes for successful performance in
actual job. The characteristics assessed in assessment center can be assertiveness, persuasive ability,
communicating ability, planning and organizational ability, self confidence, resistance to stress, energy level,
decision making, sensitivity to feelings, administrative ability, creativity and mental alertness etc.
Disadvantages – Costs of employees traveling and lodging, psychologists, ratings strongly influenced by
assessee’s inter-personal skills. Solid performers may feel suffocated in simulated situations. Those who are not
selected for this also may get affected.
Advantages – well-conducted assessment center can achieve better forecasts of future performance and
progress than other methods of appraisals. Also reliability, content validity and predictive ability are said to be
high in assessment centers. The tests also make sure that the wrong people are not hired or promoted. Finally it
clearly defines the criteria for selection and promotion.
4. 360-Degree Feedback: It is a technique which is systematic collection of performance data on an
individual group, derived from a number of stakeholders like immediate supervisors, team members, customers,
peers and self. In fact anyone who has useful information on how an employee does a job may be one of the
appraisers. This technique is highly useful in terms of broader perspective, greater self-development and multi-
source feedback is useful. 360-degree appraisals are useful to measure inter-personal skills, customer
satisfaction and team building skills. However on the negative side, receiving feedback from multiple sources
can be intimidating, threatening etc. Multiple raters may be less adept at providing balanced and objective
feedback.
5 Effective performance appraisal methods
Bhaswati Bhattacharyya
May 10, 2016
Performance Management Is One Of The Rapidly Changing Part Of Talent Management System.

Performance appraisal is the process of evaluating the performance of an employees in a certain time period and
searching for ways to improve their performance.
Many companies claim that performance appraisal process takes a lots of time and has no value even after
spending so much time on it. And also complain that it isn’t contributing to engagement. The truth is, old and
traditional methods are no longer giving effective results. It is the time for you to revamp the process.
Here are some of the modern methods of performance appraisal methods which you can implement right away.
5 Effective Performance Appraisal Methods
1. Management By Objective
It is a process in which a manager identifies the desired objectives to be achieved and gives each individual a
major areas of responsibility in terms of results expected from him/her and use these measures as a guide to
access the contribution of each individual employee.
It is less time consuming and cost effective compared to other performance appraisal methods. With this
method you can easily find out whether the stated objective is achieved or not in a given time period.
2. Behaviorally Anchored Rating Scale (BARS)
This method has been developed recently and is claimed to be one of the effective methods among all the
appraisal methods listed. It is a combination of traditional essay evaluation and rating scale. It is more
expensive than other methods and guarantees precise results.
In this method the employee’s behavior and performance are analyzed and used for evaluating overall
performance of an employee. HR department is involved in this process. Based on the performance and
behavior of an employee, they are anchored as good, average, or poor.
3. Critical Incident Method
In this method the employer or manager evaluates an employee on the basis of “certain events” known as
critical incidents where the employee did something really great or something not so great things.
The evaluator should maintain a digital or physical journal to store the information of different incidents. This
method is extremely useful for the growth of an employee since it gives detailed information unlike other
performance appraisal methods.
4. 360 Degree Feedback
This is somewhat time consuming method since there are multiple raters involved in evaluating the
performance. But it’s worth a try. In this method the feedback of the employee is collected by the people who
interact with him in the organization including his superiors, peers, subordinates, and also from customers. The
feedback is usually taken by a questionnaire designed for this purpose. This method is very useful for the
startups. Take a look at this detailed info-graphic on 360 degree performance appraisal process
5. Forced Choice Method
In this method evaluator rates an employee based on the group of statements. These statements are combination
of both negative and positive statements. You need to identify the most descriptive statements of an employee
and evaluate him. Such as:
1. Can be dependent to complete the project or task
2. Is reliable and trustworthy.
These are the 5 effective performance appraisal methods you can Implement right away. Implementing these
methods helps in the growth of an employee and hence the growth of an organization.
Performance Management and Appraisal 8 Learning Outcomes After studying this chapter you should be able
to: 8.1 Discuss the difference between performance management and performance appraisal 8.2 Identify the
necessary characteristics of accurate performance management tools 8.3 List and briefly discuss the purposes
for performance appraisals 8.4 Identify and briefly discuss the options for “what” is evaluated in a performance
appraisal 8.5 Briefly discuss the commonly used performance measurement methods and forms 8.6 Identify and
briefly discuss available options for the rater/evaluator 8.7 Briefly discuss the value and the drawbacks of a
360° evaluation 8.8 Identify some of the common problems with the performance appraisal process 8.9 Identify
the major steps we can take to avoid problems with the appraisal process 8.10 Briefly discuss the differences
between evaluative performance reviews and developmental performance reviews 8.11 Define the following
terms: Performance management Performance appraisal Motivation Traits Behaviors Results Critical incidents
method Management by Objectives (MBO) method Narrative method or form Graphic rating scale form
Behaviorally Anchored Rating Scale (BARS) form Ranking method 360° evaluation Bias Stereotyping
Electronic Performance Monitoring (EPM) Performance Management Systems Performance Management
Versus Performance Appraisal The Performance Appraisal Process Accurate Performance Measures Why Do
We Conduct Performance Appraisals? Communicating Decision Making (Evaluating) Motivating (Developing)
Evaluating and Motivating (Development) What Do We Assess? Trait Appraisals Behavioral Appraisals
Results/Outcomes Appraisals Which Option Is Best? How Do We Use Appraisal Methods and Forms? Critical
Incidents Method Management by Objectives (MBO) Method Narrative Method or Form Graphic Rating Scale
Form Behaviorally Anchored Rating Scale (BARS) Form Ranking Method Which Option Is Best? Who Should
Assess Performance? Supervisor Peers Subordinates Self Customers 360º Evaluation Who Do We Choose?
Performance Appraisal Problems to Avoid Common Problems With the Performance Appraisal Process
Avoiding Performance Appraisal Process Problems Debriefing the Appraisal The Evaluative Performance
Appraisal Interview The Developmental Performance Appraisal Interview Trends and Issues in HRM Is It Time
to Do Away With Performance Appraisals? Technology: Electronic Performance Monitoring Competency-
Based Performance Management Aligning the Appraisal Process C. Job Analysis/Job Design (required) 4.
Performance management (performance criteria and appraisal) F. Performance Management (required) 1.
Identifying and measuring employee performance 2. Sources of information (e.g., managers, peers, clients) 3.
Rater errors in performance measurement 4. Electronic monitoring 5. Performance appraisals 6. Appraisal
feedback 7. Managing performance Case 8-1. Beauty and the Beastly Situation at Aerospace Designs’
Marketing Department Case 8-2. Performance Evaluation at DHR: Building a Foundation or Crumbling Ruins?
Chapter 8 Outline SHRM HR CONTENT See Appendix A: SHRM 2010 Curriculum Guidebook for the
complete list 284 PART III: DEVELOPING AND MANAGING  Productivity  Satisfaction  Absenteeism
 Turnover Section IV: Compensating and Protecting How do you REWARD and MAINTAIN your Human
Resources? Section III: Developing and Managing How do you MANAGE your Human Resources? Section II:
Attracting and Staffing What HRM Functions do you NEED for sustainability? Section I: 21st-Century HRM
Strategic Planning and Legal Issues What HRM issues are CRITICAL to your organization’s long-term
sustainability? Performance Management Miscue The Practitioner’s Model for HRM Most managers don’t look
forward to performance appraisals. As soon as Heather stuck her head in my office and asked me to sit in on her
performance appraisal, I knew I had two employees who needed some coaching— Heather and her supervisor,
Christine. Our company bases many employment decisions on performance appraisals, so the results are
important. When I entered the room, it became apparent that although Heather believed she had been doing a
great job, Christine did not agree. Christine recorded Heather’s performance as needing improvement overall,
but did not offer any reason beyond a vague charge that Heather had a poor attitude and wasn’t a team player. I
quickly suggested a small interruption to the meeting, and asked Heather to step out of the room. It soon
became clear that the overall problem was Heather’s failure to report to work on time. When Heather was late,
it impacted her entire work group as the other employees then had to answer Heather’s phone calls. What’s
going on here? Why don’t Heather and Christine agree on Heather’s performance? Where did Christine go
wrong? How can Christine get Heather to agree with her performance review now? How can this problem be
avoided during the next formal performance appraisal session? The answers to these questions are based on
having a good performance management system. By reading this chapter, you will learn how you can avoid
these problems. Chapter 8: Performance Management and Appraisal 285 Performance Management Systems
LO 8.1 At this stage of human resource management (HRM), we now have employees in our organization who
can do the work, we’ve given them at least some initial training, and they are now doing their individual jobs.
What’s next? The next issue that we need to figure out is how to manage their performance over time to ensure
that they remain productive, and hopefully become even more capable, as they progress in their careers.
Remember our discussion from Chapter 1 that our human resources are typically one of the few options
available to create a sustainable competitive advantage for the firm. So we need to ensure that our human
resources perform at the highest possible level. To this end, in this section, we discuss the difference between
performance management and performance appraisal, and present the performance appraisal process.
Performance Management Versus Performance Appraisal “In a knowledge economy, organizations rely heavily
on their intangible assets to build value. Consequently, performance management at the individual employee
level is essential and the business case for implementing a system to measure and improve employee
performance is strong.”1 Management time and effort to increase performance not only meets this goal; it also
decreases turnover rates.2 How do we manage performance within the organization? The most common part of
the process, and the one with which we are most familiar, is the process of the performance appraisal, or
evaluation. In this chapter, we will use the phrases performance evaluation, performance appraisal, and
appraisal interchangeably. However, the performance appraisal process is not the only thing that’s done in
performance management. Performance management is the process of identifying, measuring, managing, and
developing the performance of the human resources in an organization. Basically we are trying to figure out
how well employees perform and then to ultimately improve that performance level. When used correctly,
performance management is a systematic analysis and measurement of worker performance (including
communication of that assessment to the individual) that we use to improve performance over time.
Performance appraisal, on the other hand, is the ongoing process of evaluating employee performance.
Performance appraisals are reviews of employee performance over time3 , so appraisal is just one piece of
performance management. Although we will spend most of this chapter discussing performance appraisal, there
are several other significant pieces of performance management that we already covered in past chapters and
will cover in future chapters. We discussed “strategic planning,” which provides inputs into what we want to
evaluate in our performance management system, in Chapter 2. We also discussed the major method of
identifying performance requirements in a particular job when we went through “job analysis and design” in
Chapter 4. In Chapter 7, we discussed “training and development,” which obviously play a part in performance
management. Additionally, we will discuss motivating employees, employee relations, compensation, and other
pieces in Chapters 9–14. Now that we understand the difference between performance management and
performance appraisal, let’s look at the performance appraisal process. The Performance Appraisal Process
Exhibit 8-1 illustrates the performance appraisal (PA) process. Note the connection between the organization’s
mission and objectives and the performance appraisal process. Here we briefly discuss each step of the process.
Discuss the difference between performance management and performance appraisal. Guide – C:4 Performance
management (performance criteria and appraisal) SHRM Video Link 8.1 Performance Appraisal Process 286
PART III: DEVELOPING AND MANAGING Step 1. Job analysis. This is logically our first step because if we
don’t know what a job consists of, how can we possibly evaluate an employee’s performance? We already
learned how to do a job analysis in Chapter 4, but as shown in Exhibit 8-1, we should realize that the job must
be based on the organizational mission and objectives, the department, and the job itself. Step 2. Develop
standards and measurement methods. If we don’t have standards of acceptable behavior and methods to
measure performance, how can we assess performance? We will discuss performance measurement methods in
the next part of this section, and in the major section “How Do We Use Appraisal Methods and Forms?” we
will discuss these topics in more detail. Step 3. Informal performance appraisal—coaching and disciplining.
Performance appraisal should not be simply a once- or twice-yearly formal interview. As its definition states,
performance appraisal is an ongoing process. While a formal evaluation may only take place once or twice a
year, people need regular feedback on their performance to know how they are doing.4 We will briefly discuss
coaching in the “Critical Incidents Method” subsection of “How Do We Use Appraisal Methods and Forms?”
and in more detail along with teaching how to discipline in the next chapter. Step 4. Prepare for and conduct the
formal performance appraisal. The common practice is to have a formal performance review with the boss once
or sometimes twice a year using one or more of the measurement forms we will be learning about. Later in this
chapter we will discuss the steps of preparing for and conducting the performance appraisal. In the major
sections to come, we discuss “why” we assess performance, “what” we assess, “how” we assess, and “who”
conducts the performance appraisal. Then we discuss performance appraisal problems and how to avoid them,
and we end the performance appraisal process with the actual formal review session. But before we leave this
section, we need to understand a critically important part of each step in the performance appraisal process—
accurate performance measurement. WORK APPLICATION 8-1 Select a job you have or had. Did you know
the organization’s mission and objectives? Briefly state the mission. If you don’t know it, find out. Did you
understand how your job fits or helps to meet the mission and objectives? Explain in some detail. Exhibit 8-1
The Performance Appraisal Process Step 1: Job Analysis Organizational Mission and Objectives Step 4:
Prepare for and conduct the formal PA Step 2: Develop standards and measurement methods; communicate
standards to workforce Step 3: Informal PA— coaching and discipline Chapter 8: Performance Management
and Appraisal 287 Accurate Performance Measures LO 8.2 Performance should be accurately measured so
employees will know where they can improve.5 Knowing where to improve should lead to training employees
to develop new skills to improve.6 To be an accurate measure of performance, our measure must be valid and
reliable, acceptable and feasible, specific, and based on the mission and objectives. Let’s discuss each here.
Valid and reliable. As with all areas of our people management process, we must make sure that all of our
performance management tools are valid and reliable. Here again, we can pull out and dust off the OUCH test
as a quick measure to ensure fairness and equity in the performance management and appraisal process. We
remember by now that OUCH stands for Objective, Uniform in application, Consistent in effect, and Has job
relatedness, right? However, we still need to analyze validity and reliability in some detail. If our method of
measurement is not valid and reliable, then it makes no sense to use it. We discussed reliability and validity in
Chapter 4. Recall that a valid measure is “true and correct.” When a measure has validity, it is a factual measure
that measures the process that you wanted to measure. A reliable measure is consistent; it works in generally the
same way each time we use it. Acceptable and feasible. In addition to validity and reliability, we need to look at
a couple of other characteristics of our performance measures. We need to analyze acceptability and
feasibility.Acceptability means that the use of the measure is satisfactory or appropriate to the people who must
use it. However, in performance appraisal, this isn’t enough.7 Acceptability must include whether or not the
evaluation tool is feasible. Is it possible to reasonably apply the evaluation tool in a particular case? As an
example, if the performance evaluation form is two or three pages long and covers the major aspects of the job
that is being evaluated, and both managers and employees believe that the form truly evaluates performance
measures that identify success in the job, then they are likely to feel that the tool is acceptable and feasible. If,
however, the manager must fill out a 25-page form that has very little to do with the job being evaluated, the
manager may not feel that the form is acceptable or feasible, at least partially due to its length, even if the
employee does. Conversely, if managers fill out a twopage evaluation that they feel is a true measure of
performance in employees’ jobs but the employees feel that the evaluation leaves out large segments of what
they do in their work routine, they may not feel that the form is acceptable and feasible. If either management or
employees feel that the form is unacceptable, it most likely will not be used correctly. So, we always have to
evaluate acceptability and feasibility of a measure. Specific. Next, we want any evaluation measure to be
specific enough to identify what is going well and what is not. The word specific means that something is
explicitly identified, or defined well Identify the necessary characteristics of accurate performance management
tools. Without accurate measures of performance, the performance appraisal can’t be reliable or valid. 288
PART III: DEVELOPING AND MANAGING enough that all involved understand the issue completely. In
performance appraisal, specific means that the form provides enough information for everyone to understand
what level of performance has been achieved by a particular employee within a well-identified job. Creating
specific measures is the only way that we can use a performance appraisal to improve the performance of our
employees over time. The employees have to understand what they are doing successfully and what they are
not. Many times, evaluation forms may be too general in nature to be of value for modifying employee
behaviors because we want the form to serve for a large number of different types of jobs. This can create
significant problems in the performance appraisal process. Based on the mission and objectives. Finally, you
want to make sure that your performance management system leads to accomplishment of your organizational
mission and objectives. As with everything else we do in HR, we need to ensure that the performance
management process guides our employees toward achievement of the company’s mission and objectives over
time. As managers in the organization, making sure of this connection will allow us to reinforce employee
behaviors that aim at achieving organizational goals and to identify for our employees things that they may be
doing that actively or unintentionally harm our ability to reach those goals. Thus, stating specific objectives of
exactly what each person in each job should achieve or his or her performance outcomes leads to accurate
assessment that can increase performance. For some examples of inaccurate measures of performance, complete
Applying the Concept 8-1. WORK APPLICATION 8-2 Assess the accuracy of the measurements of your
performance on your last performance appraisal. Be sure to describe the measures’ validity and reliability, their
acceptability and feasibility, if they were specific, and if they were based on the organization’s mission and
objectives. APPLYING THE CONCEPT 8-1 Measurement Accuracy Which of the following criteria for a
measure to be accurate is not met in each of the given situations? a. valid b. reliable c. accepted d. feasible e.
specific f. based on the mission and objectives ____ 1. My boss asked me to fill out a self-evaluation of my
performance. But I refused to do it. Evaluation is her job, so let her do it. ____ 2. My boss told me that I was not
doing a very good job of data entry. When I asked him what he meant, he went around in circles and never gave
me a good answer. ____ 3. The boss said I’m not producing as many widgets as I used to. But it’s not my fault
that the machine jams every now and then and I have to stop working to fix it. ____ 4. My boss asked to me to
evaluate my employees four times a year instead of only once. I told her I don’t have the time to do it that many
times. It’s just not possible to do a good review that often without cutting back other things that are more
important. ____ 5. My boss said I have a bad attitude and gave me a lower overall rating. But I pointed out that
I get all my work done well and by the deadline or early, and I questioned what my attitude had to do with my
performance. Chapter 8: Performance Management and Appraisal 289 Why Do We Conduct LO 8.3
Performance Appraisals? As you can begin to see already, the appraisal process gets extremely complicated
very quickly. And remember, anytime a process in an organization is complicated, it costs a lot of money. So
why do we even do performance appraisals? What value provided to the organization and to the individual
makes the process of evaluating the performance of our workers so critical? If performance appraisals are done
in the correct manner, they can provide us with a series of valuable results. However, done incorrectly, the
process of evaluating employee performance can actually lead to lower levels of job satisfaction and
productivity. In this section, let’s discuss three major reasons why organizations complete performance
evaluations—communicating, decision making, and motivating. Communicating The first major reason for
performance appraisal is to provide an opportunity for formal communication between management and the
employees concerning how the organization believes each employee is performing. All of us know intuitively
that successful communication requires two-way interaction between people. “Organizations can prevent or
remedy the majority of performance problems by ensuring that two-way conversation occurs between the
manager and the employee, resulting in a complete understanding of what is required, when it is required and
how the employee’s contribution measures up.” 8 Communication always requires that employees have the
opportunity and ability to provide feedback to their bosses in order to make sure that the communication is
understood. So, in performance appraisals the communication process requires that we as managers
communicate with the employees to provide them information about how we believe they’re doing in their job,
but the process also requires that we provide the opportunity for the employees to speak to us concerning factors
that inhibit their ability to successfully perform for the organization. Factors in a job that management may not
know about can include many things, including lack of training, poorly maintained equipment, lack of tools
necessary to perform, conflict within work groups, and many other things that management may not see on a
daily basis. If the communication component of the performance appraisal process does not allow for this two-
way communication, managers may not know of the obstacles that the employees have to overcome. The only
way that we can resolve problems is to know about them. So, as managers, we need to communicate with our
employees to find out when issues within the work environment cause loss of productivity so we can fix them.
Thus, two-way communication is a critical component of correcting problems through the performance
appraisal process. Decision Making (Evaluating) The second major purpose of performance appraisals is to
allow management to make decisions about employees within the organization. We need to make decisions
based on information, the information we get from our communication. Accurate information is necessary for
management decision making and is an absolutely critical component to allow the manager to improve
organizational productivity.9 We use information from annual performance appraisals to make evaluative
decisions concerning our workforce including pay raises, promotions, demotions, training and development, and
termination. When we have valid and reliable information concerning each individual within our division or
department, this gives us the ability to make decisions that can enhance productivity for the firm. List and
briefly discuss the purposes for performance appraisals. 290 PART III: DEVELOPING AND MANAGING If,
for instance, through the process of coaching (the third step of the performance appraisal process) we find that
several machine operators are having trouble keeping their equipment in working order, this piece of
information would quite likely lead to a needs assessment (as discussed in Chapter 7) to determine whether or
not maintenance training is necessary for our group of operators. Without our rigorous evaluation process, we
might not learn of this common problem as early, and as a result could do some significant damage to very
expensive equipment. This and similar types of information frequently come to the forefront as we go through
the performance appraisal process. Decision making based on good communication is a very large part of why
we take the time to do annual performance appraisals. Motivating (Developing) The third major purpose for
performance appraisal is to provide motivation to our employees to improve the way they work individually for
developmental purposes, which in turn will improve organizational productivity overall.10 What is motivation,
and are performance appraisals normally motivational? Well, from a business perspective, motivation can be
defined as the willingness to achieve organizational objectives. We want to create this willingness to achieve
the organization’s objectives, which in turn will increase organizational productivity. Our evaluative decisions
should lead to development of employees. Returning to the machine operators having trouble keeping their
equipment in working order, making the decision to train the employees leads to their development through
improving their performance, as well as better utilizing the resources to improve organizational performance.
Evaluating and Motivating (Development) An effective performance appraisal process has two parts (evaluating
and motivating), and it does both parts well. Evaluating is about assessing past performance, and motivating is
about developing employees to improve their future performance. But, are both parts done well? Have you ever
been in a position of being evaluated and debriefed as an employee? Was the process motivational? Probably
not. Think about the appraisal process and how it was carried out. Here we discuss problems with evaluation
and how to overcome them, explain how to motivate, and suggest separating evaluation and motivation.
Problems with evaluation. A common problem in appraisals is overpowering employees during an evaluation
debrief with large amounts of negative information that they have not heard during coaching. This tends to
cause the employees to “turn off,” or stop listening to their managers as they explain what is wrong. Employees
will just “raise their shields” to ward off all of the negative information. This is a natural human characteristic.
We are naturally suspicious of negative information for a variety of psychological reasons (defense
mechanisms), so when employees are presented with a large amount of negative information, they tend to
discount or even disbelieve it. They may consider the process unfair or one-sided and not an accurate measure
of their performance, and as a result the evaluation may be useless as a motivator. Avoiding problems with
evaluation. To help overcome such problems with evaluation, an effective manager who is a good coach will
generally never identify a weakness that the employee has not previously been made aware of during the formal
appraisal interview— there are no surprises. The evaluative part of the appraisal should only be a review of
what the employee already knows and should be willing to hear. However, avoiding surprises is not enough.11
Guide – F:7 Managing Performance SHRM Chapter 8: Performance Management and Appraisal 291 The
appraisal debrief must be a well-rounded look at individual employees; it should identify both positive and
negative factors in the employees’ behaviors and results within their job (and remember that the communication
needs to be two-way). As managers, we want to tell employees what they are doing right, but also where they
have room for improvement. This more balanced approach to the debriefing process will minimize the potential
that the employees will raise those shields and avoid listening. Motivating development. The important part of
development is the need for managers to provide motivational opportunities for employees to improve their
performance over time. In other words, we need to tell them how to fix the problem. We need to provide them
with tools, training, or other methods that will allow them to improve to the point where their behavior is
sufficient, and we then must continually strive to get them to perform at an above-average level and ultimately
to be superior through ongoing coaching between formal reviews. If we provide employees with tools to allow
them to improve over time, we’re focusing not on the negative past results but on the positive future potential
results.12 If they are given an honest opportunity to fix something that they know is a problem and are given the
necessary tools or training, most will take advantage of that opportunity. So performance appraisals can be
motivational if they are properly used and debriefed. Separating evaluation and development. To improve both
parts of the performance appraisal, we suggest splitting the debriefing into two separate interviews. The first
meeting is to evaluate the employees’ past performance, pointing out strengths and areas for improvement; the
employees are asked to think about how they can improve their performance. At the second meeting, manager
and employee jointly come up with a developmental plan that should lead to increased performance that will
result in a higher future evaluative rating during the next formal appraisal. We will discuss how to conduct the
two separate interviews in the “Debriefing the Appraisal” major section of this chapter. What Do We Assess?
Now that we know why we conduct performance appraisals, the next step is to figure out what needs to be
evaluated. In other words, we have to decide what aspects of the individuals and their performance we’re going
to measure. The best option for what we evaluate would come from analyzing the essential functions and
qualifications required for a particular job—or, in HR terms, our job analysis. We could then use these facts to
design an appraisal instrument with measurable and observable factors with which performance can be
evaluated.13 However, we can’t evaluate everything that is done over the course of the year. We have to choose
what we will focus on because if we can’t measure it, we can’t manage it, and what gets measured and
evaluated gets done.14 Our three primary options are traits, behaviors, and results. Trait Appraisals Traits
identify the physical or psychological characteristics of a person. We can evaluate the traits of an individual
during the performance appraisal process. Can we accurately measure traits that affect job performance, can
trait measures pass the OUCH test, are traits commonly used to measure performance, and should we measure
traits as part of our performance appraisal process? Here we answer these questions, and we will answer these
same questions for our behavior and results options. Can we accurately measure traits that affect job
performance? Certainly, there’s some evidence that particular types of traits are valuable in jobs that require
management and leadership skills. Characteristics such as inquisitiveness, conscientiousness, and general
Identify and briefly discuss the options for “what” is evaluated in a performance appraisal. WORK
APPLICATION 8-3 Assess the effectiveness of an evaluative performance appraisal you had. Did the manager
present both positive and negative performance areas? Did you “really” listen? Were there any surprises?
Explain any problems and how the evaluation could be improved. LO 8.4 292 PART III: DEVELOPING AND
MANAGING cognitive ability have been shown to have a reasonable “link” to job performance.15 But just
how accurate is the link? Many traits that most of us would be likely to focus on, such as physical
attractiveness, height, extroversion, and others, actually have been shown to have very little bearing on job
performance. If we’re going to use traits in performance evaluation, we must ensure that we focus on traits that
have a direct relationship to the essential functions of the job being done, and they have to be accurate
measures. If we decide to use trait-based evaluations, is that a good method for judging work performance?
How many of us would want to have judgments made about our work based on our appearance or personality?
Would you consider this to be a valid and reliable measure of your work performance? In most cases, it’s very
difficult to show that personal traits are valid and reliable measures of work performance. Can trait measures
pass the OUCH test? Let’s take a look at trait-based measurements using the OUCH test. Is a physical
characteristic, such as height, or a psychological characteristic, such as attitude, cheerfulness, work ethic, or
enthusiasm, an objective measure of an individual’s work performance? We would have great difficulty
creating a quantifiable and factual link between height or enthusiasm and job performance. So it’s difficult
when measuring traits to meet the objective requirement of the OUCH test. If we utilized these trait-based
measures in all cases in employee evaluations, we would be able to meet the uniform in application requirement
of the OUCH test. The third test— consistent in effect—would likely be extremely difficult to meet due to the
fact that different racial, ethnic, social, and gender groups tend to have different physical and psychological
characteristics. Remember, reliability is a measure of consistency. Could we meet the has job relatedness test?
Is a particular trait directly related to the essential functions of the job? In a very few cases this may be true, but
in most situations physical and personality characteristics have less to do with success in the job than certain
behaviors will. So it’s very difficult to meet the has job relatedness test. Finally, we need to ask whether or not
different supervisors would evaluate our traits differently, based on their traits. Would their individual biases
based on their personalities cause them to evaluate us differently? The answer is, of course, that different people
would quite likely evaluate our traits differently. Are traits commonly used to measure performance?
Surprisingly, if you go to the local office supply store and look at standard evaluation forms that are available in
preprinted pads, you will find that they usually contain many traits as part of the evaluation. Why would this be
the case? The simple answer is that at least some traits, both physical and psychological, are fairly easy to
identify, and we make the assumption that they are related to how the individual will perform on the job. Many
of us, individually and as managers, value certain things like enthusiasm even if enthusiasm has very little to do
with the ability to do a particular job or the actual results of job performance. Certainly, there are some jobs
where enthusiasm is critical. However, in most jobs, being enthusiastic employees may have very little to do
with job success. If we evaluated individuals based on the characteristic of enthusiasm, we might make an error
in judgment concerning their performance. And if we make errors in analyzing the performance of our
employees, the appraisal form becomes much less acceptable to both the individual employee and management.
Finally, if our organization happened to be sued by a former employee who claimed that they were fired based
on an appraisal process that was unreliable and not valid, it would be very difficult to defend trait-based
evaluation forms due to their subjective nature. Should we measure traits? Author Ken Blanchard says that there
are too many evaluation items that can’t be objectively measured because they attempt to measure things that no
one knows how to accurately measure, such as attitude, initiative, and promotability. An Chapter 8:
Performance Management and Appraisal 293 important question is whether both managers and employees will
agree that the measured rating is accurate. The bottom-line test (we will call it the Blanchard test) is whether
everyone understands why they are assessed at a specific level (evaluation) and what it takes to get a higher
rating (development).16 So we should only assess traits if we meet the bottom-line test of having a direct and
obvious objective relationship between the trait and success in the job. Behavioral Appraisals Our second option
in the assessment process is to evaluate employees based on behaviors. You will recall that behaviors are simply
the actions taken by individuals—the things that they do and say. Behavioral appraisals measure what
individuals do at work, not their personal characteristics. Is this a good option to use in a performance appraisal
process? Can we accurately measure behaviors that affect job performance? As a general rule, behaviors are a
much better option to use in an appraisal than traits. While an individual supervisor or manager may make a
mistake in judgment of the traits of an employee, physical actions or behaviors can be directly observed, and as
a result they are more likely to be a valid assessment of the individual’s performance. Can behavior measures
pass the OUCH test? Let’s take a look at a behavioral evaluation using the OUCH test. Would an evaluation
based on actions taken by an employee be objective? In general, directly observing and evaluating an action is
significantly more objective than making an attempt to judge a trait such as effort. If we applied the same
evaluation of behaviors to all of the individuals in the same type of job, we would have a reasonable certainty
that we were being uniform in application. The same thing would be true here in evaluating the concept of
consistent in effect. So, we come down to whether or not a behavioral evaluation has job relatedness. Would a
behavioral evaluation be directly related to the essential functions of a job? It would be if we made sure that we
chose behaviors that were necessarily a part of successfully accomplishing a task. For instance, if a person acted
correctly to fill out a requisition form, putting the proper information in the correct blocks and providing the
requisition to the appropriate person who would then order the material, we would be assessing behaviors that
are job-related. If, however, we evaluated the action of walking to the lunchroom and back to your workstation,
would that be a valid job-related behavior? More than likely it would not. Of course, this is a silly example, but
it should help you understand that no matter what we do in the evaluation process, we need to ensure that our
actions are job-related. Would behavioral evaluations be defensible in the situation of our fired employee
above? Would it be possible for us to show that our evaluation process was valid and reliable? If we choose job-
related behaviors, it becomes much easier for the organization to defend the validity and reliability of the
appraisal process. Observation of actions that are directly related to a job provides at least some presumption of
validity as well as reliability purely because the behaviors are directly job-related. Again, if we chose behaviors
that were not able to be directly associated with the job, the validity and reliability would be suspect. Should we
measure behavior? Are behaviors that measure performance more acceptable to the individual employee and the
managers than personal traits? In fact, evidence shows that most individuals are very comfortable with the
evaluation of their performance being based on their behaviors. In general, the most useful and therefore
acceptable feedback to employees is considered to be in the form of specific job-related behaviors.17 As
managers, though, we still need to be cognizant of the fact that a behavioral evaluation can be a poor measure of
work performance unless the behaviors chosen are directly applicable to being successful in the job. So, like
with traits, the Blanchard test is whether everyone understands why they are assessed at a specific level
(evaluation) and what it takes to get a higher rating (development).18 294 PART III: DEVELOPING AND
MANAGING Results/Outcomes Appraisals Our final option concerning what we evaluate is the results, or
outcomes, of the work process. Results are simply a measure of the goals achieved through a work process.
Using results as an evaluation measure provides management of the organization with an assessment of the
goals that were achieved in a particular job over time. Can we accurately measure results that affect job
performance? Is measuring the outcomes of a particular individual’s job a valid and reliable measure of that
person’s performance? Well, certainly results are a concrete measure of what has happened in the organization.
However, could results of a job have been skewed based on factors that were outside the control of the
individual who is performing that job? The answer is obviously that the results could be affected by many other
factors besides the individual. For example, the goals could be set too low and be easy to achieve, or too high
and be impossible to achieve. Even though this is true, the measurement of results is the final organizational
measure of success. The results produced through organizational processes provide the company with its return
on investment—in this case its investment in the people in the organization. So, organizations really like to
measure results. Can results pass the OUCH test? Let’s take a look at the OUCH test concerning results-based
evaluations. Is a result achieved in a particular job a concrete, factual measure that can easily be quantified?
Obviously, it is a very objective measure of what has happened in that particular job. If we apply the same
results-based measure to each similar job, then our measure is uniform in application. The measure of results
would almost certainly be consistent across different groups of employees, so we would meet the consistency in
effect requirement of the OUCH test. And of course, if we are measuring the results of what happens in a job,
we are certainly providing a measure that has job relatedness. So, with a quick scan we can see that a results-
based performance appraisal meets the requirements of the OUCH test better than either of the other two
options. Should we measure results? Results-based evaluations, like behavior, are also typically very acceptable
to both the employee and the manager. Employees readily accept resultsbased appraisals because they feel that
such measures are one of the fairest methods of analyzing their performance. After all, results are the most
concrete form of evaluation that can be performed. Either the result was achieved, or it wasn’t. We can also
defend this type of appraisal much easier than the other two options in court, if necessary. It tends to be very
easy for the organization to go into a courtroom and show that an individual’s results were absolutely lower
than the results achieved by other people in the same or similar jobs, if such an action becomes necessary. But
would a performance evaluation measured on results be valid and reliable? The results-based evaluation would
most likely be highly valid and would usually be reliable, assuming that we were able to take into account
factors outside of individuals’ control that nonetheless affect the performance of their job. So, like with traits
and behaviors, the Blanchard test is whether everyone understands why they are assessed at a specific level
(evaluation) and what it takes to get a higher rating (development).19 Which Option Is Best? Our three options
concerning what we evaluate are traits, behaviors, and results. But, which option is best? The answer’s not as
easy as you might think. Certainly, results-based and behavior-based evaluations are more defensible due to the
fact that they are more reliable and valid than trait-based evaluations. But we have to include a large number of
factors in order to select which option is best in a particular situation. WORK APPLICATION 8-4 Very briefly
describe a job you have or had. Describe how your performance was assessed based on traits, behavior, and/or
results. Chapter 8: Performance Management and Appraisal 295 APPLYING THE CONCEPT 8-2 For
example, if we need to evaluate employees who work on the assembly line, we may need to evaluate behaviors
such as punctuality—do they show up to work on time? If we have employees who, when they are there,
produce at 150% of the standard, but only show up two or three days a week, that creates a problem for the
whole assembly line. In that case, we may need to evaluate attendance and punctuality (behaviors) because
everyone on the assembly line depends on everyone else. However, if we have individuals who don’t do their
actual work where managers can measure traits and behaviors—for example, people who work from home
(telecommuters) and in independent outside sales positions—we need to rely on results. Other employees are
often not affected by the hours that the telecommuters and salespeople work. It will not matter when they are at
the office, as long as they get the job done. The firm will be concerned with how much they produced or sold.
So circumstances dictate which method we will use; we cannot say one method will always be superior to the
other two. How Do We Use Appraisal Methods and Forms? The formal performance appraisal usually involves
the use of a standard form developed by the HR department to measure employee performance. Again, “If you
can’t measure it, you can’t manage it.”20 But you must be careful how you measure success,21 as the
assessment should be as objective as possible, not subjective.22 Employees need to know the standards and
understand what good performance looks like, and they need to be able to measure their own performance. If
you are stuck with a form that has subjective sections, work with your employees to develop clear accurate
standards. Exhibit 8-2 lists the commonly used performance appraisal measurement methods and forms and
displays them on a continuum based on their use in administrative evaluative and developmental decisions. In
the following section, we discuss each of them, starting with the developmental methods and working toward
the evaluative. Guide – F:5 Performance appraisals Assessment Options Which of the following assessment
options for measuring performance is being described in each of the given situations? a. traits c. results b.
behavior ____ 6. This is the second time you got upset and yelled at customers. This has to stop. ____ 7. You
have produced 15 products again this week. You know the standard is 20, so I’m giving you a formal warning
that if you don’t get up to standard in two weeks, you will be fired. ____ 8. When you promote one of the
women from waitress to hostess, be sure she is attractive so customers have a good impression of our restaurant
and want to come back. ____ 9. I’m really surprised. Since you started working from home, you have actually
increased your data entry numbers by 5 percent. ____10. On item number 5, willingness to take responsibility,
I’m giving you an average rating. SHRM Briefly discuss the commonly used performance measurement
methods and forms. LO 8.5 296 PART III: DEVELOPING AND MANAGING Critical Incidents Method The
critical incidents method is a performance appraisal method in which a manager keeps a written record of
positive and negative performance of employees throughout the performance period. There is no standard form
used, so it is a method. Here, and for each of the other methods and forms, let’s answer two questions: Why and
when is it used, and how is it used? Why and when do we use the critical incidents method? Most formal
reviews take place only once or twice a year. Do you want to wait for formal reviews to talk to employees about
what they are doing well and when they are not performing up to expectations? Of course you want to let them
know how they are doing on an ongoing basis. Also, let’s say we are a manager with 12 employees. Can we
remember everything each of them did well, and when they messed up, and on what dates, so we can evaluate
their total performance for the past 6–12 months? Very few, if any, of us can say yes. However, many managers
don’t keep a record of critical incidents, which leads to problems of accurate measures during the formal review
meeting. We use critical incidents to do a good assessment of the entire review period, and we coach when
needed during the entire review period for developmental decisions. We need to continually conduct informal
coaching and disciplining when needed as we make notes of critical incidents to use during the formal review.
With clear standards and coaching, you can minimize disagreements over performance during the formal
performance appraisal because there are no surprises, because employees know what is coming.23 Although
critical incidents are commonly used for developmental decisions, they are also used for evaluative decisions.
For legal purposes, a list of documented critical incidents is especially important to have leading up the
evaluative decision of firing employees. We will discuss discipline and documentation in Chapter 9. How do we
use critical incidents? Managers commonly simply have a file folder for each employee, which can be hard
copy or electronic. Critical incidents are important employee actions, not minor ones, which help or hurt
performance. Every time employees do something very well, such as beat a tough deadline or save angry
customers from terminating their business relationship with the firm, a note goes in the employees’ file. Notes
also go into the file every time the employees’ behavior hurts performance, such as coming to work late or the
quality of work not meeting standards. The note is usually written by the manager and/or is in the form of
documentation, such as a warning that is given, performance reports, or a letter from a happy customer thanking
the employee for doing a great job. Coaching is part of this ongoing process, and it involves helping employees
succeed by monitoring performance through giving feedback to praise progress and to redirect inappropriate
behavior as often as needed.24 One error managers tend to make is to focus on the negative actions of
employees. Remember that Guide – F:1 Identifying and measuring employee performance SHRM Exhibit 8-2
Performance Appraisal Measurement Methods and Forms Evaluative - 1-——————- 2 -——————- 3 -
——————- 4 -——————- 5 -——————- 6 - Development Decisions Decisions Ranking Method
Graphic Rating Scales Form BARS Form Narrative Method or Form MBO Method Critical Incidents Method
Chapter 8: Performance Management and Appraisal 297 a good balanced evaluation includes both positive and
negative, so look for good performance, not just poor, and praise it when you see it.25 Management by
Objectives (MBO) Method The Management by Objectives (MBO) method is a process in which managers and
employees jointly set objectives for the employees, periodically evaluate performance, and reward according to
the results. Although it is a three-step process, no standard form is used with MBO, so it is a method. MBO is
also referred to as work planning and review, goals management, goals and controls, and management by
results. Why and when do we use the MBO method? The MBO method is one of the best methods of
developing employees. Like critical incidents, employees get ongoing feedback on how they are doing, usually
at scheduled interval meetings. We can use the MBO method successfully with our employees if we commit to
the process and truly involve employees rather than trying to make them believe that our objectives are theirs—
accurate measures. On an organization-wide basis, MBO is not too commonly used as the sole assessment
method. It is more commonly used based on the evaluative assessment during the development part of the
performance appraisal. One difficult part of MBO is that in many situations, most, if not all, employees will
have different goals, making MBO more difficult and time-consuming than using a standard assessment form.
How do we use the MBO method? MBO is a three-step process: Step 1. Set individual objectives and plans.
The manager sets objectives jointly with each individual employee.26 The objectives are the heart of the MBO
process and should be accurate measures of performance results. To be accurate, objectives should be
SMART.27 They need to be Specific, Measurable, Attainable, Relevant, and Time-based. Being specific,
measurable, and time-based is fairly easy to determine in a written goal, but being attainable and relevant is
more difficult. So we developed a model based on the work of Max E. Douglas with two examples in Model 8-1
that we can use when setting objectives for ourselves or with others. Step 2. Give feedback and evaluate
performance. Communication is the key factor in determining MBO’s success or failure, and employees should
continually critique their own performance.28 Thus, the manager and employee must communicate often to
review progress.29 The frequency of evaluations depends on the individual and the job performed. However,
most managers do not conduct enough review sessions. Step 3. Reward according to performance. Employees’
performance should be measured against their objectives. Employees who meet their objectives should be
rewarded through recognition, praise, pay raises, promotions, and so on.30 Employees who do not meet their
goals, so long as the reason is not out of their control, usually have rewards withheld and even punishment
when necessary. Model 8-1 Setting Objectives Model 1. To + 2. Action Verb + 3. Specific and Measureable
Result + 4. Target Date To + produce + 20 units + per day To increase widget productivity 5% by December 31,
2014. WORK APPLICATION 8-5 Select a job you have or had. Did your boss use critical incidents? Assess
how well your boss used coaching between formal performance appraisal meetings to review your performance.
298 PART III: DEVELOPING AND MANAGING Narrative Method or Form The narrative method or form
requires a manager to write a statement about the employee’s performance. There often is no actual standard
form used, but there can be a form, so narrative can be a method or a form. Why and when do we use the
narrative method or form? A narrative gives managers the opportunity to give their evaluative assessment in a
written form that can go beyond a simple “check of a box” to describe an assessment item. Managers can also
write up a developmental plan of how the employee will improve performance in the future. Narratives can be
used alone, but are often combined with another method or form. Although the narrative is ongoing, it is
commonly used during the formal review. How do we use the narrative method or form? The system can vary.
Managers may be allowed to write whatever they want (method), or they may be required to answer questions
with a written narrative about the employee’s performance (form). Let’s discuss both here. The no-form
narrative method can be the only assessment method used during the formal review process. But the narrative
method, when used alone, is more commonly used with professionals and executives, not operative employees.
How we write the formal narrative assessment varies, as writing content and styles are different. A narrative
based on critical incidents and MBO results is clearly the best basis for the written assessment. The narrative is
also often used as part of a form. For example, you have most likely seen an assessment form (such as a
recommendation) that has a list of items to be checked off. Following the checklist, the form may ask one or
more questions requiring a narrative written statement. Graphic Rating Scale Form The graphic rating scale
form is a performance appraisal checklist on which a manager simply rates performance on a continuum such as
excellent, good, average, fair, and poor. The continuum often includes a numerical scale, for example from 1
(lowest performance level) to 5 (highest performance level). Self-Assessment and Skill Builder 8-1 uses a
graphic rating scale form; it is found at the end of this chapter. Why and when do we use the graphic rating
scale form? Graphic rating scales are probably the most commonly used form during the formal performance
appraisal (primarily for evaluative decisions), but they should lead to development decisions as well. Why the
popularity? Because graphic rating scales can be used for many different types of jobs, they are a kind of “one
form fits all” form that requires minimal time, effort, cost, and training. If we walk into an office supply store,
we can find pads of them. But on the negative side, graphic rating scales are not very accurate measures of
performance because the selection of one rating over another, such as an excellent versus good rating, is very
subjective. For example, think about professors and how they measure performance with grades. Some give lots
of work and few As, while others give less work and almost all As. How do we use the graphic rating scale
form? It is very simple, and we have most likely all used one. For example, many colleges have student
assessments of professors at the end of the course. All we do is check off, or usually fill in a circle for, our
rating. One problem is Chapter 8: Performance Management and Appraisal 299 that some of us don’t bother to
actually read the questions. Based on our biases, some of us just go down the list checking the same rating
regardless of actual performance on the item. To be fair, this problem is not common with managers formally
evaluating their employees. However, it does tend to occur when customers evaluate products and services,
including student assessments of professors. To overcome this problem, which is unfortunately not commonly
done, we can reverse the scale from good to poor on different questions. Why isn’t this done all the time? Some
HR, or other, managers who make the scales do not know they should do this. Some who do know they should
reverse the scales don’t because they don’t want to end up with overall ratings being pushed to the middle
because people don’t read the questions. Behaviorally Anchored Rating Scale (BARS) Form The Behaviorally
Anchored Rating Scale (BARS) form is a performance appraisal that provides a description of each assessment
along a continuum. Like with rating scales, the continuum often includes a numerical scale from low to high.
Why and when do we use the BARS form? The answer to why and when is the same as for graphic rating
scales. So let’s focus on the differences between graphic rating scale and BARS forms. BARS forms overcome
the problem of subjectivity by providing an actual description of the performance for each rating along the
continuum, rather than one simple word (excellent, good, etc.) like graphic rating scales. A description of each
level of performance makes the assessment a more objective accurate measure. So if BARS forms are more
accurate, why aren’t they more commonly used than graphic rating scale forms? It’s partly economics and
partly expertise. Again, the graphic rating scale can be used for many different jobs, but BARS forms have to be
customized to every different type of job. And developing potentially hundreds of different BARS forms takes a
lot of time (which costs money) and expertise. Even when a firm has an HR staff, the question becomes whether
developing BARS forms is the most effective use of staff members’ time. Obviously, it depends on the types of
jobs being evaluated and the resources available to complete the evaluation process. How do we use BARS
forms? Like graphic rating scales, we simply select a level of performance along the continuum. College
accreditation associations are requiring more measures of student outcomes as assurance of learning, and as part
of the process they want more BARS rubrics as evidence. So in college courses, especially for written
assignments, professors give out rubrics that describe in some detail the difference between excellent (A), good
(B), average (C), poor (D), and not acceptable (F) grades for multiple criteria put together to provide a final
grade. Here is a very simple example of making a graphic rating scale item into the more objective BARS form.
Attendance—excellent, good, average, fair, poor Attendance—number of days missed 1, 2, 3–4, 5, 6 or more
There shouldn’t be any surprises or lack of agreement on performance levels during the formal performance
appraisal interview. 300 PART III: DEVELOPING AND MANAGING Ranking Method The ranking method
is a performance appraisal method that is used to evaluate employee performance from best to worst. There
often is no actual standard form used, and we don’t always have to rank all employees. Why and when do we
use the ranking method? Managers have to make evaluative decisions, such as who is the employee of the
month, who gets a raise or promotion, and who gets laid off. So when we have to make evaluative decisions, we
generally have to use ranking. However, our ranking can, and when possible should, be based on other methods
and forms. Ranking can also be used for developmental purposes by letting employees know where they stand
in comparison to their peers—they can be motivated to improve performance. For example, when one of the
authors passes back exams, he places the grade distribution on the board. It does not in any way affect the
current grades—but it lets students know where they stand, and he does it to motivate improvement. How do we
use the ranking method? Under the ranking method, the manager compares an employee to other similar
employees, rather than to a standard measurement. An offshoot of ranking is the forced distribution method,
which is similar to grading on a curve. Predetermined percentages of employees are placed in various
performance categories, for example, excellent, 5%; above average, 15%; average, 60%; below average, 15%;
and poor, 5%. The employees ranked in the top group usually get the rewards (raise, bonus, promotion), those
not at the top tend to have the reward withheld, and those at the bottom sometimes get punished. In Self-
Assessment and Skill Builder 8-1, you are asked to rank the performance of your peers. Which Option Is Best?
While this section does not contain an exhaustive list, it provides examples of each major method of
performance appraisal. Determining the best appraisal method or form to use depends on the objectives of the
organization. A combination of the methods and forms is usually superior to any one used by itself. For
developmental objectives, the critical incidents, MBO, and narrative methods work well. For administrative
decisions, a ranking method based on the evaluative methods and especially graphic rating scale or BARS
forms works well. Remember that the success of the performance appraisal process does not just lie in the
formal method or form used once or twice a year. It depends on the manager’s human relations skills in ongoing
critical incidents coaching, and on effective measures of performance that are accurate so that everyone knows
why they are rated at a given level (evaluative), as well as how to improve (develop) for the next assessment.31
PerformanceReview.com is a website that has been designed to help managers write complete and effective
performance appraisals online. The site offers practical advice to guide managers through the appraisal
process.32 Who Should Assess Performance? Now that we’ve learned the why, what, and how of the
performance appraisal process, the next thing we need to discuss is options for the rater, or evaluator. There are
a number of different options concerning who should evaluate the individual employee, and the decision needs
to be based on a series of factors. Let’s take a look at our options for who should evaluate an employee. Guide –
F:2 Sources of Information (e.g., managers, peers, clients) SHRM WORK APPLICATION 8-6 Select an
organization, preferably one you work or have worked for. Identify and briefly describe the assessment methods
and/or forms that are used to assess employee performance. Chapter 8: Performance Management and Appraisal
301 Supervisor When we ask who should evaluate employees, the most common response is their immediate
supervisor. Why would the supervisor be the best person to evaluate an employee? Well, the supervisor is
supposed to know what the employee should be doing, right? Certainly, supervisors are frequently one of the
best and most commonly used options to choose as evaluators for the employees under their control. However,
this is not always the case due to problems with supervisor performance assessments. Problems with supervisor
evaluations. What if the supervisor doesn’t see the employee very frequently? This may not be all that
uncommon in a modern organization. Many times today, supervisors may be in a different building or even a
different city than the individuals they supervise. Virtual teams, Internet-linked offices, telecommuting, and
other factors cause supervisors to not be in constant touch with their employees, unlike the situation 20 or 30
years ago. There are other problems as well. What if there’s a personality conflict? Supervisors are human, just
like their employees, and may just not relate well to some of their employees. This may cause a personal bias
for, or against, certain employees that may invalidate the appraisal process if it’s significant enough. What if the
supervisor doesn’t know what employees are supposed to be doing in their jobs? Aren’t supervisors always
supposed to know every job for which they are responsible? Again, 30 years ago this may have been true.
However, in today’s work environment, with the amount of information necessary to do the complex tasks that
organizations must accomplish in order to compete, nobody can know every job. There’s just too much
information for any one individual to learn. So jobs have been segmented down into smaller and smaller areas,
and the supervisor may not know each of those jobs in great detail. So there are certainly problems that can
occur in the case of a supervisor being responsible for a subordinate employee’s evaluation process. This being
the case, what other options do we have? APPLYING THE CONCEPT 8-3 Appraisal Methods and Forms
Which of the following assessments is being described in each of the given situations? a. critical incidents
method b. MBO method c. narrative method or form d. BARS form e. graphic rating scale form f. ranking
method ____ 11. One of your employees has applied for a better job at another company and asked you for a
letter of recommendation. ____ 12. You are overworked, so you want to develop a performance appraisal form
you can use with all 25 of your employees who do a variety of jobs. ____ 13. You have been promoted from a
supervisory position to a middle management position. You have been asked to select your replacement. ____
14. One of your employees is not performing up to standard. You decide to talk to her in order to improve her
performance. ____ 15. You want to create a system for developing each of your employees individually.
Identify and briefly discuss available options for the rater/evaluator. LO 8.6 302 PART III: DEVELOPING
AND MANAGING Avoiding supervisor review problems. A simple answer to overcome these problems is to
have others, in addition to the supervisor, assess performance. Also, multiple measures can make a performance
assessment more accurate. For example, using other evaluators can help overcome personal bias and provide
information that supervisors don’t always know about. Peers As discussed, the supervisor is not always
knowledgeable enough to make a valid assessment of employee performance. Another possible option is to use
coworkers or peers of the individual employee as appraisers. When would it be valuable to use peer evaluations
in an organization? If the supervisor is absent or has infrequent contact with the employees, but all employees
have multiple coworkers that they interact with on a frequent basis, peer evaluations may be valuable. Peers or
coworkers also often know the job of the individual employee better than the supervisor does, and they are more
directly affected by the employee’s actions, either positive or negative. In addition, peers can evaluate the
ability of the individual to interact with others successfully in a group or team setting. This may be very difficult
for supervisors to see unless they are intimately involved with the group. Problems with peer reviews. There are
certainly issues that can come up in peer evaluations that can cause the process to become less objective. In fact,
research evidence regarding the validity of peer evaluations is really unclear.33 Personality conflicts and
personal biases can affect how individual employees rate their peers. Individuals within a group or team may
just have significantly different personality types, and these differences can cause friction within the work group
that may spill over when it comes time to evaluate those with whom they are in conflict. Additionally, no matter
how much we try and protect against it, personal biases can affect working relationships and may show up in
peer evaluations. Avoiding peer review problems. Because we know that these problems can occur within a
peer evaluation, the organization can take the issues into account and adjust rating values as necessary. For
example, assume you are the manager of a work group of six people who in your opinion work very well
together and provide a quality work product, and you review a set of peer evaluations from the work group. In
your review you notice that two of the members of the group gave each other significantly lower-than-average
grades—one of the two is a young male, and the other is an older female. However, the other four members of
the group gave both of them good marks for their contributions to the group. This quite likely is a situation
where a personality conflict has occurred between the two members, which caused them to lower each other’s
grades. Knowing that the other four members of the group evaluated these two individuals as valued members
of the team, you may want to adjust the individual ratings from the two individuals to more closely match the
overall evaluations from the team, noting that it appears that a personality conflict may have lowered their
individual grades of each other. Even with the potential for personality conflicts and bias, peer evaluations can
give us good insight into the inner workings of a group or team when the supervisor has infrequent contact with
the team. In SelfAssessment and Skill Builder 8-1, you will do a performance assessment of your peers.
Subordinates Our next available option is the subordinates of an individual supervisor in the firm. We would
typically only use subordinate evaluators for manager-level employees. However, who within the firm knows,
and suffers the consequences of, the actions of supervisors more than the people who work for them?
Subordinate evaluations can give us good insight into the managerial practices and potential missteps of people
who control other employees in our organization. As a result, subordinate evaluations may give us valuable
information that we would be unable to find out using any other means. Chapter 8: Performance Management
and Appraisal 303 Problems with subordinate reviews. Can subordinate evaluations cause a problem within the
department or work group? Is the potential for bias, especially from subordinates who have been disciplined by
the supervisor, significant in this type of evaluation? Of course there is a potential for bias. Obviously, the
subordinates may try to get back at their supervisor for giving them tasks that they did not want to perform, or
for disciplining them for failure in their jobs. There may be a personality conflict, or some subordinates
certainly may be biased against their supervisor or manager. So there are certainly negative aspects to
subordinate evaluations. On the other end of the scale, the subordinates may inflate the capabilities of the
manager, at least partly because of a lack of understanding of all the tasks and duties required of the manager. In
fact, in a recent survey, about two thirds of employees rated their managers higher than the managers’ self-
ratings.34 Avoiding subordinate review problems. In all of these problem areas, if we know that there is a
potential problem, we can most likely guard against it. In many cases, as we go through a group of subordinate
evaluations, we will see one or two outliers providing either very high or very low marks for the supervisor. In
such a case we should probably throw those outliers out of the calculation when determining overall marks for
the supervisor. It’s honestly surprising how often these outliers are extremely easy to spot in a subordinate
evaluation process. Another significant issue in the case of subordinate evaluations is confidentiality.
Subordinate evaluations must be confidential in nature, or it is unlikely that the subordinates will provide an
honest evaluation of their supervisor. Why is this the case? Obviously, if the evaluation is not confidential, the
supervisor can and may take retribution on subordinates who provide unflattering evaluations. So, if the
evaluation is not anonymous, many of the subordinates will likely inflate the capabilities of the supervisor,
which minimizes the value of the evaluation process itself. So, even though subordinate evaluations have the
potential for biases and other problems, we can help to overcome these problems, and they can provide us with
valuable information about the supervisor’s capabilities. Self Self-assessment is also an option in the
performance appraisal process, or is it? Virtually all employees do a self-assessment whether they are actually
formally asked to do so as part of the assessment or not. It is required with MBO. Even when not asked to do a
self-assessment, employees will still walk into the review discussion with some informal self-assessment that
they compare to the supervisor’s rating. But are self-evaluations valuable, or will the employees overestimate
their individual capabilities and tell us that they’re perfect? (As you know, every chapter of this book has one or
more self-assessments, and the one for this chapter is Self-Assessment and Skill Builder 8-1; it is at the end of
the chapter. You will assess your performance on a group project. If you want to, you can do the self-
assessment now.) Problems with self-assessments. Most of the research evidence shows that selfassessments
tend to overestimate the individual’s ability to do a job.35 However, some of the research says that employees
either underestimate or accurately estimate their job performance over time. A significant portion of the
evidence seems to show that individuals with lower levels of knowledge and skills within their field tend to
inflate their self-assessment of their abilities.36 Conversely, as individuals become more knowledgeable and
more skilled, the evidence tends to show that they will either accurately estimate or even underestimate their
capabilities in their jobs.37,38,39 Avoiding self-assessment problems. Based on the fact that most of the
evidence shows that employees overestimate their ability to do their job, is this a valid performance measure?
Here again, even though the measure may have validity concerns, if we know that selfevaluations tend to be
skewed, we can most likely adjust for this factor. In addition, receiving 304 PART III: DEVELOPING AND
MANAGING information from individuals concerning their perception of their skill set is extremely valuable in
a number of management processes, including plans for training and development opportunities, providing
work assignments, and counseling and disciplinary measures, among others. A big step in overcoming self-
assessment problems, as well as other assessment problems, is the Blanchard test—do the employees
understand why they are assessed at a specific level (evaluation) and what it takes to get a higher rating
(development)?40 Customers We may also want to ask customers to evaluate individuals within the company.
We use the word customers in a broad sense to include people outside the organization, including customers for
our products and services and suppliers to the firm. Customers can also be internal including people in other
departments of the firm—for example, the print shop that makes copies for other departments or the mail room
that receives and delivers communications and products to the rest of the firm. When and why would we want
to use customers in the evaluation process? We may want to use customers as evaluators when the individual
being evaluated has frequent contact with organizational customers, either internal or external to the firm. If
employees interact routinely with internal or external customers, we need to know how the customers feel about
their interactions with the employees because obviously external customers are the ones who ultimately pay the
bills. It does not matter what else we do successfully if our customers are uncomfortable with their interactions
with our employees. If external customers are upset about their interactions with our employees, they have the
ability to go elsewhere with their business. Even internal customers can create significant problems within the
firm due to conflict between departments or divisions. So we want to ask customers to evaluate the individuals
with whom they come into contact. Problems with customer assessments.What do you think the major problem
is with customer-based evaluations? One problem is that customer assessments commonly use simple rating
scales, which we discussed as being very subjective. Also, customers are usually not trained to do an accurate
assessment. So bias is a problem. For these and other reasons, the popular opinion is that customer evaluations
are almost always skewed to the negative. However, research shows that this is not necessarily the case.41 In
some situations, customer evaluations actually exceed evaluations of the individual that are internal to the firm
or department. Avoiding customer assessment problems. Regardless of whether or not customers will tell us
when we’re doing an exceptional or acceptable job, customer evaluations provide us with valuable information
concerning our employees who have direct customer contact. If this is the case, can we adjust the evaluation
process knowing that customer evaluations are frequently skewed either positively or negatively? Obviously,
we can. One of the basic methods of adjusting the customer evaluation process is to compare the individuals
being evaluated and identify the ratios of negative and positive comments to allow us to identify more
successful and less successful employees. Although this is an imperfect measure, it still provides value to the
firm in the fact that customers’ perception is critical to our relationship with them. So, we need to measure this
relationship. 360º Evaluation As a final option, we can do “all of the above.” The 360° evaluation, in effect,
analyzes individuals’ performance from all sides—from their supervisor’s viewpoint, from their subordinates’
viewpoint, from customers’ viewpoint (if applicable), from their peers’ viewpoint, Briefly discuss the value and
the drawbacks of a 360° evaluation. LO 8.7 WORK APPLICATION 8-7 Select your current or a past job.
Identify who had input into your performance appraisal. Chapter 8: Performance Management and Appraisal
305 and using their own self-evaluation. Obviously, the 360° evaluation would give us the most accurate, best
possible analysis of individuals and their performance within the company. DuPont developed 360° reviews
back in 1973, but they are still popular today.42 With the trend of structuring work in teams, peer evaluations
are now being used regularly.43 Those who fill out the appraisal form usually do so confidentially. The
feedback from all these people is used to evaluate and develop the employee. Problems with 360º evaluations. If
they are the best, then why don’t we always use 360° evaluations? The simple answer is “time and money.” It
takes a significant amount of time for a group of individuals to evaluate one person if we use a 360° format. By
using up so much organizational time, it obviously also costs us a significant amount of money. If we multiply
the numbers based on the time required to evaluate one individual to count everyone in the organization, the
costs can quickly become massive. Avoiding problems with 360º degree evaluations. Unfortunately, there really
is no simple way to avoid such problems, besides what is commonly done—not using 360° evaluations. When
used, the 360° evaluation format tends to be most valuable if it is used for purposes of individual development,
rather than for making administrative evaluative decisions.44 A good 360° feedback system can provide
specific suggestions about how to improve individual competencies.45 It can also go a long way toward
minimizing some of the most common problems with the performance appraisal process, which we will review
next. Who Do We Choose? Now that we know our options for who should conduct an evaluation of each
employee, which option should we use? Again, we need to remember that each of the options costs us money
because it takes time for the individual who must perform the appraisal. So, we need to determine which option
or options to use. We can use any of these methods combined with any other, all the way up to the point of the
360° evaluation. However, we only want to use a 360° evaluation when it’s worth it. If it’s not necessary, then it
doesn’t make a lot of sense due to the cost of this method. For instance, is there any need to do a 360°
evaluation of janitorial or housekeeping staff? Does this make sense? Obviously, in this case we probably don’t
need to do this type of evaluation. In most cases, with low-level staff members, a supervisor’s evaluation is
sufficient. We also make this statement because the evaluation is often more than just a supervisor’s biased
opinion. Even though only the supervisor does the formal assessment, the supervisor often does get informal
feedback regarding performance from customers and peers during conversations. Customers will often
complain to the supervisor if the service is not satisfactory, and peers will complain about a fellow employee
who is not meeting standards for some reason. The supervisor’s critical incident file is often written based on
information received from peers and customers. What about the case of an outside salesperson? In this situation,
the results tend to speak for themselves. Sales numbers are available to the salesperson and manager. Where the
supervisor rarely sees the individual but the customer interacts with our salesperson on a routine basis, we can
ask the customer to do an evaluation of the salesperson as well as asking the salesperson for a self-appraisal.
With the sales figures, a self-assessment, and customer feedback, we can develop a plan to increase future
performance. Finally, if we are evaluating the marketing manager for the firm, we may want to do a 360°
evaluation because this individual would affect all of the groups—subordinates, customers, peers, the
organization, and himself or herself. So, we evaluate the specific situation and use the number of methods
necessary to get an accurate assessment of the individual. Once again, we need to do a cost-benefit analysis to
determine when the benefits of increasing performance outweigh the cost to give us a return on our investment.
In essence, we attempt to maximize performance while minimizing the total cost of the appraisal process.
WORK APPLICATION 8-8 Select an organization, preferably one you work or have worked for. Identify some
of the positions and people who should be evaluated using 360° evaluations. Briefly describe your cost-versus-
benefit analysis to justify your selection. Identify some of the common problems with the performance appraisal
process. LO 8.8 306 PART III: DEVELOPING AND MANAGING Performance Appraisal Problems to Avoid
During the performance appraisal process, there are common problems that we face. However, knowing these
common problems, we can take measures to avoid them. So in this section we discuss the problems first with
simple ways to avoid each of them as an individual. Then we discuss what the organization can do to overcome
these problems on an organization-wide basis. We can actually overcome multiple problems with the same
method. See Exhibit 8-3 for a list of problems and ways to avoid them. Common Problems With the
Performance Appraisal Process Let’s briefly discuss each of the common problems during the performance
appraisal process listed in Exhibit 8-3 here. Bias. Bias is simply a personality-based tendency, either toward or
against something. In the case of performance assessment, bias is toward or against an individual employee. All
human beings have biases, but supervisors especially cannot afford to allow their biases to enter into their
evaluation of subordinates in the firm. This is very easy to say, but very difficult to do. Biases make the
evaluation process subjective rather than objective, and certainly provide the opportunity for a lack of
consistency in effect on different groups of employees. So to overcome the bias problem, we need to be
objective and not let our feelings of liking or disliking the individual influence our assessment. Stereotyping.
Stereotyping is mentally classifying a person into an affinity group, and then identifying the person as having
the same assumed characteristics as the group. Though stereotyping is almost always assumed to be negative,
there are many incidents of positive stereotypes. However, regardless of whether the stereotype is positive or
negative, making bership in a group, rather than explicitly identifying the characteristics of the individuals,
creates the potential for significant error in evaluations. So we can avoid stereotyping by getting to know each
employee as an individual and objectively evaluating individual employees based on their actual performance.
Halo error.This error occurs when the evaluator has a generally positive or negative (negative halo error is
sometimes called “horns error”) impression of an individual, and the evaluator then artificially extends that
general impression to many individual categories of performance to create an overall evaluation of the
individual that is either positive or negative.46 In other words, if employees are judged by their supervisor to be
generally “good” employees, and the supervisor then evaluates each of the areas of their performance as Guide
– F:3 Rater Errors in Performance Measurement Common Problems Avoiding Problems Bias Stereotyping Halo
Error Distributional Errors Similarity Error Proximity Error Recency Error Contrast Error Attribution Error
Develop Accurate Performance Measures Use Multiple Criteria Minimize the Use of Trait-Based Evaluations
Use the OUCH and Blanchard Tests Train Your Evaluators Use Multiple Raters Exhibit 8-3 Performance
Appraisal Problems and Avoiding Them SHRM Chapter 8: Performance Management and Appraisal 307 good,
regardless of any behaviors or results to the contrary, the supervisor is guilty of halo error. We can avoid halo
error by remembering that employees are often strong in some areas and weaker in others, and we need to
objectively evaluate individual employees based on their actual performance for each and every item of
assessment. Distributional errors. These errors occur in three forms: severity or strictness, central tendency, and
leniency. They are based on a standard normal distribution, or the bell curve that we are all so familiar with. In
severity orstrictness error, the rater evaluates everyone, or nearly everyone, as below average. Central tendency
error occurs when raters evaluate everyone under their control as average—nobody is either really good or
really bad. Finally, leniency error occurs when the rater evaluates all others as above average. Leniency error,
therefore, is basically a form of grade inflation. We can avoid distributional errors by giving a range of
evaluations. The distribution is often based on the ranking method of evaluation and forced distribution.
Similarity error. This error occurs when raters evaluate subordinates that they consider more similar to
themselves as better employees, and subordinates that they consider different from themselves as poorer
employees. We all have a tendency to feel more comfortable with people who we feel are more similar to
ourselves,47 and if we are not careful, we can allow this feeling of comfort with similar individuals to be
reflected in the performance appraisal process. We can avoid similarity error by embracing diversity and
objectively evaluating individual employees based on their actual performance, even if they are different from
us and don’t do things the same way that we do. Proximity error. This error states that similar marks may be
given to items that are near (proximate to) each other on the performance appraisal form, regardless of
differences in performance on those measures. We can avoid proximity error by objectively evaluating
employees’ actual performance on each and every item on the assessment form. Recency error. This error
occurs when raters use only the last few weeks or month of a rating period as evidence of their ratings of others.
For instance, if a warehouse worker has been a strong performer for most of the appraisal period, but right
before his annual evaluation he knocks over a stack of high-cost electronic equipment while driving a forklift,
he may be rated poorly due to recency error. We can avoid the recency error by evaluating the employee based
on the entire assessment period, commonly 6–12 months. Using the critical incidents method really helps our
recall and assessment of the entire period more objectively. Contrast error. In contrast error, the rater compares
and contrasts performance between two employees, rather than using absolute measures of performance to
measure each employee. For example, the rater may contrast a good performer with an outstanding performer,
and as a result of the significant contrast, the good performer may seem to be “below average.” This would be a
contrast error. We can avoid contrast error by objectively evaluating individual employees based on their actual
performance. We must use the ranking method correctly; first we assess each individual based on the items on
the assessment form—then we rank the individuals based on their assessments. Attribution error. In simplified
terms, attribution is a process where an individual assumes reasons or motivations (such as attitudes, values, or
beliefs) for an observed behavior. So, attribution error in performance appraisal might occur when the rater
observes an employee action—such as an argumentative answer to a question—and assumes that the individual
has a negative attitude toward the job and is a poor performer. This may not be true, and in such a case the rater
would be guilty of an attribution error. We need to avoid attribution error because it is based on our subjective
conclusion. When in doubt, we shouldn’t assume we know why the employee did or didn’t do something. We
should talk to employees to find out so that we can objectively evaluate employees based on their actual
performance. WORK APPLICATION 8-9 Identify the major steps we can take to avoid problems with the
appraisal process. 308 PART III: DEVELOPING AND MANAGING APPLYING THE CONCEPT 8-4
Avoiding Appraisal Problems Which of the following common problems or errors is being described in each of
the given situations? a. bias b. stereotyping c. halo error d. distributional errors e. similarity error f. proximity
error g. recency error h. contrast error i. attribution error ____ 16. My year’s performance was not going very
well. So I made sure to really push and do a good job for the month of December, and I got a good performance
review. ____ 17. I did a really good job of coming to all the classes and participating in the discussions, so the
professor gave me an A- even though my test-score average was a B+. ____ 18. I got an average rating, which
is lower than I deserve, because my boss found out I was talking about him behind his back. ____ 19. I’m tired
of hearing how much Juan is selling and being told I don’t measure up. ____ 20. My boss gave me a good
overall rating instead of an excellent rating. I told her I thought I deserve excellent, but she said everyone gets a
good rating and that I’m doing a very good job. Avoiding Performance Appraisal Process Problems As you can
see above, there are a significant number of ways that performance appraisals can fail to provide an accurate
assessment of the capabilities and the behaviors of individual employees. Thus far we have only provided
simple things we can do to overcome these problems as individuals. How can a firm avoid these problems on an
organization-wide basis throughout the performance appraisal process? Luckily, there are a number of fairly
simple steps that we can take within the organization to minimize the negative issues that occur in the
performance appraisal process. All we have to do is look at the problems noted, and we can fairly quickly come
up with some possible solutions to at least the majority of those problems using the same methods. Let’s discuss
how the firm can limit the potential for the appraisal process to go astray by developing accurate performance
measures, training evaluators, and using multiple raters. Develop Accurate Performance Measures As discussed
earlier in this chapter, if the performance appraisal methods and forms are not accurate measures, the entire
performance appraisal process will have problems. Therefore, the organization should have its own HR
specialist or hire consultants to develop the assessment process and measures. Now, let’s discuss three things
HR specialists commonly do to help ensure accurate measures. Use multiple criteria. One method of
overcoming some of the problems with the appraisal process is to ensure that we use more than one or two
criteria to evaluate an individual’s performance over time. We should generally have at least one evaluation
criterion for each major function within an individual job. As we noted earlier, behaviors and results that occur
over the entire course of the evaluation period are typically the best criteria to use in the process of evaluating
an individual’s performance, but employees behave in many different ways in different circumstances
throughout the course of a year, so we shouldn’t Identify the major steps we can take to avoid problems with the
appraisal process. LO 8.9 Chapter 8: Performance Management and Appraisal 309 limit the appraisal process to
one or two actions on the part of that individual employee. By evaluating multiple criteria, we have the ability
to lower the incidence of halo, recency, contrast, and attribution errors, and may even be able to affect bias and
stereotyping, because many criteria, not just one or two, are being analyzed. Minimize the use of trait-based
evaluations. Our next method of overcoming problems within the appraisal process is to minimize the
evaluation of individual traits. As we noted in the section on what we have the ability to evaluate, trait-based
evaluations tend to be more subjective than behavior- or results-based evaluations and as a result should
generally not be used unless there is a specific reason why the particular trait must be exhibited in order to be
successful in a job. Only when we have specific reason for trait-based evaluations should those traits be
measured and evaluated in the appraisal process. In addition, because of their subjectivity, trait-based
evaluations are much more difficult to defend in cases where the organization used the evaluation process for
later disciplinary action with an individual employee. By minimizing the evaluation of traits, we lower the
incidence of bias, stereotyping, similarity error, and potentially attribution error. So, minimizing trait
evaluations lowers the ability of the rater to make some of the most significant mistakes that can occur in the
appraisal process. Give the measures the OUCH and Blanchard tests. Yes. We already stated this with each of
the three types of assessment. But these two tests are so important to successful accurate measures that we are
repeating them again. With the OUCH test, is the measure objective, uniform in application, and consistent in
effect, and does it have job relatedness? With the Blanchard test, does everyone understand why they are
assessed at a specific level (evaluation) and what it takes to get a higher rating (development)?48 Train
Evaluators Once we have accurate measurement methods and forms, the next thing that we should do to help
overcome some of the issues with the appraisal process is to train our evaluators concerning the common errors
and problems that occur and how to use the methods and forms. Train evaluators to overcome the common
problems of assessment. Simply through the process of training, many of the common problems are mitigated,
if not eliminated. Once evaluators become aware that the common errors occur with some regularity, they
almost immediately begin to evaluate such errors and guard against them. Even the bias and stereotyping errors
may be mitigated through the rater training process. As we’ve said several times in this book, most of our
employees want to do a good job, and once they know that an error is being committed, they will make attempts
to correct that error. So, rater training provides them with knowledge of these errors and allows them the
opportunity to correct them. Train evaluators to use the measurement methods and forms. Evaluators should
also be trained to use the various performance assessment methods and forms. Because the critical incidents
method is not commonly used as a formal assessment method, evaluators should be taught to use it to help
overcome recency error. Evaluators need training to effectively use MBO and to write a good narrative. When a
rating scale is used, some training should be given to better understand the differences between the word
descriptors along the continuum (excellent, good, etc.). BARS and ranking forms are fairly straightforward, but
when they are used, some training can help overcome problems. Use Multiple Raters The next tool to minimize
errors in the evaluation process, at least in some cases, is to use multiple raters to evaluate an individual. As we
noted earlier, this becomes expensive very quickly, so we must decide whether or not the value inherent in
using multiple evaluators Briefly discuss the differences between evaluative performance reviews and
developmental performance reviews. LO 8.10 WORK APPLICATION 8-10 Select your current or a past job.
Identify and explain how it did or did not use each of the three methods organizations can use to overcome
common problems during the performance appraisal process. How could it improve the process? 310 PART III:
DEVELOPING AND MANAGING overcomes the cost of the process. If it does, using multiple evaluators can
conquer some significant problems in the appraisal process. What will the process of using multiple evaluators
do to improve the appraisal process? Multiple evaluators limit the ability of one individual appraiser to provide
a biased opinion concerning an employee’s performance, as well as limiting the ability for stereotyping in the
appraisal process. In addition, halo, similarity, contrast, and attribution errors become less likely, and
distributional errors tend to even out among multiple raters. It is for these reasons that 360° evaluations have
gained favor in many organizations over the past 20 years. Debriefing the Appraisal The debriefing process is
where we communicate the analysis of each individual’s performance with that person. Earlier in the chapter,
we noted that there are two major reasons for assessing performance: for evaluative decisions and for
development. We also suggested breaking the formal performance appraisal debriefing into two separate
interviews. In this section, we describe how to conduct both reviews. The Evaluative Performance Appraisal
Interview Planning ahead is critical when it comes to performance appraisal interviews. Therefore, this section
is separated into preparing for and conducting the evaluative interview. Because the evaluative interview is the
basis for the developmental interview, it should be conducted first. Preparing for an Evaluative Interview When
preparing for an evaluative interview, follow the steps outlined in Model 8-2. Our evaluation should be fair
(ethically and legally not based on any of the problems discussed).49 If we have had regular coaching
conversations with our employees, they know where they stand,50 and our preparation is mostly done except
the form. So our relationship with an employee will directly affect the outcome.51 Employees should also
critique their own performance through a self-assessment using the form.52 So Step 1 of Model 8-2 is to simply
set up the meeting. Step 2 has employees use the form to conduct a self-assessment of their performance, and in
Step 3 we, too, assess employees’ performance using the form. In keeping with the balanced evaluation, in Step
4, we identify both strengths and areas for improvement that serve as the basis for the developmental interview.
Last, Step 5 is to predict employee reactions to our assessment and plan how to handle them. Using critical
incidents will help support our assessment when employees disagree. Don’t forget the Blanchard test states that
we should be able to explain, and agree on, the employee’s level of performance. Guide – F:6 Appraisal
feedback SHRM Model 8-2 The Evaluative Performance Appraisal Interview 1. Make an Appointment 2. Have
the employee perform a self-assessment 3. Assess the employee’s performance 4. Identify strengths and areas
for improvement 5. Predict the employee’s reactions and plan how to handle them 1. Open the interview 2. Go
over the assessment form 3. Agree on strengths and areas for improvement 4. Conclude the interview
Conducting the Appraisal Interview Preparation for the Appraisal Interview Video Link 8.2 Prepare for the
Evaluative Interview Chapter 8: Performance Management and Appraisal 311 Conducting an Evaluative
Interview During the interview, encourage employees to talk and listen to the critique of their performance.53
Model 8-2 lists the steps for conducting an evaluative performance appraisal interview. We open the meeting
with some small talk to put the person at ease in Step 1. Then in Step 2 we go over our evaluation of the items
on the assessment form. For Step 3, we identify the employee’s strengths and weaknesses, and discuss and
agree on them. Our last Step 4 is to conclude the interview, which may be to make the appointment for the
developmental interview. When we are the employee, we should be open to negative feedback, even if we don’t
agree with it. We shouldn’t make excuses or blame others. If we don’t agree with the assessment, we should say
something like “Thanks for the feedback, but I don’t agree with it for the following reasons.” Then we should
give our objective reasons without being argumentative and disrespectful. We may want to schedule a follow-up
meeting to have time to gather facts that support our stance on the assessment.54 The Developmental
Performance Appraisal Interview Again, planning ahead is critical when it comes to performance appraisal
interviews. Therefore, this section is also separated into preparing for and conducting the interview. Preparing
for a Developmental Interview After the employee’s performance evaluation is completed, we should prepare
for the developmental interview based on areas for improvement. Yes—managers are busy, and may question
the need for coaching and cost of separate formal developmental interviews, but spending time developing
employees leads to increased performance and lower turnover.55 To do this, follow the steps in Model 8-3,
which begins with simply setting up a time to conduct the review. As stated in Step 2, have employees come up
with their own objectives and strategies for improvement,56 and then develop objectives for them (in Step 3).
Conducting a Developmental Interview The steps to follow when conducting a developmental performance
appraisal interview are listed in Model 8-3. Again, we start with small talk to open the interview. In Step 2, it is
important to agree on developmental objectives. As part of Step 3, employees need to know exactly what they
must do to improve and increase the rating on the next review, and follow-up feedback on progress is essential
for changing behavior.57 So Step 4 is to set up a follow-up meeting to review progress. When conducting Steps
3 and 4, we don’t want the employee working on too many things at once, so keep the number of objectives
Model 8-3 The Developmental Performance Appraisal Interview 1. Make an appointment 2. Have the employee
develop objectives and plans for improving performance 3. Develop objectives and plans for improving
performance 1. Open the interview 2. Agree on objectives 3. Develop plans for meeting the objectives 4. Make
a follow-up appointment 5. Conclude the interview Preparation for the Appraisal Interview Conducting the
Appraisal Interview WORK APPLICATION 8-11 Assess how well your present or past boss helped develop
your knowledge, skills, and competencies through informal coaching and/or the formal performance appraisal
interview. Describe how the boss could improve. 312 PART III: DEVELOPING AND MANAGING between 1
and 3. We can always add new objectives later. We end in Step 5 by concluding the interview with some
positive encouragement about reaching the objectives. Trends and Issues in HRM It’s time to take a look at
some of the trends and issues in performance appraisal over the past several years. The first item in this
chapter’s trends and issues is a question: Should we even be using performance appraisals? Second, we will
take a look at Electronic Performance Monitoring or EPM—does it improve performance and add value to the
organization’s performance appraisal process by providing results-based evidence of employee productivity?
Our third issue deals with the question of competency-based performance management, rather than the
historical task-based evaluation of performance. And finally, we will discuss one method of aligning the
organization’s performance appraisals so that the variability between managers does not cause one group of
employees to suffer relative to another group, due to the fact that the managers don’t happen to evaluate
consistently. Is It Time to Do Away With Performance Appraisals? Samuel Culbert, a clinical psychologist at
the University of California at Los Angeles, has written a book called Get Rid of the Performance Review!58
His premise is that performance appraisals are one-sided analyses by the manager of what the subordinate is
doing wrong. He notes that if the process can become a two-way communication between the manager and the
subordinate, a performance review becomes a “performance preview.” The boss and the subordinate “have
conversations” that allow the manager to become a coach and tutor for the subordinate. However, if you take
note of the purposes for performance appraisals that we identified early in this chapter, communication is one of
the three main aims of the process. As we discussed, we need two-way communication between the supervisor
and the subordinate. If it’s one-way, the process has very little chance of improving the subordinate’s
performance over time. In addition, one of our other purposes—motivation—also requires a continuing
conversation between the supervisor and the subordinate— coaching. The performance management process
does not occur one day a year. If it is going to be successful, it has to occur continuously throughout the year as
the supervisor and the subordinate have conversations about ongoing performance. The most significant
problem, if organizations were to get rid of performance reviews, is that these appraisals are used legitimately
by organizations in order to make good decisions about their employees and their development. If performance
appraisals are not completed, the organization doesn’t have valid and reliable information about the human A
well-designed form can help managers do a good job during the formal performance appraisal. Chapter 8:
Performance Management and Appraisal 313 resources in the organization and therefore has no ability to make
good decisions about things such as training, promotions, pay raises, and other factors. Going back to the
OUCH and Blanchard tests, in any personnel action within the organization we need to attempt to be as
objective as possible. An appraisal process that is done correctly (and most aren’t) is an absolutely necessary
piece if the organization is going to be objective in management of its human resources—one of the most
critical pieces of organizational success today. In fact, what Culbert is really saying is if you are not going to do
it right with accurate measures and coaching, don’t do performance reviews. This is what good managers have
been saying for the last 40 years. If we’re going to be successful in improving employee performance over time,
two-way conversations have to occur that allow employees to identify problems and issues that prevent them
from being as successful as possible—coaching. If coaching occurs, individual performance is almost certain to
increase, and as a result organizational performance will increase overall over the course of time. We will
discuss how to coach in the next chapter. Technology: Electronic Performance Monitoring Electronic
Performance Monitoring (EPM) is the process of observing ongoing employee actions using computers or other
nonhuman methods. The number of employees monitored through EPM has increased drastically in the past 20
years. In the early 1990s, about one third of employees were being monitored electronically. By 2001,
approximately 78% were monitored electronically,59 and in 2010 that number more than likely increased even
more. The reason for this steep increase is that EPM apparently is an effective means of increasing
productivity.60 EPM allows management to know if employees are actually working or doing personal things
during work hours. The biggest upside to EPM seems to be that it provides information for concrete results-
based performance evaluations. Certainly, this is a valuable, outcome. However, some researchers and
practitioners argue against EPM because of a number of factors including ethical questions concerning such
monitoring, legal concerns over employee privacy, and apparent increases in stress due to constant monitoring
of performance. So, the question is whether or not organizations should use EPM systems. There’s no simple
answer to such a question. Again, EPM has been shown to increase productivity, and organizations need to
maximize employee productivity. However, increases in stress are known to decrease productivity if the stress
level becomes too significant. So there’s an obvious trade-off between more employee monitoring and
controlling stress levels in our workforce. Management must understand this trade-off in order to successfully
improve productivity in the organization overall. In addition, the ethical and legal questions noted in the
previous paragraph may be significant enough in some cases to cause individual employees to leave the
organization. If these individuals are our more productive workers, and especially if they are knowledge
workers, what does the loss of these knowledgeable individuals do to organizational productivity? There
doesn’t appear to be any current research-based answer to these questions. Therefore, because these questions
exist, organizations must be very careful in how they implement EPM processes so that they improve their
chances of reaching the stated goal of EPM—improving organizational productivity. Finally, as these programs
are rolled out in the organization, managers must be acutely aware of the potential for increased levels of stress
as well as employee feelings concerning invasion of privacy that could lead to decreases in productivity and
higher rates of turnover as well.61 In other words, management must work to overcome the potential problems
and costs in order to gain the benefits. WORK APPLICATION 8-12 Select an organization you work or have
worked for. Does it use formal evaluations? Do you believe the organization should or should not conduct
formal evaluations? Guide – F:4 Electronic monitoring SHRM 314 PART III: DEVELOPING AND
MANAGING Competency-Based Performance Management What is competency-based performance
management? Historically, the performance appraisal process evaluates specific employee skills and the
employee’s success in using those skills to produce products or services for the organization. Competency-
based performance, on the other hand, evaluates large sets of capabilities and knowledge which, if put to good
use, can significantly improve organizational productivity to a much greater extent than just doing a job using
an existing skill set. Or, using Chapter 7 terms, development is more effective than simply training. Because
jobs have been changing at a rapid pace over the past 20 years, competencybased performance management is
becoming a more useful form for performance appraisal than the historical skill-based, transactional process.
How are jobs changing? According to the Society for Human Resource Management (SHRM), the nature of
work is changing from single-skilled jobs to multiskilled jobs, from repetitive tasks to problemsolving tasks,
from individual work to teamwork, and from functional specialization to collaboration.62 Taking a look at the
ways in which work is changing, we can understand why it may be necessary for the organization to move from
skill-based performance appraisal to evaluations based on larger-scale competencies. Because competencies are
becoming so significant in organizations, the performance management systems need to be redesigned so that
we evaluate the skills and capabilities that are most important to the business. However, these types of
performance management systems can present significant design challenges to the organization. To successfully
use competency-based performance management, the organization has to move from an analysis and
measurement of the individual activities within a process to a more holistic evaluation of the ability to combine
and improve activities to create the most successful organizational outcomes. SHRM notes that one of the
problems with knowledge workers is that “performance analysts cannot directly observe much of what they
do.”63 This being the case, new competencybased evaluation methods that measure the ability to manipulate
and manage information and to collaborate across many dimensions must be designed and used. SHRM
explains that because the most common type of historical job (the individual repetitive job) is going away, the
organization has an increasing need for competency-based evaluations. They also note that competency-based
evaluations are necessary in order to align performance with rewards if the organization is going to use a
competency-based pay and incentives program.64 Competency-based pay programs have been shown to focus
individual goals more closely to the organization’s overall strategic goals. Because of all these factors,
competency-based performance appraisals will likely continue to increase as a percentage of overall
performance appraisal processes. Aligning the Appraisal Process The last of our trends and issues for Chapter 8
deals with problems that occur because of harder and easier individual evaluators causing the performance
appraisal process to be inconsistent. But, what processes can be created in the organization that will minimize
this inconsistency? There are two approaches. One method is to gather all of the raters, within a given division,
department, or section of the organization, in one place where they discuss each of the individuals being
evaluated. A process called “calibration” provides the organization with a methodology for normalization of
grades across raters.65 Many organizations have done something similar to the process of calibration for years
by gathering groups of managers together and, through a series of discussions, coming to an agreement on the
rating of each of their employees. WORK APPLICATION 8-14 Select an organization you work or have
worked for. Does it use competency-based performance management? Do you believe the organization should
or should not use it? WORK APPLICATION 8-13 Select an organization you work or have worked for. Does it
use EPM? If so, describe the EPM system. Do you believe the organization should or should not use EPM?
Chapter 8: Performance Management and Appraisal 315 Calibration is done face-to-face with a group of
managers who are responsible for one division or department within the organization. However, the end result
of the calibration process is not necessarily a ranking of employees. It is designed simply to standardize, or even
out, evaluations between multiple managers. There are some issues with this process, though. If one manager is
a better communicator or persuader than another, the process can still be inconsistent. Managers who are quiet,
and who generally will not speak out in favor of or against something, may be at a disadvantage in these types
of meetings. In order for a calibration or ranking meeting to be successful, all of the managers in the room must
be given a chance to speak on behalf of their employees. In fact, a professional facilitator may help to get
individual managers the time to speak in support of their employees. There’s no perfect method of ensuring that
performance appraisals are consistent between different managers in the organization. However, open meetings
where managers discuss each of their individual ratings can help to minimize the differences between raters. On
the other side, autocratically dictating a ranking process based on a forced distribution also helps overcome this
problem of managers being too hard and easy in their evaluations. But not allowing managers to have input into
the method of making raters more consistent in their assessments can lead to other problems within the
performance appraisal process. So, two important questions must be considered in deciding on using
participation in calibration or dictating a mandatory forced distribution. First, what are the chances of getting
the group of managers to agree on a calibration? If you know you have managers who very firmly disagree on
assessment, one being very hard and another being very easy, maybe calibration will not work and could cause
problems between managers. Second, dictating a forced distribution is faster and thus costs less. So do the
benefits from participation in calibration outweigh the costs of the time and effort to use calibration? In a
knowledge-based organization, the answer is often yes, but not always. Wrap-Up This chapter has covered the
process of managing employee performance. What have we learned that will allow us to become better
managers? We discussed the concept of performance management, and noted that it is a continuous process, not
a once-a-year evaluation of performance. We then proceeded through a discussion of the steps in the
performance appraisal process. We answered the question of why we even do them. Next we looked at what we
evaluate—traits, behaviors, and results—and identified and then discussed how the evaluation is typically done
using various assessment methods and forms. We then discussed options for who can complete the appraisal,
why we would choose one option over others, and when a 360° evaluation is valuable. After covering the
assessment process itself, we then presented some of the common problems that individual evaluators and
organizations encounter with the appraisal process and how to minimize or even overcome those problems.
Then we discussed the debriefing process, where the manager and the subordinate sit down and discuss the
employee’s evaluation. Here, we discussed the two types of debriefs—the evaluative and the developmental
appraisal interview. Finally, we examined some of the trends in appraisal of employees in the firm, including
whether or not to even complete them, the use of electronic monitoring to evaluate performance, the change in
some organizations to a competency-based performance evaluation process, and, finally, how to make the
process more consistent across raters. That’s another big dose of information, and enough for this chapter, so
let’s move on to the chapter summary and end-of-chapter material. WORK APPLICATION 8-15 For a change,
let’s use your college professors’ grading. Are some professors hard graders (they give few As) and others easy
(they give lots of As), or are they all consistent? Assuming there is inconsistency, should the college
administration dictate a forced distribution or use calibration? Video Link 8.3 Performance Evaluation 316
PART III: DEVELOPING AND MANAGING 8.1 Discuss the difference between performance management
and performance appraisal Performance management identifies, measures, manages, and develops the
performance of people in the organization. It is designed to improve worker performance over time.
Performance appraisal is the part of the performance management process that identifies, measures, and
evaluates the employee’s performance, and then discusses that performance with the employee. 8.2 Identify the
necessary characteristics of accurate performance management tools The performance management tools that
we use need to be valid and reliable, acceptable and feasible, and specific. Valid means that it measures the
process that we wanted to measure. Reliable means the measure works in a generally consistent way each time
we use it. Acceptability and feasibility deal with the measure being a satisfactory measure with the people who
use it and a reasonable measure capable of being successfully applied in a particular situation. Finally, specific
means the measure defines the performance well enough that we understand the current level of performance
achieved and what, if anything, employees need to do to improve their performance to comply with standards.
8.3 List and briefly discuss the purposes for performance appraisals Communication is the first purpose.
Appraisals need to provide an opportunity for formal two-way communication between management and the
employee concerning how the organization feels the employee is performing. The second purpose is
“information for evaluative decisions.” We need good information on how employees are performing so that we
can take fair and equitable actions with our workforce, to improve organizational productivity. Motivation for
development is the last major purpose. Used correctly, appraisals can motivate by providing opportunities for
employees to improve their performance over time. 8.4 Identify and briefly discuss the options for “what” is
evaluated in a performance appraisal Our three primary options are traits, behaviors, and results. There is some
evidence that particular types of traits are valuable in jobs that require management and leadership skills, but
many traits have been shown to have very little bearing on job performance, making them invalid measures of
performance. We can also use behaviors to evaluate our workers. Behaviors are usually a much better appraisal
option because physical actions or behaviors can be directly observed and as a result are more likely to be a
valid assessment of the individual’s performance. Finally, we can evaluate performance based on results.
Results are a concrete measure of what has happened in the organization. However, results may be skewed
based on factors that are outside the control of the individual who is being evaluated. 8.5 Briefly discuss the
commonly used performance measurement methods and forms The critical incidents method utilizes records of
major employee actions over the course of the appraisal period in order to complete the employee evaluation.
The MBO method uses objectives jointly set by the manager and the employee to gauge employee performance
during the evaluation period. In the narrative method, the manager writes either a structured or an unstructured
paragraph about the employee’s performance. Graphic rating scale forms provide a numerical scale so that the
manager can check off where an employee falls on the continuum. BARS forms provide a description of the
behaviors that make up acceptable performance at each level on the scale. Finally, the ranking method creates a
hierarchy of employees from best to worst. 8.6 Identify and briefly discuss available options for the
rater/evaluator Supervisors are a logical choice when they have ongoing contact with the subordinate and know
the subordinate’s job. When the supervisor may not spend lots of time with the individual employee, peers may
be a better choice as evaluators because they may know the job of the individual employee better than the
supervisor does, and are more directly affected by the employee’s actions. Subordinate evaluations can give us
good insight into the managers who control employees in our organization. We may want to use customers as
evaluators when the individual being evaluated has frequent contact with those customers because we need to
know how customers feel about their interactions with our employees. Self-evaluation is valuable in a number
of management processes, from training and development to counseling and disciplinary measures, among
others. 8.7 Briefly discuss the value and the drawbacks of a 360° evaluation The 360° evaluation gives us the
best overall analysis of any employee in the firm, because it looks at the employee’s performance in the eyes of
all others who are affected by the individual. Chapter Summary Visit www.sagepub.com/lussier for helpful
study resources. Chapter 8: Performance Management and Appraisal 317 The 360° evaluation format is more
useful for individual development than it is for administrative purposes. The biggest downside is that the
process takes a lot of time, which means that it also costs the company a lot of money. 8.8 Identify some of the
common problems with the performance appraisal process Personal biases and stereotyping are two of the most
significant appraisal problems. Other problems include halo error; distributional errors—the grading is either
too harsh or too lenient, or everyone is judged to be average; similarity error; proximity error; recency error;
contrast error; and attribution error. 8.9 Identify the major steps we can take to avoid problems with the
appraisal process The first step would be to develop accurate performance measures. Accurate performance
measures use multiple criteria, minimize trait-based evaluations, and can be analyzed using the OUCH test and
the Blanchard test. Next, train the evaluators, because as soon as they know some of the common errors, those
errors become less pronounced. Use multiple raters to mitigate any potentially biased evaluations and minimize
other errors such as similarity, contrast, and attribution errors. Finally, don’t evaluate what you don’t know.
Find people in the organization who do know the job and have them evaluate the individual performing that job.
8.10 Briefly discuss the differences between evaluative performance reviews and developmental performance
reviews The evaluative interview is a review of the individual employee’s performance over a certain period.
The evaluation needs to be fair and equitable, not based on bias. Employees must be given the opportunity to
talk as well as listen to the critique of their performance. The developmental interview, on the other hand, will
focus on areas for improvement over time. Managers should have employees come up with their own objectives
and strategies for improvement, as well as develop their own objectives for employees. 360° evaluation
Behaviorally Anchored Rating Scale (BARS) form Behaviors Bias Critical incidents method Electronic
Performance Monitoring (EPM) Graphic rating scale form Management by Objectives (MBO) method
Motivation Narrative method or form Performance appraisal Performance management Ranking method
Results Stereotyping Traits Complete each of the following statements using one of this chapter’s key terms:
________ the process of identifying, measuring, managing, and developing the performance of the human
resources in an organization ________ the ongoing process of evaluating employee performance ________ the
willingness to achieve organizational objectives ________ identify the physical or psychological characteristics
of a person ________ the actions taken by an individual ________ a measure of the goals achieved through a
work process ________ a performance appraisal method in which a manager keeps a written record of positive
and negative performance of employees throughout the performance period ________ a process in which
managers and employees jointly set objectives for the employees, periodically evaluate performance, and
reward according to the results ________ requires a manager to write a statement about the employee’s
performance ________ a performance appraisal checklist on which a manager simply rates performance on a
continuum such as excellent, good, average, fair, and poor Key Term Review Key Terms 318 PART III:
DEVELOPING AND MANAGING ________ a performance appraisal that provides a description of each
assessment along a continuum ________ a performance appraisal method that is used to evaluate employee
performance from best to worst ________ analyzes individuals’ performance from all sides—from their
supervisor’s viewpoint, from their subordinates’ viewpoint, from customers’ viewpoint (if applicable), from
their peers’ viewpoint, and using their own self-evaluation ________ a personality-based tendency, either
toward or against something ________ mentally classifying a person into an affinity group, and then identifying
the person as having the same assumed characteristics as the group ________ the process of observing ongoing
employee actions using computers or other nonhuman methods 1. The annual performance evaluation process is
naturally motivational because the company identifies each employee’s weaknesses. T F 2. In performance
appraisals, the word specific means that the form provides enough information for everyone to understand what
level of performance has been achieved by a particular person within a well-identified job. T F 3. As a manager,
an important part of your job is to make sure that your employees know exactly what is expected of them—the
standards. T F 4. The basic performance appraisal is very simple to carry out. T F 5. To meet the
communication purpose of performance appraisals, managers have to allow the employee the opportunity to
speak to them concerning factors that inhibit their ability to succeed. T F 6. Without good information on
performance of individual workers, managers cannot make reasonable decisions about their workforce. T F 7.
Traits that most people would be likely to focus on, such as physical attractiveness, punctuality, and
extroversion, have been shown to have very little bearing on job performance. T F 8. Results-based appraisal is
the most concrete, or factbased, form of appraisal. T F 9. The critical incidents and MBO methods tend to be the
best appraisal methods for an evaluative interview. T F 10. The immediate supervisor is always the best person
to evaluate any employee. T F 11. Personality conflicts and personal biases can affect how individual
employees rate their peers. T F 12. Subordinate evaluations must be confidential in nature, or it is unlikely that
the subordinates will provide an honest evaluation of their supervisor. T F 13. We rarely use 360° evaluations
because they are so difficult to coordinate. T F 14. If they are guilty of halo error, evaluators assume reasons or
motivations (such as attitudes, values, or beliefs) for an observed behavior. T F 15. Using multiple evaluators
will limit the ability of one individual appraiser to provide a biased opinion concerning an employee’s
performance. T F The following critical-thinking questions can be used for class discussion and/or for written
assignments to develop communication skills. Be sure to give complete explanations for all answers. 1. Other
than an annual evaluation, what would you do to “manage” the performance of your employees? Explain why
you chose the items that you did. 2. What would you do as the manager in order to make sure that your
employees knew the standards that they would be evaluated against? Explain your answer. 3. Do you really
think that it is possible for a performance appraisal to be motivational? Why or why not? 4. Can you think of a
situation where a trait-based evaluation would be necessary? Explain your answer. 5. You are in charge, and
you want to evaluate a group of assembly workers. Who would you choose as the evaluator(s)? What about an
evaluation of the director of operation? Explain your answer. 6. How would you minimize the chance that
stereotyping could affect the evaluation process in your company? Quick Check (True-False) Communication
Skills Chapter 8: Performance Management and Appraisal 319 7. Which of the solutions to performance
appraisal problems would you implement first if you were in charge? Second? Why? 8. What would you do to
make the performance appraisal debrief more comfortable and less confrontational for your employees? How do
you think this would help? 9. Do you agree that performance appraisals should be discontinued in companies?
Defend your answer. 10. Is Electronic Performance Monitoring ethical? Would you use it if it was your choice?
Why or why not? Cases Please visit the student study site at www.sagepub.com/lussier to view the video links
in this chapter. REVIEW QUESTIONS (TRUE-FALSE) Answers 1. F 2. T 3. T 4. F 5. T 6. T 7. T 8. T 9. F 10.
F 11. T 12. T 13. F 14. F 15. T Video Answers Case 8-1. Beauty and the Beastly Situation at Aerospace
Designs’ Marketing Department “Oh no! What now?” said Tom Moore, Director of Human Resources at
Aerospace Designs. “Just when I thought this mess was over on how the Marketing Department does
performance appraisal, we’re smacked with a sexual harassment lawsuit. Well, we’ve got to do something about
this predicament, and fast.” Aerospace Designs Background Aerospace Designs (AD) was founded in the early
1960s. A privately held company started by two engineers, it was deliberately designed to feed off the
blossoming U.S. military budget as the United States fought the Cold War. It became part of the supplier system
to the massive Grumman contractor on Long Island, New York, and took on a military-like culture and
structure. Aerospace’s Marketing Department Aerospace Designs was predominantly a population of White
males, and the hiring of minorities and women would assist in meeting its government-imposed affirmative
action goals. The Marketing Department had never employed women. It was a very flat structure, consisting of
three internal salesmen, a sales coordinator on-site, and one road salesman, who all reported directly to Frank
Fasting, the Vice President of Sales and Marketing. (See Appendix A for an abbreviated organizational chart of
the Sales and Marketing Department.) Aerospace Designs had hired Frank in hopes that he would be able to
bring it out of its recent trend of flat growth. He was expected to grow the existing stable aerospace electronics
business, and to firmly establish both a lights product line and a land-based vehicle business for military and
commercial operations. The addition of new staff positions to the Marketing Department, of which the
Marketing Assistant was one, was designed to help establish a web presence and improve the capabilities for
print media and trade show coordination. Enter Lola Lola Meyer was above average in height, single, blonde,
and 32 years old with lingering aspirations to be a model. Having a four-year degree, and opting out of the
education field, she came over to Marketing in an attempt to find a steady job where she might be taken
seriously. Although Frank had reservations regarding hiring Lola for the job given her qualifications, Sue Jones,
the Human Resources Manager, eventually persuaded him to give Lola a chance. After a few months on the job,
Frank approved arrangements for Lola to take courses related to the work that needed to be done, as it became
apparent that she lacked some technical marketing skills necessary to be effective in her position. 320 PART III:
DEVELOPING AND MANAGING Lola’s Performance Evaluation The ensuing year went by without fanfare.
Lola, Frank, and the rest of the Marketing Department seemed to coexist amicably. Frank proved to be an
outgoing, friendly sort, as you might expect of someone who is in Sales. His greatest weakness as a manager
seemed to be his lack of administrative follow-through. Aerospace Designs policies dictated an annual
performance evaluation for every employee. This review unfortunately hadn’t been done by Frank in a timely
manner for Lola. By the time January rolled around, Lola’s review was two months late. Frank discussed with
Sue that he was not pleased with Lola’s performance to date and would indicate such on her review. Sometime
in April Frank became ill and needed to take time off to care for his personal health. Lola’s review was written
by Frank but not formally presented to Lola. Since it was now delayed nearly five months and it was apparent
that Frank would be out for several more months, the decision was made to have Mark Gurello (Senior Sales
Manager overseeing Marketing in Frank’s absence) present Lola with the poor performance evaluation. This
took place at the end of April. Lola was rated overall as “less than competent” and was not given a salary
increase. Lola’s Reaction Lola was both shocked and dismayed. In the beginning of May, she met with Sue to
discuss her performance review. She handed Sue an 18-page, handwritten rebuttal of her evaluation. Her reply
admitted her inability to reach designated goals, but stated that her performance was hindered due to items
beyond her control. During this discussion with Sue, Lola alleged that sexual conversations and behavior had
occurred in her work environment. Specifically, she cited that Frank had used highly inappropriate language,
including nicknames for the President of Aerospace Designs. When she walked in on one of these conversations
and was asked to comment, she abruptly left, and immediately filed her rebuttal report with HR. Sue’s Response
and Lola’s Bombshell Upon reading about these incidents, Sue conducted a prompt, thorough internal
investigation and determined that Lola’s performance was marginal and upheld the performance review as
written. She also determined that inappropriate conversations had taken place, and Frank received a written
reprimand and was required to attend sexual harassment awareness training when he returned to the job. Lola’s
supervisor was permanently changed to Mark, and her workstation was moved to the other side of the
Marketing area, away from Frank’s office door. Lola was agreeable to these actions taken by the company.
However, three months later Lola filed a sexual harassment lawsuit against the firm, stating that she could not
get a fair evaluation given the harassing environment she was working in. Questions 1. What evidence does this
case provide for formulating and implementing a systematic approach to performance appraisal? 2. Do you
believe that Lola’s performance evaluation was valid and reliable? Do you feel that Frank had a bias or
stereotypical mind when filling out the evaluation? Explain your answer. 3. What in the case indicates a
problem with this supervisor’s evaluation? Please connect examples from this case to what the chapter
discusses. 4. How did Lola, her supervisor, and human resources communicate with one another? Do you feel
that a performance appraisal interview should have been more formally established and conducted? Why or
why not? 5. How can Lola’s accusation of sexual harassment affect her personal work performance and her
performance evaluation? Case created by Herbert Sherman, PhD, and Mr. Theodore Vallas, Department of
Management Sciences, School of Business Brooklyn Campus, Long Island University Abbreviated
Organizational Chart Sales and Marketing Department, Aerospace Designs, Inc., 2001 Mark Gurello Senior
Sales Manager Al Suttmeier Sales Manager Paul Shane Applications Manager Ray Tiedermann Sales Support
Coordinator Frank Fasting Vice President Chapter 8: Performance Management and Appraisal 321 Case 8-2.
Performance Evaluation at DHR: Building a Foundation or Crumbling Ruins? DHR Construction was managed
by Richard Davis, operating manager and senior partner. Homes were built on-demand to customer
specifications. Richard Davis was in charge of the financial management of the firm including working with
suppliers, creditors, and subcontractors (obtaining bids and construction loans). Davis and Richard Hodgetts,
the general partner, met on a weekly basis and communicated through phone calls and e-mail. The role of
project foreman was delegated to either one of their subcontractors or a hired employee and, in the worst-case
scenario, filled by a reluctant Hodgetts (who had a full-time job outside of the business and had minimal free
time). DHR earned a reputation for honesty, promptness in paying bills, and professionalism—rare commodities
for a small home builder in the area. However, DHR was also very demanding of suppliers—if you promised a
job was going to be completed or supplies were going to be delivered by a certain date and you did not meet the
deadline, you were going to hear from the firm. Repeated miscues would result in not being asked to bid on
future projects. Enter James Kennison James Kennison was a successful corporate executive who was good
with his hands; his main hobby and passion was working on his home. His mild-mannered, laid-back approach
to life was perfect for the professional environment of his former firm, MicroTech, a business that produced
specialized electronic parts and gauges. Kennison left the corporate world when he became economically self-
sufficient in order to simplify his life, reconnect with nature, and become, as he called it, “self-actualized.” In
order to keep busy, Kennison decided that he would put his passion for building to good use and hire himself
out as an independent handyman/subcontractor. His aptitude, acumen, and eventempered style made it very
easy for Kennison to fit into any work crew that would hire him. After a few jobs, Kennison decided to work on
his own and hired himself out as a finisher on home construction projects. It was in that capacity that Kennison
was originally hired by Davis and Hodgetts to work as a subcontractor on the homes in their Mountain Trails
project. Kennison’s wit, charm, and polished demeanor sat well with Davis and Hodgetts, and he became a
fixture at their weekly business meetings. It was not surprising, then, that Davis and Hodgetts approached
Kennison about taking over the position of contractor/foreman when a sudden vacancy occurred. Kennison had
a plethora of experience, had a real head for business, and was respected by the other subcontractors as a fellow
artisan, one who knew the work and was not afraid to get dirty doing it. Although Kennison seemed open and
honest in his dealings with Davis (with Kennison consistently indicating that all was going well), it didn’t take
more than a month before Davis realized that all was not going as planned. Davis’s Gantt chart indicated that
several homes were falling behind schedule with one of the homes failing inspection. Evaluative Appraisal
Interview: Cracks in the Drywall? Davis and Hodgetts talked about the situation at some length and decided that
both of them needed to talk with Kennison at the next dinner meeting and find out exactly what was happening
at the job site since Kennison hadn’t commented on work delays or problems with the inspectors. At the
meeting, Davis reiterated with Kennison what he thought were the job responsibilities, the important tasks to be
accomplished, and the need to have open and candid communications between them. Kennison admitted that
getting subcontractors to show up as scheduled was starting to become a problem and that he thought that the
construction inspections would be quickly dealt with. He apologized for the delays and said that he would keep
in better contact with Davis and let him know exactly what was happening, especially if there were any new
problems. Davis reminded Kennison that he needed to keep a close watch on the subcontractors since they had a
tendency to work for multiple builders simultaneously and therefore would jump from job to job. Kennison
assured Davis and Hodgetts that he would manage the situation and that things would improve. The talk with
Kennison seemed to get things back on track. Kennison provided Davis with a list of the subcontractors to
invite to their dinner meetings. When the issue was raised with these subcontractors about work scheduling, the
subcontractors promised to do the best they could to perform the work as required. The next few days saw a
flurry of activity at the work site as the subcontractors, guided by Kennison, tried to catch up with the
construction schedule. The next inspection came off without a hitch. Here’s to the New Boss, Same as the Old
Boss After a few days, the subcontractors were back to their old routine of not showing up at the work site when
planned. After a few weeks went by, Kennison tried to cover for the work not being done by the subcontractors
but to no avail. The situation deteriorated when one of the home purchasers, who visited the work site, reported
to Davis that their home was way behind schedule. After a quick talk with Kennison, several of the
subcontractors had to be fired by Davis because they continued to not show up when scheduled without
notification. Worse, now other subcontractor]s (e.g., painters) were quitting because the homes were not ready
to work on. Questions 1. What appraisal method best describes how Davis and Hodgetts evaluated Kennison’s
work? 322 PART III: DEVELOPING AND MANAGING 2. Given your answer to Question 1, why do you
believe that this method of appraisal did not produce long-lasting results in Kennison’s ability to manage the
subcontractors? 3. Assume that you are Davis and Hodgetts. What appraisal system would you use for
Kennison? Why? 4. Evaluate how well Davis and Hodgetts prepared for and conducted the appraisal interview
with Kennison. 5. Discuss “who” evaluated and “who” should be evaluating Kennison’s performance. Explain
why. Case created by Herbert Sherman, PhD, and Mr. Theodore Vallas, Department of Management Sciences,
School of Business Brooklyn Campus, Long Island University Chapter 8: Performance Management and
Appraisal 323 SKILL BUILDER 8-1 Peer and Self-Assessment This exercise actually includes the usual self-
assessment for each chapter, and an evaluation of peers, plus developing measures of performance. Objective
To develop your skill at assessing your performance and that of your peers. To develop your skill at developing
measures of performance. Skills The primary skills developed through this exercise are: 1. HR Management
skill—Conceptual and design skills 2. HRM 2010 Curriculum Guidebook—F: Performance management
Assignment Part 1—Self-Assessment During your college courses, you most likely had to do some form of
group assignment. Select one group you worked with for this assignment. Based on your performance in your
prior group, or it could be for this course, do a self-evaluation using the rating scale form below. Evaluator
(you) ____________________________________ (Self-Evaluation) This exercise can stop with just a self-
assessment or continue to also include peer evaluations. A A– Always B+ B B – Usually C + C C– Frequently
D+ D D– Sometimes F Rarely 324 PART III: DEVELOPING AND MANAGING Assignment Part 2—Peer
Review 1. Part 2 begins by conducting a peer evaluation using the above form for each of the other members in
your group with this heading: Group Member ______________________________ (Peer Evaluation) Either
copy the above form for each group member, do your assessment on any sheet without the form, or your
instructor will provide you with a form that includes multiple forms for you to complete for each group
member. 2. Below, rank each group member (including yourself) based on his or her performance. The first
person listed (number 1) should be the best performer, and the last person listed should be the least effective
performer, based on the performance appraisal above. If members are close or equal, you may assign them the
same rank number, but you must list the better one first. 3. To the right of each group member (including
yourself) place the letter overall grade (A–F) you would assign to this member based on the performance
appraisal. You may give more than one member the same grade if he or she deserves the same grade. You may
also use plus and minus grades. Rank Name Grade _____________
__________________________________________________ _____________ _____________
__________________________________________________ _____________ _____________
__________________________________________________ _____________ _____________
__________________________________________________ _____________ _____________
__________________________________________________ _____________ SKILL BUILDER 8-2
Debriefing the Appraisal Note: This exercise is designed for groups that have been working together as part of
the course requirements for some time. It is a continuation of Skill Builder 8-1. Based on your peer evaluations,
you will conduct performance appraisals for your group members. Objective To develop a plan to improve your
team performance, and to develop your skills in conducting performance appraisals. Skills The primary skills
developed through this exercise are: 1. HR Management skill—Conceptual and design skills 2. SHRM 2010
Curriculum Guidebook—F: Performance management Assignment You will be both the evaluator and
evaluatee. Get together with group members and beginning with the letter A have each member select a letter.
Pair off as follows: A and B, C and D, E and F, etc. If there is an odd number in the group, each member will sit
out one round. A, C, and E (etc.) conduct the evaluation interview using the form in Skill Builder 8-1, directly
followed by the developmental interview to give suggestions on improve group member’s performance for B,
D, and F (be sure to follow the evaluative and developmental interview steps in Models 8-1 and 8-2). Be an
evaluator and evaluate; do not be peers having a discussion. When you finish, or the instructor tells you the time
is up, reverse roles of evaluator and evaluatee—B, D, and F are the evaluators. When the instructor tells you to,
or the time is up, form new groups of two and decide who will be the evaluator first. Continue changing groups
of two until every group member has appraised and been appraised by every other group member. Apply It
What did I learn from this experience? How will I improve my group performance in the course? How will I use
this knowledge in the future?
Performance Appraisal Methods for Startups & Small Businesses
By Uma Roychoudhuri
In Performance Reviews
Comments

Performance appraisal method is a systematic process that evaluates an individual employee’s

performance in terms of his productivity with respect to the pre-determined set of objectives. It is an
annual activity, which gives the employee an opportunity to reflect on the duties that were dispatched by
him, since it involves receiving feedback regarding their performance. It also evaluates the individual’s
attitude, personality, behaviour and stability in his job profile. There are various applications of
appraisals like compensation, performance improvement, promotion, termination, test validation, and
much more. Various performance appraisal methods are followed by organisations to ensure fair
appraisals to their employees. Appraisals facilitate communication between the management and the
employees, which helps in conveying the expectations of the management to the employee and vice versa.
The frequency of appraisals varies. Most MNCs offer them annually, some opt for shorter cycles like half
yearly, or quarterly, or even monthly, if the employees performs exceptionally at his job. It is subjective
to the performance appraisal method that is used, and the purpose of the appraisal. In case of startups, it
has been observed that shorter cycles are preferred, so that they can motivate their employees more
frequently to perform better.
The criteria for performance appraisal methods are based on various aspects like productivity, quality of
work, duration of service and training. Productivity is measured mostly in the case of manufacturing i.e.
the number of units manufactured or delivered by the employee. In case of quality of work, precision of
the work done is taken into consideration. Duration of services is used as a criterion by Government
entities, where they assume the longest serving employee to be the deserved one for an appraisal. When
an employee is hired in an organisation, his appraisal is subjective to the speed at which he grasps things
and information he is exposed to.
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Performance appraisal methods based on the above-mentioned criteria are listed below:
1. Assessment Centre Method:
The purpose of this method is to test candidates in social situations. It can be used by startups for
evaluating employees serving at senior level. This method of evaluation is helpful for assessing managers,
who have to deal with their subordinate, peers and supervisors for day-to-day business. It helps
employers understand the capacity and the capability of the individual in social settings. It involves using
situational exercises like an in-basket exercise, role-playing incident, business game and many other
similar exercises. It gives the employer an insight to the personality of the employee like openness,
tolerance, introversion/extroversion, acceptability, etc.
2. Behaviourally Anchored Rating Scale:
This is latest a modern appraisal technique, which has been developed recently. It is claimed that the
Behaviourally Anchored Rating Scale method is one of the most equitable technique compared to other
methods of appraisals. It is a combination of narrative techniques like essay evaluation and quantifiable
techniques like rating scale. It is comparatively more expensive than other techniques, but it usually
guarantees precision and effectiveness.
3. Critical Incident Technique:
This technique is similar to the essay evaluation method. It involves making statements that describes
both the positive and the negative reactions to stimulus by the employee at his work place. The statements
are recorded cumulatively in a given period of time, so that one can evaluate how good the employee is at
his job. His proficiency will be determined by how he deals with his day-to-day activities. The appraiser
in this method is usually the direct supervisor or manager under whom the employee is serving. This
technique is not only used for performance appraisals but also utilized in job interviews. The interviewer
gives scenarios to the interviewee and asks them, how they would react to the given scenarios.
4. Essay Evaluation:
The essay method is an affordable and effective way of appraising employees, especially in startups. This
method involves writing a detailed descriptive essay of the performance by the employee’s direct
supervisor or manager. The essay concentrates on describing the various strengths, weaknesses, attitude
and behaviour of the individual towards job duties. This method is less structured and thus gives the
appraiser an opportunity to explore and describe niche qualities or shortcomings of the employee that
need to be worked on. It is far less complicated to execute compared to the other methods, only if biases
could be kept at bay.
5. Human Asset Accounting Method:
This is a very commercial and practical performance appraisal methods for organisations. In this
scenario, the human capital is associated with the amount of revenue that individual generates, or the
number of happy customers, or the number of leads generated in sales. It is a fair process from the point
of view of the organisation and the employee, because it directly indicates the profitability of the
company. This method is adopted by most startups, since it is easy to execute and track. Therefore, the
amount of business generated by an employee determines whether he deserves to be promoted or
terminated.
Also Read about the best Performance Management System
6. Management By Objective:
A rather interactive and fair form of appraisal, the Management By Objective method is less time
consuming and of course cost effective. The technique involves setting up of objectives and goals for the
employee either by the employer, or his manager, or both employee and employer. This performance
appraisal method helps the employee to perform better, because he is well aware of his goals and already
knows the quality and quantity that needs to be delivered. It has been observed that when both employee
and employer together decide the objectives, the probability of the individual meeting the goal is much
higher. This is a fair method of evaluating because the employee knows the odds that he is measured
against. It doesn’t involve giving constant feedback to the employee, because he is being constantly self
introspective, thereby saving time and efforts of the employer.
7. Paired Comparison Method:
This method bears more relevance and importance in startups/SMBs, which have small teams. It
compares each employee with every individual present in the same team and depending on their
comparative performance to the employee who has performed the best, appraisals are given. It is
considered reliable because it follows a systematic method of comparative evaluation. This technique is
most apt when, the organisation plans on giving appraisal only to the best employee in the team.
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8. Rating Scale:
This performance appraisal method can be used by startups and small businesses that are scaling and are
trying to set up processes in place. It is process-based and involves the organisation to set pre-determined
objectives that employees are expected to meet. Individuals are then rated by their supervisors or
managers. It is similar to the grading system that is usually followed in schools, but is effective and
systematic. Employees are evaluated for their skills, teamwork, communication skills, precision, etc. And
they are expected to meet a basic score. If they do not meet the score then they are sent for performance
improvement training which would help them cope up with their shortcomings.
9. Trait Focussed Appraisals:
This technique is useful for reinforcing positive work ethics and culture in the organisation. It considers
attributes like helpfulness, dependability, punctuality, etc for being appraised by the organisation. It
motivates employees to be competitive in a fair manner and yet be available for helping out colleagues if
need be. Startups should consider giving their employees trait focused appraisals once in a while, because
it reinforces positive culture in the organisation.
10. 360 Degree Feedback:
This method involves getting a feedback about the employee from every individual who interacts with
him during his working hours. They can be his peers, his subordinates, his superiors, customers who
have interacted with him and even he himself would be interviewed about his perception of himself and
his duties at the workplace. This performance appraisal method would be very useful for startups,
because the best way to review an employee’s overall performance and get an insight about his
behaviour, personality and attitude this is the best method to follow. Although it is a little time
consuming, but it is cost effective and precise. It keeps biases out of play due to multiple opinions, so that
the review isn’t affected by biases of one person.
Appraisals are the means to an employee’s career development. Therefore, effective performance
appraisal methods not only help the employee grow, but also the organisation. If the employee is given
feedback regularly and frequently, the organisation will be at the receiving end of the profit too.
Performance reviews are important because they help identify and set goals for the employee, recognize
performance over time, guide progress, identify the problem areas or weaknesses, improve
performance and discuss career development in the company. Companies should give promotions and
appraisals frequently because it keeps the employees motivated to perform better, thereby maximizing
the efficiency of the employee, and the productivity of the company.
Performance Appraisal Process
Performance Appraisal

 Performance Appraisal
 History & origin of Performance Appraisal
 Objectives of Performance Appraisal
 Benefits of Performance Appraisal
 Performance Appraisal Process
 Performance Appraisal Rating Factors
o Traditional methods of Performance Appraisal
o Modern Methods of Performance Appraisal
o 360 Degrees Performance Appraisal
 How to get best performance appraisal from your boss?
 Performance Appraisal at Pepsi-Cola International
 Potential Appraisal
 Performance Counseling
1.Establishing performance standards
The first step in the process of performance appraisal is the setting up of the standards which will be used to as the base
This step requires setting the criteria to judge the performance of the employees as successful or unsuccessful and the de
and objectives. The standards set should be clear, easily understandable and in measurable terms. In case the performanc
should be taken to describe the standards.

2.Communicating the
standards
Once set, it is the responsibility of the management to communicate the standards to all the employees of the organizatio
rmed and the standards should be clearly explained to the employees. This will help them to understand their roles and to
The standards should also be communicated to the appraisers or the evaluators and if required, the standards can also be
feedback from the employees or the evaluators.

3.Measuring the actual perf

ormance
The most difficult part of the Performance appraisal process is measuring the actual performance of the employees that i
period of time. It is a continuous process which involves monitoring the performance throughout the year. This stage req
techniques of measurement, taking care that personal bias does not affect the outcome of the process and providing assis
4.Comparing actual performance with desired performance
The actual performance is compared with the desired or the standard performance. The comparison tells the deviations in
standards set. The result
can show the actual performance being more than the desired performance or, the actual performance being less than the
the organizational performance. It includes recalling, evaluating and analysis of data related to the employees’ performan

5.Discussin
g results [Feedback]
The r
esult of
the appraisal is communicated and discussed with the employees on on

e-to-one basis. The focus of this discussion is on communication and listening. The results, the problems and the possibl
solving and reaching consensus. The feedback should be given with a positive attitude as this can have an effect on the e
feedback by managers should be in such way helpful to correct mistakes done by the employees and help them to motiva
Performance feedback task should be handled very carefully as it may leads to emotional outburst if it is not handing pro
before giving them feedback as it may be received positively or negatively depending upon the nature and at
titude of employees.

A research conducted by TJinsite, underlined that in an effective organisation, assignments and projects are monitored c
organisations, ongoing monitoring - periodic reviews and managerial feedback - provides the opportunity to check how
e-determined standards and to make changes in unrealistic or problematic standards.
5 ways to give negative feedback to employees

Feedback at work is important for an individual's development. However, some people are over-sensitive to negative fee
leaders to understand how to convey it. ET's Rica Bhattacharyya talks to some experts.

1) Combine negative & positive

The ideal way of giving feedback to someone who's extremely emotional
is to go for the sandwich method. Sandwich the negative feedback between two layers of positive feedback.

This helps in softening the impact of the negative feedback. By starting and ending in positive words, you ensure that the

2) Be objective
It is important that you ensure that the person receiving the feedback knows that the feedback is not personal vendetta. S
employee may have ,linking the negative feedback to the person giving it. So, if you ask someone reporting to you the re
a control freak. Sadly, nearly all the time, the attribution strains the relationship between the two parties.

3) Don't use harsh words

Rather than telling someone outright that they are bad at something, it is better when you word it in a less harsh manner,
them get better at what they are currently bad at.Sometimes, the most hurtful sentences are perceived in a way which ma
make the employee feel safe. Only when s/he feels safe, they will be in a state of mind to understand and appreciate wha

4) Importance of feedback
One should begin by highlighting the importance of feedback — both positive as well as negative — in a professional's l
how constructive feedback has helped you or someone you know, or the said employee knows, positively and made that
make sure that your tone is calm and soft and like that of a mentor, rather than a rude, condescending or angry one.

5) Give feedback in private for sensitive people

With emotional people, it is also important that you always give feedback in private. Emotions are a result of a person's
usually a very sensitive topic with highly emotional people. Giving feedback to such people in front of a room full of pe

6.Decision-making
The purpose of conducting employee performance appraisal is for making decisions about employees without any bias b
about employees rewarding, promotions, demotions, transfers and sometimes suspensions/dismissal of employees are de
The decision taken by HR manager should match exactly with performance appraisal results of employees to avoid griev
overall performance of the organisation.

Five ways to deal with a poor appraisal

Bad appraisals, like bad hair days (one of those days when nothing seems to be going right), happen to the best of us. Qu
your performance and concentrate on the course ahead.

Look Within: The first step in dealing with a bad appraisal is to keep an honest mindset and introspect about your perfo
wrong with me?'. Once you attack that, other things usually fall into place," says Dabur India HR head A Sudhakar.

Talk to the Boss: Speak to the boss about the performance review. "There is a good chance your boss may not have rem
undertaken," says Meenakshi Roy, senior vice president, human resource, Reliance Broadcast Network.

Take it in your Stride: There is a good chance that your boss' critical evaluation is spot on. "Try never to take these crit
mistake. Consider consulting another senior colleague or a mentor," says Roy.

Plan Ahead: "Be actively involved in setting your targets for the year ahead based on your strengths," says S Roy, a mid
review your performance with your boss. That way, there will be fewer unpleasant surprises.

Move on Gracefully: At times, reasons not connected with your performance affect the appraisal you deserve. "You can
comes of it, it's time to move on," says Sudhakar. But don't make an ugly exit. "You never know when it can come back
5 ways to discard tag as poor performer

Nobody wants to be seen as a poor performer. There always a reason why you're being perceived that way and it is your

1) Find the Root Cause

The first step towards shedding the tag is to dig deep and find out where the poor performance stems from. Is it lack of s
perform? Once you know and accept why you're underperforming, it becomes relatively easy to take corrective action.

2) Seek feedback
Seek constant 360-degree feedback to understand your shortcomings and work on them. Analysing feedback in a positiv
personally. Take criticism constructively and learn from past mistakes.

3) Take Initiative & Deliver

If it is lack of ability or skill, you must take the initiative to train yourself on the particular skill you lack. Have an hones
know that you need training to improve your skills, if that is what you're lacking. When an employee is proactive, manag
trained, apply your learnings to the task at hand. Delivering consistently helps you come out of the shadow of being a po

4) Work with High Performers

While working in teams or on group projects, seek to work with highperforming team members, or those whose work ha
help you learn from their experiences, as well as showcase your work in a positive light.

5) Take Small Steps

The label of a poor performer comes when you haven't been delivering over a period of time. It is not easy to get rid of i
well at smaller tasks that are more short term in nature. A number of such small wins will help you be known as a good p
change in how people see you.

Performance Appraisal
Performance appraisal is a systematic process in which employees job performance is evaluated in relation to
the projects on which employee has worked and his contribution to the organisation. It is also known as an
annual review or performance review.
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It helps the managers place the right employees for the right jobs, depending on their skills. Often, employees
are often curious to know about their performance details and compare it with their fellow colleagues and how
they can improve upon it. So every company needs a good performance appraisal system.
(source-wisestep)
Performance Appraisal
The basic purpose of performance appraisal is to identify an employees worth and contribution to the company.
Important factors include – attendance, efficiency, attitude, quality of work, amount of work are just a few
important factors.
The physical or objective factors like attendance, amount of work, efficiency can be easily measured by the
records maintained by the Human Resource Department Manager.
However, it gets a bit icky, when it comes to measuring subjective factors like attitude, behaviour, friendliness
etc. But to properly evaluate an individual’s performance, appraisal of both subjective and objective factors
needs to be done.
As Dale Yoder said, “Performance appraisal includes all formal procedures used to evaluate personalities and
contributions and potential of group members in a working organisation. It is a continuous process to secure
information necessary for making correct and objective decisions on employees. Methods of Performance
Appraisal
There are various methods that are used by managers and employers to evaluate the performance of the
employees, but they can be put into two categories:
 Traditional Methods of Appraisal
 Modern Methods of Appraisal
(source – businesstopia)
Advantages of Performance Appraisal
1. A systematic performance appraisal system helps the managers to properly identify the performance of
employees in a systematic manner and their areas of talent and areas where they are lacking.
2. It helps the management to place the right employees for the perfect jobs depending on their skills in
particular areas.
3. Performance appraisal helps employees identify the areas in which they need to improve. The managers
can also use this information to provide constructive criticism of the way employees perform their work.
4. Potential employees are often given promotions on the basis of or the results of performance appraisals.
People who have high ratings get promotions. They can also transfer or demote employees if they not
performing up to the expectations of the managers.
5. An appraisal is also useful in determining the effectiveness and results of training programmes. It can
show managers how much employees have improved after taking the training programmes. This will
give managers data on how to change and evolve the training programmes.
 6. It creates healthy competition among employees as they will try to improve their performance and score
better than their colleagues.
7. Managers use appraisal programmes to identify the grievances of employees and act upon them.
8. Keeping extensive records of performance appraisal will give managers will give managers a very good
idea of which employees have the highest growth rate and are which ones have a declining rate of
performance.
Learn the Selection Process here.
Disadvantages of Performance Appraisal
1. If the factors being used in the performance appraisal are incorrect or not relevant, the appraisal will fail
to provide any useful or effective data.
2. Sometimes, equal weightage is not given to important factors when performing an appraisal.
3. Some objective factors are very vague and difficult to gauge like attitude and initiative. There is no
scientific method to measure these factors.
4. Managers are sometimes not qualified enough to correctly assess the employees and their abilities. Thus,
these mistakes can be very detrimental to the growth of the company.
Solved Question on Performance Appraisal
List three ways performance appraisal helps an organisation.
Answer – Three ways performance appraisal helps an organisation mention as follows:
 A systematic performance appraisal system helps the managers to properly identify the performance of
employees in a systematic manner and their areas of talent and areas where they are lacking.
 Performance appraisal helps employees identify the areas in which they need to improve. Furthermore,
the managers can also use this information to provide constructive criticism of the way employees
perform their work.
 It helps the management to place the right employees for the perfect jobs depending on their skills in
particular areas.
HRM in Action: Employee Engagement as a Strategic HR Tool Employee engagement refers to the level of
commitment workers make to their employer, seen in their willingness to stay at the firm and to go beyond the
call of duty.1 Firms want employees that are highly motivated and feel they have a real stake in the company’s
success. Such employees are willing to finish tasks in their own time and see a strong link between the firm’s
success and their own career prospects. In short, motivated, empowered employees work hand in hand with
employers in an atmosphere of mutual trust. Companies with engaged workforces have also reported less
absenteeism, more engagement with customers, greater employee satisfaction, less mistakes, fewer employees
leaving, and naturally higher profits. Such is the power of this concept that former Secretary of State for
Business, Peter Mandelson, commissioned David McLeod and Nita Clarke to investigate how much UK
competitiveness could be enhanced by wider use of employee engagement. David and Nita concluded that in a
world where work tasks have become increasingly similar, engaged employees could give some companies the
edge over their rivals. They also identified significant barriers to engagement such as a lack of appreciation for
the concept of employee engagement by some companies and managers. Full participation by line managers is
particularly crucial. From the employee point of view, it is easy to view engagement as a management fad,
particularly if the company fails to demonstrate the necessary commitment. Some also feel that in a recession,
employee engagement becomes less of a priority when in Performance Management and Appraisal CHAPTER
8 234 M08_MOND2998_12_PIE_C08.QXD 1/19/11 11:37 PM Page 234 235 fact it could be the factor that
enables a business in trouble to stay afloat. Others feel that in an environment where recruitment is easier due to
increasing unemployment, firms tend to slacken their commitment to engagement. A company that has
demonstrated the value of employee engagement is John Lewis, who sell a range of household goods, clothes,
and electronics. The John Lewis business model has been hailed as a good way to run public services and
70,000 store employees recently received a slice of a £151.3 million bonus. The engagement strategy of John
Lewis is facilitated by its unusual employee-owned structure. Employees are known as partners and the
company is run by a Partnership Council, a Partnership Board, and a Chairman. At least 80 percent of the
Partnership Council is elected and this is one of the ways employees feel that they can influence the working of
the company. At the core of the John Lewis philosophy is a belief that employees are critical to success.
Employees benefit from an environment that positively encourages a healthy work–life balance and engagement
in community projects and charity work. Tangible benefits include a noncontributory final salary pension
scheme, store discounts, subsidized holidays, and even a contribution towards concert tickets. Tesco is another
retailing company that has embraced employee engagement. Chief Executive, Terry Leahy, remarked recently
that he knew more about Tesco customers than his employees and set out to improve that situation. One of the
most significant factors in this process has been an improved understanding with USDAW, the shop workers
union. Tesco also launched two notable engagement projects in 2008, one of which encouraged employees to
take part in a talent contest. Vouchers for in-store shopping were also distributed to employees at Christmas.
After completing this chapter, students should be able to: 1. Define performance management and describe the
importance of performance management. 2. Define performance appraisal and identify the uses of performance
appraisal. 3. Discuss the performance appraisal environmental factors. 4. Describe the performance appraisal
process. 5. Identify the various performance criteria (standards) that can be established. 6. Identify who may be
responsible for performance appraisal and the performance period. 7. Identify the various performance appraisal
methods. 8. List the problems that have been associated with performance appraisal. 9. Explain the
characteristics of an effective appraisal system. 10. Describe the legal implications of performance appraisal.
11. Explain how the appraisal interview should be conducted. CHAPTER OBJECTIVES
M08_MOND2998_12_PIE_C08.QXD 1/19/11 11:37 PM Page 235 Tesco is already receiving encouraging
results for its investment in employee engagement. Stores with the most committed employees are the most
successful in terms of turnover. However, suprisingly, many companies still conclude that employee
engagement is not for them.2 This chapter begins by discussing employee engagement. Then performance
management is defined and the importance of integrating learning and performance management discussed. The
relationship of performance management to performance appraisal is then studied. Next, we look at the uses
made of appraisal data and the environmental factors affecting the performance appraisal process. The
performance appraisal process is then described and the possible criteria used in evaluating performance are
discussed. Then the person(s) responsible for appraisal and the appraisal period are described, and the various
performance appraisal methods are explained. Problems associated with performance appraisal and
characteristics of an effective appraisal system are described next, followed by a discussion of the legal aspects
of performance appraisal and the appraisal interview. This chapter concludes with a global perspective entitled
“Two Cultures’ Views of Performance Appraisal.” 236 OBJECTIVE 8.1 Define performance management and
describe the importance of performance management. employee engagement Level of commitment workers
make to their employer, seen in their willingness to stay at the firm and to go beyond the call of duty.
Performance Management Performance management (PM) is a goal-oriented process directed toward ensuring
that organizational processes are in place to maximize the productivity of employees, teams, and ultimately, the
organization. It is a major player in accomplishing organizational strategy in that it involves measuring and
improving the value of the workforce. PM includes incentive goals and the corresponding incentive values so
that the relationship can be clearly understood and communicated. There is a close relationship between
incentives and performance.3 Performance management systems are one of the major focuses in business today.
Although every HR function contributes to performance management, training and performance appraisal play a
more significant role. Whereas performance appraisal occurs at a specific time, performance management is a
dynamic, ongoing, continuous process. Every person in the organization is a part of the PM system. Each part of
the system, such as training, appraisal, and rewards, is integrated and linked for the purpose of continuous
organizational effectiveness. With PM, the effort of each and every worker should be directed toward achieving
strategic goals. If a worker’s skills need to be improved, training is needed. With PM systems, training has a
direct tie-in to achieving organizational effectiveness. In addition, pay and performance are directly related to
achieving organizational goals. Robert J. Greene, CEO of Reward Systems Inc., said, “Performance
management is the single largest contributor to organizational effectiveness. If you ignore performance
management, you fail.”4 Organizations must take a more strategic approach to performance appraisal. Instead
of using the familiar “check the box, write a comment” ritual, organizations need to integrate the company’s
mission, vision, and values into their performance management systems. Performance Appraisal Performance
appraisal (PA) is a formal system of review and evaluation of individual or team task performance. A critical
point in the definition is the word formal, because in actuality, managers should be reviewing an individual’s
performance on a continuing basis.5 PA is especially critical to the success of performance management.
Although performance appraisal is but one component of performance management, it is vital, in that it directly
reflects OBJECTIVE 8.2 Define performance appraisal and identify the uses of performance appraisal.
performance management (PM) Goal-oriented process directed toward ensuring that organizational processes
are in place to maximize the productivity of employees, teams, and ultimately, the organization. performance
appraisal (PA) Formal system of review and evaluation of individual or team task performance.
M08_MOND2998_12_PIE_C08.QXD 1/19/11 11:37 PM Page 236 CHAPTER 8 • PERFORMANCE
MANAGEMENT AND APPRAISAL 237 the organization’s strategic plan. Although evaluation of team
performance is critical when teams exist in an organization, the focus of PA in most firms remains on the
individual employee. Regardless of the emphasis, an effective appraisal system evaluates accomplishments and
initiates plans for development, goals, and objectives. Performance appraisal is often a negative, disliked
activity and one that seems to elude mastery.6 Managers do not like giving them and employees do not like
receiving them.7 In fact, in one survey, almost 80 percent of workers stated dissatisfaction with their PA
process.8 If this is so, why not just eliminate it? Actually, some managers might do just that if they did not need
to provide feedback, encourage performance improvement, make valid decisions, justify terminations, identify
training and development needs, and defend personnel decisions.9 Performance appraisal serves many
purposes, and improved results and efficiency are increasingly critical in today’s globally competitive
marketplace. Therefore, abandoning the only program with performance in its name and employees as its focus
would seem to be an illadvised overreaction. On top of these considerations, managers must be concerned about
legal ramifications. Developing an effective performance appraisal system has been and will continue to be a
high priority for management. Uses of Performance Appraisal For many organizations, the primary goal of an
appraisal system is to improve individual and organizational performance. There may be other goals, however.
A potential problem with PA, and a possible cause of much dissatisfaction, is expecting too much from one
appraisal plan. For example, a plan that is effective for developing employees may not be the best for
determining pay increases. Yet, a properly designed system can help achieve organizational objectives and
enhance employee performance. In fact, PA data are potentially valuable for virtually every human resource
functional area. Human Resource Planning In assessing a firm’s human resources, data must be available to
identify those who have the potential to be promoted or for any area of internal employee relations. Through
performance appraisal it may be discovered that there is an insufficient number of workers who are prepared to
enter management. Plans can then be made for greater emphasis on management development. Succession
planning (discussed previously in Chapter 4) is a key concern for all firms. A well-designed appraisal system
provides a profile of the organization’s human resource strengths and weaknesses to support this effort.
Recruitment and Selection Performance evaluation ratings may be helpful in predicting the performance of job
applicants. For example, it may be determined that a firm’s successful employees (identified through
performance evaluations) exhibit certain behaviors when performing key tasks. These data may then provide
benchmarks for evaluating applicant responses obtained through behavioral interviews, discussed in Chapter 6.
Also, in validating selection tests, employee ratings may be used as the variable against which test scores are
compared. In this instance, determination of the selection test’s validity would depend on the accuracy of
appraisal results. Training and Development Performance appraisal should point out an employee’s specific
needs for training and development. For instance, if Pat Compton’s job requires skill in technical writing and
her evaluation reveals a deficiency in this factor, she may need additional training in written communication. If
a firm finds that a number of first-line supervisors are having difficulty in administering disciplinary action,
training sessions addressing this problem may be appropriate. By identifying deficiencies that adversely affect
performance, T&D programs can be developed that permit individuals to build on their strengths and minimize
their deficiencies. An appraisal system does not guarantee properly trained and developed employees. However,
determining T&D needs is more precise when appraisal data are available. HR Web Wisdom Performance
Management http://www.opm.gov/ perform/overview.asp Office of Personnel Management Web site on
performance management. M08_MOND2998_12_PIE_C08.QXD 1/19/11 11:37 PM Page 237 OBJECTIVE 8.3
Discuss the performance appraisal environmental factors. 238 PART 4 • HUMAN RESOURCE
DEVELOPMENT Career Planning and Development As discussed in the appendix to Chapter 7, career
planning is an ongoing process whereby an individual sets career goals and identifies the means to achieve
them. On the other hand, career development is a formal approach used by the organization to ensure that
people with the proper qualifications and experiences are available when needed. Performance appraisal data is
essential in assessing an employee’s strengths and weaknesses and in determining the person’s potential.
Managers may use such information to counsel subordinates and assist them in developing and implementing
their career plans. Compensation Programs Performance appraisal results provide a basis for rational decisions
regarding pay adjustments. Most managers believe that you should reward outstanding job performance
tangibly with pay increases. They believe that the behaviors you reward are the behaviors you get. Rewarding
behaviors necessary for accomplishing organizational objectives is at the heart of a firm’s strategic plan. To
encourage good performance, a firm should design and implement a reliable performance appraisal system and
then reward the most productive workers and teams accordingly. Internal Employee Relations Performance
appraisal data are also used for decisions in several areas of internal employee relations, including promotion,
demotion, termination, layoff, and transfer. For example, an employee’s performance in one job may be useful
in determining his or her ability to perform another job on the same level, as is required in the consideration of
transfers. When the performance level is unacceptable, demotion or even termination may be appropriate.
Assessment of Employee Potential Some organizations attempt to assess an employee’s potential as they
appraise his or her job performance. Although past behaviors may be a good predictor of future behaviors in
some jobs, an employee’s past performance may not accurately indicate future performance in other jobs. The
best salesperson in the company may not have what it takes to become a successful district sales manager,
where the tasks are distinctly different. Similarly, the best systems analyst may, if promoted, be a disaster as an
information technology manager. Overemphasizing technical skills and ignoring other equally important skills
is a common error in promoting employees into management jobs. Recognition of this problem has led some
firms to separate the appraisal of performance, which focuses on past behavior, from the assessment of
potential, which is future-oriented. Performance Appraisal Environmental Factors External and internal
environmental factors can influence the appraisal process. For example, legislation requires that appraisal
systems be nondiscriminatory. In the case of Mistretta v Sandia Corporation (a subsidiary of Western Electric
Company, Inc.), a federal district court judge ruled against the company, stating, “There is sufficient
circumstantial evidence to indicate that age bias and age based policies appear throughout the performance
rating process to the detriment of the protected age group.” The Albemarle Paper v Moody case also supported
validation requirements for performance appraisals, as well as for selection tests. Organizations should avoid
using any appraisal method that results in a disproportionately negative impact on a protected group. The labor
union is another external factor that might affect a firm’s appraisal process. Unions have traditionally stressed
seniority as the basis for promotions and pay increases. They may vigorously oppose the use of a management-
designed performance appraisal system used for these purposes. Factors within the internal environment can
also affect the performance appraisal process. For instance, a firm’s corporate culture can assist or hinder the
process. Today’s dynamic organizations, which increasingly use teams to perform jobs, recognize overall team
results as M08_MOND2998_12_PIE_C08.QXD 1/19/11 11:37 PM Page 238 CHAPTER 8 • PERFORMANCE
MANAGEMENT AND APPRAISAL 239 well as individual contributions. A nontrusting culture does not
provide the environment needed to encourage high performance by either individuals or teams. In such an
atmosphere, the credibility of an appraisal system will suffer regardless of its merits. Performance Appraisal
Process As shown in Figure 8.1, the starting point for the PA process is identifying specific performance goals.
An appraisal system probably cannot effectively serve every desired purpose, so management should select the
specific goals it believes to be most important and realistically achievable. For example, some firms may want
to stress employee development, whereas other organizations may want to focus on pay adjustments. Too many
PA systems fail because management expects too much from one method and does not determine specifically
what it wants the system to accomplish. TRENDS & INNOVATIONS Integrating Learning and Performance
Management Companies are now integrating learning and performance management into a total system. Mike
DeVries, vice president of human resources at Cummins Mid-South LLC, said, “We didn’t have a good system
on goals [and] development plans, tracking progress throughout the year. More time was spent administering
[appraisals] than looking at effectiveness. In addition, the company did not have defined learning offerings for
all employees.”10 The company looked for automated solutions to accommodate its 550 employees. Today,
DeVries’ world is much different. He says, “Now, individual goals are aligned with corporate goals. We can
calculate the effectiveness of [employees’] reviews and goals, and the system identifies training needs.” More
companies are integrating their learning and performance functions as technology makes it easier and more
affordable.11 There has been a need for integrating learning and performance for years but technology had not
caught up to the need. There were learning management systems and performance management systems but
they did not work together as a total system. Now they have converged. Most integrated systems use a
competency model where competencies or skills are first identified for each job and the competencies provide
the basis for performance appraisal. Managers rate the performance of each employee and look for differences
between individual ratings and desired ratings. An employee development plan is formulated based on the gaps.
Employees can go to the system to review the plan and assess how they are doing. When the next appraisal date
arrives, the manager and the employee have a clear record of the employee’s development activities.12
Historically, HR has struggled with describing to upper management the value of training. David Karel, vice
president of product marketing for SuccessFactors, a learning and performance management systems provider
in San Mateo, California, said, “In the old world, the learning organization was tracking the number of people
trained. Now, learning can tie what they are doing to productivity. They can show much more directly how they
are impacting the company.” Jon Ciampi, vice president of product management for SumTotal, said,
“Employees will leave if they don’t see a career path. By identifying skills gaps and a path to get there, you can
let employees actively manage their own careers.” In addition, time spent on the appraisal has been significantly
reduces. DeVries said, “Appraisals are more consistent, there’s more content, and employees know what they
are being assessed on.”13 These systems can also assist in staffing. With an integrated system, managers can
easily view up-to-date information on employees’ skills. Tamar Elkeles, Qualcomm’s vice president of learning
and organizational development, said, “Without a lot of hiring, you need to find ways to utilize talent
differently.” For example, if 30 new multimedia engineers are needed, and the system can identify 15 current
employees with the necessary skill sets, then only 15 have to be hired.14 Those who have lived with the new
systems have no desire to go back to the old way. DeVries said, “Without a system like this, it’s hard for a
manager to understand how to do a development plan and follow through on it, to identify skills gaps and track
those. If you’re trying to keep up with improving performance without a system like this, I don’t see how you
can get there.”15 OBJECTIVE 8.4 Describe the performance appraisal process.
M08_MOND2998_12_PIE_C08.QXD 1/19/11 11:37 PM Page 239 OBJECTIVE 8.5 Identify the various
performance criteria (standards) that can be established. 240 PART 4 • HUMAN RESOURCE
DEVELOPMENT Figure 8.1 Performance Appraisal Process Identify Specific Performance Appraisal Goals
Establish Performance Criteria and Communicate Them to Employees Examine Work Performed Appraise
Performance Discuss Appraisal with Employee The next step in this ongoing cycle continues with establishing
performance criteria (standards) and communicating these performance expectations to those concerned. Then
the work is performed and the supervisor appraises the performance. At the end of the appraisal period, the
appraiser and the employee together review work performance and evaluate it against established performance
standards. This review helps determine how well employees have met these standards, determines reasons for
deficiencies, and develops a plan to correct the problems. At this meeting, goals are set for the next evaluation
period, and the cycle repeats. Establish Performance Criteria (Standards) There is an old adage that says “What
gets watched gets done.” Therefore, management must carefully select performance criteria as it pertains to
achieving corporate goals.16 The most common appraisal criteria are traits, behaviors, competencies, goal
achievement, and improvement potential. Traits Certain employee traits such as attitude, appearance, and
initiative are the basis for some evaluations. However, many of these commonly used qualities are subjective
and may be either unrelated to job performance or difficult to define. In such cases, inaccurate evaluations may
occur and create legal problems for the organization as well. This was the case in Wade v Mississippi
Cooperative Extension Service where the circuit court ruled: In a performance appraisal system, general
characteristics such as leadership, public acceptance, attitude toward people, appearance and grooming,
personal conduct, outlook on life, ethical habits, resourcefulness, capacity for growth, mental alertness, and
loyalty to organization are susceptible to partiality and to the personal taste, whim, or fancy of the evaluator as
well as patently subjective in form and obviously susceptible to completely subjective treatment by those
conducting the appraisals. At the same time, certain traits may relate to job performance and, if this connection
is established, using them may be appropriate. Traits such as adaptability, judgment, appearance, and attitude
may be used when shown to be job-related. M08_MOND2998_12_PIE_C08.QXD 1/19/11 11:37 PM Page 240
competencies Broad range of knowledge, skills, traits, and behaviors that may be technical in nature, relate to
interpersonal skills, or are business-oriented. CHAPTER 8 • PERFORMANCE MANAGEMENT AND
APPRAISAL 241 Behaviors When an individual’s task outcome is difficult to determine, organizations may
evaluate the person’s task-related behavior or competencies. For example, an appropriate behavior to evaluate
for a manager might be leadership style. For individuals working in teams, developing others, teamwork and
cooperation, or customer service orientation might be appropriate. Desired behaviors may be appropriate as
evaluation criteria because if they are recognized and rewarded, employees tend to repeat them. If certain
behaviors result in desired outcomes, there is merit in using them in the evaluation process. Competencies
Competencies include a broad range of knowledge, skills, traits, and behaviors that may be technical in nature,
relate to interpersonal skills, or are business-oriented. Some managers recommend that cultural competencies
such as ethics and integrity be used for all jobs. There are also competencies that are job-specific. For example,
analytical thinking and achievement orientation might be essential in professional jobs. In leadership jobs,
relevant competencies might include developing talent, delegating authority, and people management skills.
The competencies selected for evaluation purposes should be those that are closely associated with job success.
Research conducted by the University of Michigan Business School and sponsored by the Society for Human
Resource Management (SHRM) and the Global Consulting Alliance determined that success in HR is
dependent on competency and specific skills in the following five key areas: Strategic contribution: Connecting
firms to their markets and quickly aligning employee behaviors with organizational needs. Business knowledge:
Knowing how businesses are run and translating this into action. Personal credibility: Demonstrating
measurable value; being part of an executive team. HR delivery: Providing efficient and effective service to
customers in the areas of staffing, performance management, development, and evaluation. HR technology:
Using technology and Web-based means to deliver value to customers.17 Goal Achievement If organizations
consider ends more important than means, goal achievement outcomes become an appropriate factor to
evaluate. The outcomes established should be within the control of the individual or team and should be those
results that lead to the firm’s success. At upper levels, the goals might deal with financial aspects of the firm
such as profit or cash flow, and market considerations such as market share or position in the market. At lower
organizational levels, the outcomes might be meeting the customer’s quality requirements and delivering
according to the promised schedule. To assist the process, the manager needs to provide specific examples of
how the employee can further his or her development and achieve specific goals. Both parties should reach an
agreement as to the employee’s goals for the next evaluation period and the assistance and resources the
manager needs to provide. This aspect of employee appraisal should be the most positive element in the entire
process and help the employee focus on behavior that will produce positive results for all concerned.
Improvement Potential When organizations evaluate their employees’ performance, many of the criteria used
focus on the past. From a performance management viewpoint, the problem is that you cannot change the past.
Unless a firm takes further steps, the evaluation data become merely historical documents. Therefore, firms
should emphasize the future, including the behaviors and outcomes needed to develop the employee, and, in the
process, achieve the firm’s goals. This involves an assessment of the employee’s potential. Including potential
in the evaluation process helps to ensure more effective career planning and development. You should
remember that the evaluation criteria presented here are not mutually exclusive. In fact, many appraisal systems
are hybrids of these approaches. M08_MOND2998_12_PIE_C08.QXD 1/19/11 11:37 PM Page 241
OBJECTIVE 8.6 Identify who may be responsible for performance appraisal and the performance period. 242
PART 4 • HUMAN RESOURCE DEVELOPMENT Responsibility for Appraisal Often the human resource
department is responsible for coordinating the design and implementation of performance appraisal programs.
However, it is essential that line managers play a key role from beginning to end. These individuals usually
conduct the appraisals, and they must directly participate in the program if it is to succeed. Several possibilities
exist with regard to the person who will actually rate the employee. Immediate Supervisor An employee’s
immediate supervisor has traditionally been the most logical choice for evaluating performance and this
continues to be the case. The supervisor is usually in an excellent position to observe the employee’s job
performance and the supervisor has the responsibility for managing a particular unit. When someone else has
the task of evaluating subordinates, the supervisor’s authority may be undermined. Also, subordinate training
and development is an important element in every manager’s job and, as previously mentioned, appraisal
programs and employee development are usually closely related. On the negative side, the immediate supervisor
may emphasize certain aspects of employee performance and neglect others. Also, managers have been known
to manipulate evaluations to justify pay increases and promotions and vice versa. When geography separates
subordinates from their supervisors, evaluation becomes increasingly difficult. In other cases, the appraised
employee may be more technically knowledgeable than the boss, and this presents another potential problem.
One suggestion for overcoming these disadvantages is to bring subordinates into the process more closely. Have
them suggest ways to fairly evaluate their performance and then use their suggestions as part of the appraisal
criteria. In most instances, the immediate supervisor will probably continue to be involved in evaluating
performance. Organizations will seek alternatives, however, because of technological advances and a desire to
broaden the perspective of the appraisal. Subordinates Historically, our culture has viewed evaluation by
subordinates negatively. However, this thinking has changed somewhat. Some firms conclude that evaluation of
managers by subordinates is both feasible and needed. They reason that subordinates are in an excellent position
to view their superiors’ managerial effectiveness. Advocates believe that this approach leads supervisors to
become especially conscious of the work group’s needs and to do a better job of managing. In the higher
education environment, it is a common practice for instructors to be evaluated by students. Critics are concerned
that the manager (and instructors) will be caught up in a popularity contest or that employees will be fearful of
reprisal. If this approach has a chance for success, one thing is clear: the evaluators must be guaranteed
anonymity. Ensuring this might be particularly difficult in a small department and especially if demographic
data on the appraisal form could identify raters. Peers and Team Members A major strength of using peers to
appraise performance is that they work closely with the evaluated employee and probably have an undistorted
perspective on typical performance, especially in team assignments. Organizations are increasingly using teams,
including those that are self-directed. The rationale for evaluations conducted by team members includes the
following: Team members know each others’ performance better than anyone and can, therefore, evaluate
performance more accurately. Peer pressure is a powerful motivator for team members. Members who
recognize that peers within the team will be evaluating their work show increased commitment and
productivity. Peer review involves numerous opinions and is not dependent on one individual. Problems with
peer evaluations include the reluctance of some people who work closely together, especially on teams, to
criticize each other. On the other hand, if an employee has been M08_MOND2998_12_PIE_C08.QXD 1/19/11
11:37 PM Page 242 CHAPTER 8 • PERFORMANCE MANAGEMENT AND APPRAISAL 243 at odds with
another worker he or she might really “unload on the enemy,” resulting in an unfair evaluation. Another
problem concerns peers who interact infrequently and lack the information needed to make an accurate
assessment. When employees work in teams, and their appraisal system focuses entirely on individual results, it
is not surprising that they show little interest in their teams. But, this problem can be corrected. If teamwork is
essential, make it a criterion for evaluating employees; rewarding collaboration will encourage teamwork. Self-
Appraisal If employees understand their objectives and the criteria used for evaluation, they are in a good
position to appraise their own performance. Many people know what they do well on the job and what they
need to improve. If they have the opportunity, they will criticize their own performance objectively and take
action to improve it. Paul Falcone, vice-president of HR at Nickelodeon, said, “The fascinating thing is that
employees are usually tougher on themselves than you will ever be.”18 Also, because employee development is
self-development, employees who appraise their own performance may become more highly motivated. Self-
appraisal provides employees with a means of keeping the supervisor informed about everything the worker has
done during the appraisal period.19 Even if a self-appraisal is not a part of the system, the employee should at
least provide the manager a list of his or her most important accomplishments and contributions over the
appraisal period. This will prevent the manager from being blindsided when the employee complains, perhaps
justifiably, “You didn’t even mention the Bandy contract I landed last December!” As a complement to other
approaches, self-appraisal has great appeal to managers who are primarily concerned with employee
participation and development. For compensation purposes, however, its value is considerably less. Some
individuals are masters at attributing good performance to their own efforts and poor performance to someone
else’s. Customer Appraisal Customer behavior determines a firm’s degree of success. Therefore, some
organizations believe it is important to obtain performance input from this critical source. Organizations use this
approach because it demonstrates a commitment to the customer, holds employees accountable, and fosters
change. Customer-related goals for executives generally are of a broad, strategic nature, whereas targets for
lower-level employees tend to be more specific. For example, an objective might be to improve the rating for
accurate delivery or reduce the number of dissatisfied customers by half. It is important to have employees
participate in setting their goals and to include only factors that are within the employees’ control. Appraisal
Period Formal performance evaluations are usually prepared at specific intervals. Although there is nothing
magical about the period for formal appraisal reviews, in most organizations they occur either annually or
semiannually. Even more significant, however, is the continuous interaction (primarily informal), including
coaching and other developmental activities, that continues throughout the appraisal period. Managers should
be conditioned to understand that managing performance is a continuous process that is built into their job every
day. In the current business climate, it may be well for all firms to consider monitoring performance more often.
Southwest Airlines has asked its managers to have monthly check-ins with staff rather than semi-annual ones.20
One study found that 63 percent of high-growth companies review performance more than once a year; in
comparison, just 22 percent of low-growth companies review performance more than once a year.21 Changes
occur so fast that employees need to look at objectives and their own roles throughout the year to see whether
changes are in order. In high-tech organizations, the speed of change mandates that a performance period be
shorter, perhaps every three or four months. Some organizations use the employee’s date of hire to determine
the rating period. At times a subordinate’s first appraisal may occur at the end of a probationary period,
anywhere from M08_MOND2998_12_PIE_C08.QXD 1/19/11 11:37 PM Page 243 360-degree feedback
evaluation method Popular performance appraisal method that involves evaluation input from multiple levels
within the firm as well as external sources. OBJECTIVE 8.7 Identify the various performance appraisal
methods. 244 PART 4 • HUMAN RESOURCE DEVELOPMENT 30 to 90 days after his or her start date.
However, in the interest of consistency, it may be advisable to perform evaluations on a calendar basis rather
than on anniversaries. If firms do not conduct all appraisals at the same time, it may be impossible to make
needed comparisons between employees. Performance Appraisal Methods Managers may choose from among a
number of appraisal methods. The type of performance appraisal system used depends on its purpose. If the
major emphasis is on selecting people for promotion, training, and merit pay increases, a traditional method,
such as rating scales, may be appropriate. Collaborative methods, including input from the employees
themselves, may prove to be more suitable for developing employees. 360-Degree Feedback Evaluation Method
The 360-degree feedback evaluation method is a popular performance appraisal method that involves evaluation
input from multiple levels within the firm as well as external sources. The 360-degree method is unlike
traditional performance reviews, which provide employees with feedback only from supervisors.22 In this
method, people all around the rated employee may provide ratings, including senior managers, the employee
himself or herself, supervisors, subordinates, peers, team members, and internal or external customers.23 As
many as 90 percent of Fortune 500 companies use some form of 360-degree feedback for either employee
evaluation or development.24 Many companies use results from 360-degree programs not only for conventional
applications but also for succession planning, training, and professional development. Unlike traditional
approaches, 360-degree feedback focuses on skills needed across organizational boundaries. Also, by shifting
the responsibility for evaluation to more than one person, many of the common appraisal errors can be reduced
or eliminated. Software is available to permit managers to give the ratings quickly and conveniently. The 360-
degree feedback method may provide a more objective measure of a person’s performance. Including the
perspective of multiple sources results in a broader view of the employee’s performance and may minimize
biases that result from limited views of behavior. Having multiple raters also makes the process more legally
defensible. However, it is important for all parties to know the evaluation criteria, the methods for gathering and
summarizing the feedback, and the use to which the feedback will be put. An appraisal system involving
numerous evaluators will naturally take more time and, therefore, be more costly. Nevertheless, the way firms
are being organized and managed may require innovative alternatives to traditional top-down appraisals.
According to some managers, the 360-degree feedback method has problems. Ilene Gochman, director of
Watson Wyatt’s organization effectiveness practice, says, “We’ve found that use of the 360 is actually
negatively correlated with financial results.”25 GE’s former CEO Jack Welch maintains that the 360-degree
system in his firm had been “gamed” and that people were saying nice things about one another, resulting in all
good ratings.26 Another critical view with an opposite twist is that input from peers, who may be competitors
for raises and promotions, might intentionally distort the data and sabotage the colleague. Yet, since so many
firms use 360-degree feedback evaluation, it seems that many firms have found ways to avoid the pitfalls.
Google has a different approach to 360-degree feedback as it provides managers and employees to nominate
‘peer reviewers’ from anywhere across the organization. According to the company’s manager of HR
technology and operations, Melissa Karp, “People are fairly candid in their feedback.”27 One might ask, what
happens at Google when people write unconstructive comments? Karp said, “managers are encouraged to use
that as a ‘coachable moment’ to talk to the person who wrote something unconstructive. However, at Google
this hasn’t been too much of a problem.”28 The biggest risk with 360-degree feedback is confidentiality. Many
firms outsource the process to make participants feel comfortable that the information they share and receive is
HR Web Wisdom 360 Degree Evaluation http://www. custominsight.com/ 360-degree-feedback/ 360-
deliveringfeedback.asp Delivering feedback. M08_MOND2998_12_PIE_C08.QXD 1/19/11 11:37 PM Page
244 rating scales method Performance appraisal method that rates employees according to defined factors.
CHAPTER 8 • PERFORMANCE MANAGEMENT AND APPRAISAL 245 Figure 8.2 Rating Scales Method
of Performance Appraisal Evaluate the performance in each of the following factors on a scale of 1 to 5:
Multiplied by 16 = Part 1—Task Outcomes (Weighted 80% of total score) List mutually agreed-to performance
factors from the job description Points and goals established from the preview performance review. • • • • • •
Quality of work • Quantity of work Total Points Average Score (Divide total points by number of factors used)
Comments Part 2—Personal Behaviors (10% of total score) • Leadership • Interpersonal skills • Developing
others • Customer service • Teamwork Total Points Average Score (Divide total points by number of applicable
factors) Comments 5 = Outstanding, consistently exceeds expectations for this factor. 4 = Above Expectations,
consistently meets and occasionally exceeds expectations. 3 = Meets Expectations, consistently meets
expectations. 2 = Below Expectations, occasionally fails to meet expectations. 1 = Needs Improvement,
consistently fails to meet expectations. Name Supervisor/Manager Appraisal Period: Job Title Department From
To Multiplied by 2 = completely anonymous, but the information is very sensitive and, in the wrong hands,
could impact careers. Rating Scales Method The rating scales method is a performance appraisal method that
rates employees according to defined factors. Using this approach, evaluators record their judgments about
performance on a scale. The scale includes several categories, normally 5–7 in number, defined by adjectives
such as outstanding, meets expectations, or needs improvement. Although systems often provide an overall
rating, the method generally allows for the use of more than one performance criterion. One reason for the
popularity of the rating scales method is its simplicity, which permits quick evaluations of many employees.
When you quantify the ratings, the method facilitates comparison of employees’ performances. The factors
chosen for evaluation are typically of two types: job-related and personal characteristics. Note that in Figure
8.2, job-related factors include quality and quantity of work, M08_MOND2998_12_PIE_C08.QXD 1/19/11
11:37 PM Page 245 246 PART 4 • HUMAN RESOURCE DEVELOPMENT Performance goals for next
appraisal period: • • • • • Self-development activities for this employee Part 3—Personal Traits (10% of total
score) • Adaptability • Judgment • Appearance • Attitude • Initiative Total Points Average Score (Divide total
points by 5) Comments Employee comments Evaluated By: Approved Employee’s Signature (Does not
necessarily indicate agreement) Title Title Title Multiplied by 2 = Points from Part 1 + Part 2 + Part 3 = Total
Points Date Date Date whereas personal factors include such behaviors as interpersonal skills and traits, like
adaptability. The rater (evaluator) completes the form by indicating the degree of each factor that is most
descriptive of the employee and his or her performance. In this illustration, evaluators total and then average the
points in each part. They then multiply this average by a factor representing the weight given to each section.
The final score (total points) for the employee is the total of each section’s points. Some firms provide space for
the rater to comment on the evaluation given for each factor. This practice may be especially encouraged, or
even required, when the rater gives an extreme rating, either the highest or lowest. For instance, if an employee
is rated needs improvement (a 1 on the sample form) on teamwork, the rater provides written justification for
this low evaluation. The purpose of this requirement is to focus on correcting deficiencies and to discourage
arbitrary and hastily made judgments. Figure 8.2 Continued M08_MOND2998_12_PIE_C08.QXD 1/19/11
11:37 PM Page 246 ranking method Performance appraisal method in which the rater ranks all employees from
a group in order of overall performance. work standards method Performance appraisal method that compares
each employee’s performance to a predetermined standard or expected level of output. essay method
Performance appraisal method in which the rater writes a brief narrative describing the employee’s
performance. critical incident method Performance appraisal method that requires keeping written records of
highly favorable and unfavorable employee work actions. CHAPTER 8 • PERFORMANCE MANAGEMENT
AND APPRAISAL 247 The more precise the definition of factors and degrees, the more accurately the rater
can evaluate worker performance. For instance, in order to receive an outstanding rating for a factor such as
quality of work, a person must consistently go beyond the prescribed work requirements. When the various
performance levels are described merely as above expectations or below expectations without further
elaboration, what has the employee really learned? These generalities do not provide the guidance needed for
improving performance. It is important that each rater interpret the factors and degrees in the same way. Raters
acquire this ability through performance appraisal training. Many rating scale forms also provide for
consideration of future behavior. Notice that the form shown as Figure 8.2 has space for performance goals for
the next period and self-development activities for the next appraisal period. Critical Incident Method The
critical incident method is a performance appraisal method that requires keeping written records of highly
favorable and unfavorable employee work actions. When such an action, a “critical incident,” affects the
department’s effectiveness significantly, either positively or negatively, the manager writes it down. At the end
of the appraisal period, the rater uses these records along with other data to evaluate employee performance.
With this method, the appraisal is more likely to cover the entire evaluation period and not focus on the past few
weeks or months. Essay Method The essay method is a performance appraisal method in which the rater writes
a brief narrative describing the employee’s performance. This method tends to focus on extreme behavior in the
employee’s work rather than on routine day-to-day performance. Ratings of this type depend heavily on the
evaluator’s writing ability. Supervisors with excellent writing skills, if so inclined, can make a marginal worker
sound like a top performer. Comparing essay evaluations might be difficult because no common criteria exist.
However, some managers believe that the essay method is not only the most simple but also an acceptable
approach to employee evaluation. Work Standards Method The work standards method is a performance
appraisal method that compares each employee’s performance to a predetermined standard or expected level of
output. Standards reflect the normal output of an average worker operating at a normal pace. Firms may apply
work standards to virtually all types of jobs, but production jobs generally receive the most attention. An
obvious advantage of using standards as appraisal criteria is objectivity. However, in order for employees to
perceive that the standards are objective, they should understand clearly how the standards were set.
Management must also explain the rationale for any changes to the standards. Ranking Method The ranking
method is a performance appraisal method in which the rater ranks all employees from a group in order of
overall performance. For example, the best employee in the group is ranked highest, and the poorest is ranked
lowest. You follow this procedure until you rank all employees. A difficulty occurs when all individuals have
performed at comparable levels (as perceived by the evaluator). Paired comparison is a variation of the ranking
method in which the performance of each employee is compared with that of every other employee in the
group. A single criterion, such as overall performance, is often the basis for this comparison. The employee who
receives the greatest number of favorable comparisons receives the highest ranking.
M08_MOND2998_12_PIE_C08.QXD 1/19/11 11:37 PM Page 247 behaviorally anchored rating scale (BARS)
method Performance appraisal method that combines elements of the traditional rating scale and critical
incident methods; various performance levels are shown along a scale with each described in terms of an
employee’s specific job behavior. 248 PART 4 • HUMAN RESOURCE DEVELOPMENT Some professionals
in the field argue for using a comparative approach, such as ranking, whenever management must make human
resource decisions. They believe that employees are promoted or receive the highest pay increases not because
they achieve their objectives, but rather because they achieve them better than others in their work group.
Forced Distribution Method The forced distribution method of performance appraisal requires the rater to assign
individuals in a work group to a limited number of categories, similar to a normal frequency distribution. The
purpose of forced distribution is to keep managers from being excessively lenient and having a disproportionate
number of employees in the “superior” category.29 Forced distribution systems have been around for decades
and firms such as General Electric, Cisco Systems, EDS, Hewlett-Packard, Microsoft, Pepsi, Caterpillar, Sun
Microsystems, Goodyear, Ford Motor, and Capital One use them today.30 Proponents of forced distribution
believe they facilitate budgeting and guard against weak managers who are too timid to get rid of poor
performers. They think that forced rankings require managers to be honest with workers about how they are
doing. The forced distribution systems tend to be based on three levels. In GE’s system, the best performers are
placed in the top 20 percent, the next group in the middle 70 percent, and the poorest performing group winds
up in the bottom 10 percent. The underperformers are, after being given a time to improve their performance,
generally let go.31 If any of the underperformers are able to improve their performance, you might wonder if
any in the 70 percent group would get nervous! Although used by some prestigious firms, the forced
distribution system appears to be unpopular with many managers. In a survey of HR professionals, 44 percent
of respondents thought their firm’s forced ranking system damages morale and generates mistrust of
leadership.32 Some believe it fosters cutthroat competition, paranoia, and general ill will, and destroys
employee loyalty. A Midwestern banker states that his company “began a rank-and-yank system that flies
directly in the face of the ‘teamwork’ that senior management says it wants to encourage. Don’t tell me I’m
supposed to put the good of the team first and then tell me the bottom 10 percent of us are going to lose our jobs
because, team be damned, I’m going to make sure I’m not in that bottom 10 percent.”33 Critics of forced
distribution contend that they compel managers to penalize a good, although not a great, employee who is part
of a superstar team. One reason employees are opposed to forced ranking is that they suspect that the rankings
are a way for companies to rationalize firings more easily. Behaviorally Anchored Rating Scale Method The
behaviorally anchored rating scale (BARS) method is a performance appraisal method that combines elements
of the traditional rating scales and critical incident methods; various performance levels are shown along a scale
with each described in terms of an employee’s specific job behavior. Table 8.1 illustrates a portion of a BARS
system that was developed to evaluate college recruiters. Suppose the factor chosen for evaluation is Ability to
Present Positive Company Image. On the very positive end of this factor would be “Makes excellent impression
on college recruits. Carefully explains positive aspects of the company. Listens to applicant and answers
questions in a very positive manner.” On the very negative end of this factor would be “Even with repeated
instructions continues to make a poor impression. This interviewer could be expected to turn off college
applicants from wanting to join the firm.” As may be noted, there are several levels in between the very
negative and the very positive. The rater is able to determine more objectively how frequently the employee
performs in each defined level. A BARS system differs from rating scales because, instead of using terms such
as high, medium, and low at each scale point, it uses behavioral anchors related to the criterion being measured.
This modification clarifies the meaning of each point on the scale and reduces rater bias and error by anchoring
the rating with specific behavioral examples based on job analysis information. Instead of providing a space for
entering a rating figure for a category such as Above Expectations, the BARS method provides examples of
such behavior. This approach forced distribution method Performance appraisal method in which the rater is
required to assign individuals in a work group to a limited number of categories, similar to a normal frequency
distribution. M08_MOND2998_12_PIE_C08.QXD 1/19/11 11:37 PM Page 248 OBJECTIVE 8.8 List the
problems that have been associated with performance appraisal. results-based system Performance appraisal
method in which the manager and subordinate jointly agree on objectives for the next appraisal period; in the
past a form of management by objectives. CHAPTER 8 • PERFORMANCE MANAGEMENT AND
APPRAISAL 249 Table 8.1 BARS for Factor: Ability to Present Positive Company Image Clearly Outstanding
Performance Makes excellent impression on college recruits. Carefully explains positive aspects of the
company. Listens to applicant and answers questions in a very positive manner. Excellent Performance Makes
good impression on college recruits. Answers all questions and explains positive aspects of the company.
Answers questions in a positive manner. Good Performance Makes a reasonable impression on college recruits.
Listens to applicant and answers questions in knowledgeable manner. Average Performance Makes a fair
impression on college recruits. Listens to applicant and answers most questions in a knowledgeable manner.
Slightly Below Average Performance Attempts to make a good impression on college recruits. Listens to
applicants but at times could be expected to have to go to other sources to get answers to questions. Poor
Performance At times makes poor impression on college recruits. Sometimes provides incorrect information to
applicant or goes down blind avenues before realizing mistake. Very Poor Performance Even with repeated
instructions continues to make a poor impression. This interviewer could be expected to turn off college
applicant from wanting to join the firm. facilitates discussion of the rating because it addresses specific
behaviors, thus overcoming weaknesses in other evaluation methods. Regardless of apparent advantages of the
BARS method, reports on its effectiveness are mixed. A specific deficiency is that the behaviors used are
activity oriented rather than results oriented. Also, the method may not be economically feasible since each job
category requires its own BARS. Yet, among the various appraisal techniques, the BARS method is perhaps the
most highly defensible in court because it is based on actual observable job behaviors. Results-Based System
The manager and subordinate jointly agree on objectives for the next appraisal period in a results-based system,
in the past a form of management by objectives. In such a system, one objective might be, for example, to cut
waste by 10 percent. At the end of the appraisal period, an evaluation focuses on how well the employee
achieved this objective. Problems in Performance Appraisal As indicated at the beginning of this chapter,
performance appraisal is constantly under a barrage of criticism. The rating scales method seems to be the most
vulnerable target. Yet, in all fairness, many of the problems commonly mentioned are not inherent in this
method but, rather, reflect improper implementation. For example, firms may fail to provide adequate rater
training or they may use appraisal criteria that are too subjective and lack job-relatedness. The following section
highlights some of the more common problem areas. Appraiser Discomfort Conducting performance appraisals
is often a frustrating human resource management task. One management guru, Edward Lawler, noted the
considerable documentation showing that performance appraisal systems neither motivate individuals nor
effectively guide their M08_MOND2998_12_PIE_C08.QXD 1/19/11 11:37 PM Page 249 strictness Being
unduly critical of an employee’s work performance. leniency Giving an undeserved high performance appraisal
rating to an employee. horn error Evaluation error that occurs when a manager generalizes one negative
performance feature or incident to all aspects of employee performance, resulting in a lower rating. halo error
Evaluation error that occurs when a manager generalizes one positive performance feature or incident to all
aspects of employee performance, resulting in a higher rating. 250 PART 4 • HUMAN RESOURCE
DEVELOPMENT development. Instead, he maintains, they create conflict between supervisors and
subordinates and lead to dysfunctional behaviors.34 This caveat is important. If a performance appraisal system
has a faulty design, or improper administration, employees will dread receiving appraisals and the managers
will despise giving them. In fact, some managers have always loathed the time, paperwork, difficult choices,
and discomfort that often accompanies the appraisal process. Going through the procedure cuts into a manager’s
high-priority workload and the experience can be especially unpleasant when the employee in question has not
performed well. Lack of Objectivity A potential weakness of traditional performance appraisal methods is that
they lack objectivity. In the rating scales method, for example, commonly used factors such as attitude,
appearance, and personality are difficult to measure. In addition, these factors may have little to do with an
employee’s job performance. Although subjectivity will always exist in appraisal methods, employee appraisal
based primarily on personal characteristics may place the evaluator and the company in untenable positions
with the employee and equal employment opportunity guidelines. The firm may be hard-pressed to show that
these factors are job-related. Halo/Horn A halo error occurs when a manager generalizes one positive
performance feature or incident to all aspects of employee performance, resulting in a higher rating.35 For
example, Rodney Pirkle, accounting supervisor, placed a high value on neatness, a factor used in the company’s
performance appraisal system. As Rodney was evaluating the performance of his senior accounting clerk, Jack
Hicks, he noted that Jack was a very neat individual and gave him a high ranking on this factor. Also,
consciously or unconsciously, Rodney permitted the high ranking on neatness to carry over to other factors,
giving Jack undeserved high ratings on all factors. Of course, if Jack had not been neat, the opposite could have
occurred. This phenomenon is known as the horn error, an evaluation error that occurs when a manager
generalizes one negative performance feature or incident to all aspects of employee performance, resulting in a
lower rating. Leniency/Strictness Some managers are too generous with praise or too hard on a person. Dick
Grote, a performance management expert and president of Grote Consulting Corporation, a management
consulting firm in Dallas, said, “It is not OK to have performance rated differently from manager to manager
because these decisions impact compensation, development and succession planning.”36 Giving undeserved
high ratings to an employee is referred to as leniency. This behavior is often motivated by a desire to avoid
controversy over the appraisal. It is most prevalent when highly subjective (and difficult to defend) performance
criteria are used, and the rater is required to discuss evaluation results with employees. When managers know
they are evaluating employees for administrative purposes, such as pay increases, they are likely to be more
lenient than when evaluating performance to achieve employee development. Leniency, however, may result in
failure to recognize correctable deficiencies. The practice may also deplete the merit budget and reduce the
rewards available for superior employees. In addition, an organization will find it difficult to terminate poor-
performing employees who continuously receive positive evaluations. Being unduly critical of an employee’s
work performance is referred to as strictness. Although leniency is usually more prevalent than strictness, some
managers, on their own initiative, apply an evaluation more rigorously than the company standard. This
behavior may be due to a lack of understanding of various evaluation factors. The worst situation is when a firm
has both lenient and strict managers and does nothing to level the inequities. Here, the weak HR Web Wisdom
Appraisal News http://www. performance-appraisal. com/home.htm Performance appraisal news and general
PA information is provided. M08_MOND2998_12_PIE_C08.QXD 1/19/11 11:37 PM Page 250 central
tendency error Evaluation appraisal error that occurs when employees are incorrectly rated near the average or
middle of a scale. CHAPTER 8 • PERFORMANCE MANAGEMENT AND APPRAISAL 251 performers get
relatively high pay increases and promotions from a lenient boss, whereas the strict manager shortchanges the
stronger employees. This can have a demoralizing effect on the morale and motivation of the top-performing
people. Central Tendency Central tendency error is an evaluation appraisal error that occurs when employees
are incorrectly rated near the average or middle of a scale. This practice may be encouraged by some rating
scale systems that require the evaluator to justify in writing extremely high or extremely low ratings. With such
a system, the rater may avoid possible controversy or criticism by giving only average ratings. However, since
these ratings tend to cluster in the fully satisfactory range, employees do not often complain. Nevertheless, this
error does exist and it influences the accuracy of evaluations. Typically, when pay raises are given, they will be
based on an employee’s performance. When a manager gives an underachiever or overachiever, an average
rating, it undermines the compensation system.37 Recent Behavior Bias Anyone who has observed the behavior
of young children several weeks before Christmas can readily identify with the problem of recent behavior bias.
Suddenly, the wildest kids in the neighborhood develop angelic personalities in anticipation of the rewards they
hope to receive from Old Saint Nick. Individuals in the workforce are not children, but they are human.
Virtually every employee knows precisely when a performance review is scheduled. Although his or her actions
may not be conscious, an employee’s behavior often improves and productivity tends to rise several days or
weeks before the scheduled evaluation. It is only natural for a rater to remember recent behavior more clearly
than actions from the more distant past. However, formal performance appraisals generally cover a specified
time, and an individual’s performance over the entire period should be considered. Maintaining records of
performance throughout the appraisal period helps avoid this problem. Personal Bias (Stereotyping) This pitfall
occurs when managers allow individual differences to affect the ratings they give. If these are factors to avoid
such as gender, race, or age, not only is this problem detrimental to employee morale, but it is blatantly illegal
and can result in costly litigation. The effects of cultural bias, or stereotyping, can definitely influence
appraisals.38 Managers establish mental pictures of what are considered ideal typical workers, and employees
who do not match this picture may be unfairly judged. Discrimination in appraisal can be based on other factors
as well. For example, mildmannered employees may be appraised more harshly because they do not seriously
object to the results. This type of behavior is in sharp contrast to the more outspoken employee, who often
confirms the adage: the squeaky wheel gets the grease. Manipulating the Evaluation In some instances,
managers control virtually every aspect of the appraisal process and are therefore in a position to manipulate the
system. For example, a supervisor may want to give a pay raise to a certain employee or the supervisor may just
“favor” one worker more than another.39 In order to justify this action, the supervisor may give the employee
an undeserved high performance evaluation and perhaps a less favored, but productive, employee a lower
rating.40 Or, the supervisor may want to get rid of an employee and so may give the individual an undeserved
low rating. In either instance, the system is distorted and the goals of performance appraisal cannot be achieved.
In addition, in the latter example, if the employee is a member of a protected group, the firm may wind up in
court. If the organization cannot adequately support the evaluation, it may suffer significant financial loss.
M08_MOND2998_12_PIE_C08.QXD 1/19/11 11:37 PM Page 251 One study revealed that more than 70
percent of responding managers believe that inflated and lowered ratings are given intentionally. Table 8.2
shows these managers’ explanations for their rationale. The results suggest that the validity of many
performance appraisal systems is flawed, although another study indicated that appraisal data are valid 75
percent of the time.41 Yet, having invalid appraisal data 25 percent of the time would be nothing to brag about.
It seems obvious that evaluator training emphasizing the negative consequences of rater errors would pay for
itself many times over. Employee Anxiety The evaluation process may also create anxiety for the appraised
employee. This may take the form of discontent, apathy, and turnover. In a worst-case scenario, a lawsuit is
filed based on real or perceived unfairness.42 Opportunities for promotion, better work assignments, and
increased compensation may hinge on the results. This could cause not only apprehension, but also outright
resistance. One opinion is that if you surveyed typical employees, they would tell you performance appraisal is
management’s way of highlighting all the bad things they did all year. 252 PART 4 • HUMAN RESOURCE
DEVELOPMENT ETHICAL DILEMMA Abdication of Responsibility You are the new vice president for
human resources of a company that has not been performing well, and everyone, including yourself, has a
mandate to deliver results. The pressure has never been greater. Shareholders are angry after 31 months of a
tough market that has left their stock underwater. Many shareholders desperately need stock performance to pay
for their retirement. Working for you is a 52-year-old manager with two kids in college. In previous evaluations,
spineless executives told him he was doing fine, when he clearly was not, and his performance is still far below
par. If you are to show others in the company that you are willing to make tough decisions, you feel you must
fire this individual. The question is who’s going to suffer: the firm and ultimately shareholders whose
retirements are in jeopardy, or a nice guy who’s been lied to for 20 years. What would you do?43 Table 8.2
Reasons for Intentionally Inflating or Lowering Ratings Inflated Ratings The belief that accurate ratings would
have a damaging effect on the subordinate’s motivation and performance The desire to improve an employee’s
eligibility for merit The desire to avoid airing the department’s dirty laundry The wish to avoid creating a
negative permanent record of poor performance that might hound the employee in the future The need to protect
good performers whose performance was suffering because of personal problems The wish to reward
employees displaying great effort even though results are relatively low The need to avoid confrontation with
certain hard-to-manage employees The desire to promote a poor or disliked employee up and out of the
department Lowered Ratings To scare better performance out of an employee To punish a difficult or rebellious
employee To encourage a problem employee to quit To create a strong record to justify a planned firing To
minimize the amount of the merit increase a subordinate receives To comply with an organization edict that
discourages managers from giving high ratings Source: Clinton Longenecker and Dean Ludwig, “Ethical
Dilemmas in Performance Appraisal Revisited,” Journal of Business Ethics 9 (December 1990): 963. Reprinted
by permission of Kluwer Academic Publishers. M08_MOND2998_12_PIE_C08.QXD 1/19/11 11:37 PM Page
252 OBJECTIVE 8.9 Explain the characteristics of an effective appraisal system. CHAPTER 8 •
PERFORMANCE MANAGEMENT AND APPRAISAL 253 Characteristics of an Effective Appraisal System
The basic purpose of a performance appraisal system is to improve performance of individuals, teams, and the
entire organization. The system may also serve to assist in making administrative decisions concerning pay
increases, promotions, transfers, or terminations. In addition, the appraisal system must be legally defensible.
Although a perfect system does not exist, every system should possess certain characteristics. Organizations
should seek an accurate assessment of performance that permits the development of a plan to improve
individual and group performance. The system must honestly inform people of how they stand with the
organization. The following factors assist in accomplishing these purposes. Job-Related Criteria Job-relatedness
is perhaps the most basic criterion needed in employee performance appraisals. The Uniform Guidelines on
Employee Selection Procedures and court decisions are quite clear on this point. More specifically, evaluation
criteria should be determined through job analysis. Subjective factors, such as initiative, enthusiasm, loyalty,
and cooperation may be important; however, unless clearly shown to be job-related, they should not be used.
Performance Expectations Managers and subordinates must agree on performance expectations in advance of
the appraisal period.44 How can employees function effectively if they do not know what they are being
measured against? On the other hand, if employees clearly understand the expectations, they can evaluate their
own performance and make timely adjustments as they perform their jobs, without having to wait for the formal
evaluation review. The establishment of highly objective work standards is relatively simple in many areas,
such as manufacturing, assembly, and sales. For numerous other types of jobs, however, this task is more
difficult. Still, evaluation must take place based on clearly understood performance expectations.
Standardization Firms should use the same evaluation instrument for all employees in the same job category
who work for the same supervisor. Supervisors should also conduct appraisals covering similar periods for these
employees. Regularly scheduled feedback sessions and appraisal interviews for all employees are essential.
Formal documentation of appraisal data serves several purposes, including protection against possible legal
action. Employees should sign their evaluations. If the employee refuses to sign, the manager should document
this behavior. Records should also include a description of employee responsibilities, expected performance
results, and the role these data play in making appraisal decisions. Although performance appraisal is important
for small firms, they are not expected to maintain performance appraisal systems that are as formal as those
used by large organizations. Courts have reasoned that objective criteria are not as important in firms with only
a few employees because in smaller firms top managers are more intimately acquainted with their employees’
work. Trained Appraisers A common deficiency in appraisal systems is that the evaluators seldom receive
training on how to conduct effective evaluations. Unless everyone evaluating performance receives training in
the art of giving and receiving feedback, the process can lead to uncertainty and conflict. The training should be
an ongoing process in order to ensure accuracy and consistency. The training should cover how to rate
employees and how to conduct appraisal interviews. Instructions should be rather detailed and the importance of
making objective and unbiased ratings should be emphasized. An e-learning training module may serve to
provide information for managers as needed. M08_MOND2998_12_PIE_C08.QXD 1/19/11 11:37 PM Page
253 OBJECTIVE 8.10 Describe the legal implications of performance appraisal. 254 PART 4 • HUMAN
RESOURCE DEVELOPMENT Continuous Open Communication Most employees have a strong need to know
how well they are performing. A good appraisal system provides highly desired feedback on a continuing basis.
There should be few surprises in the performance review. Managers should handle daily performance problems
as they occur and not allow them to pile up for six months or a year and then address them during the
performance appraisal interview. Continuous feedback is vitally important to help direct, coach, and teach
employees to grow and improve performance.45 When something new surfaces during the appraisal interview,
the manager probably did not do a good enough job communicating with the employee throughout the appraisal
period. Even though the interview presents an excellent opportunity for both parties to exchange ideas, it should
never serve as a substitute for the dayto-day communication and coaching required by performance
management. Conduct Performance Reviews In addition to the need for continuous communication between
managers and their employees, a special time should be set for a formal discussion of an employee’s
performance. Since improved performance is a common goal of appraisal systems, withholding appraisal results
is absurd. Employees are severely handicapped in their developmental efforts if denied access to this
information. A performance review allows them to detect any errors or omissions in the appraisal, or an
employee may disagree with the evaluation and want to challenge it. Constant employee performance
documentation is vitally important for accurate performance appraisals. Although the task can be tedious and
boring for managers, maintaining a continuous record of observed and reported incidents is essential in building
a useful appraisal. The appraisal interview will be discussed in a later section. Due Process Ensuring due
process is vital. If the company does not have a formal grievance procedure, it should develop one to provide
employees an opportunity to appeal appraisal results that they consider inaccurate or unfair. They must have a
procedure for pursuing their grievances and having them addressed objectively. Legal Implications Employee
lawsuits may result from negative evaluations. Employees often win these cases, thanks in part to the
employer’s own performance appraisal procedures. A review of court cases makes it clear that legally
defensible performance appraisal systems should be in place. Perfect systems are not expected, and the law does
not preclude supervisory discretion in the process. However, the courts normally require these conditions:
Either the absence of adverse impact on members of protected classes or validation of the process. A system
that prevents one manager from directing or controlling a subordinate’s career. The appraisal should be
reviewed and approved by someone or some group in the organization. The rater, or raters, must have personal
knowledge of the employee’s job performance. The appraisal systems must use predetermined criteria that limit
the manager’s discretion. Mistakes in appraising performance and decisions based on invalid results can have
serious repercussions. For example, discriminatory allocation of money for merit pay increases can result in
costly legal action. In settling cases, courts have held employers liable for back pay, court costs, and other costs
related to training and promoting certain employees in protected classes. An employer may also be vulnerable
to a negligent retention claim if an employee who continually receives unsatisfactory ratings in safety practices,
for example, is kept on the payroll and he or she causes injury to a third party. In these instances, firms might
reduce their liability if they provide substandard performers with training designed to overcome the
deficiencies. It is unlikely that any appraisal system will be immune to legal challenge. However, systems that
possess the characteristics discussed above are more legally defensible. At the same time, they can provide a
more effective means for achieving performance management goals. M08_MOND2998_12_PIE_C08.QXD
1/19/11 11:37 PM Page 254 OBJECTIVE 8.11 Explain how the appraisal interview should be conducted.
CHAPTER 8 • PERFORMANCE MANAGEMENT AND APPRAISAL 255 Appraisal Interview The appraisal
interview is the Achilles’ heel of the entire evaluation process. In fact, appraisal review sessions often create
hostility and can do more harm than good to the employee–manager relationship. To minimize the possibility of
hard feelings, the face-to-face meeting and the written review must have performance improvement, not
criticism, as their goal. The reviewing manager must use all the tact he or she can muster in discussing areas
needing improvement. Managers should help employees understand that they are not the only ones under the
gun. Rating managers should emphasize their own responsibility for the employee’s development and
commitment for support. The appraisal interview definitely has the potential for confrontation and undermining
the goal of motivating employees. The situation improves considerably when several sources provide input,
including perhaps the employee’s own self-appraisal. Regardless of the system used, employees will not trust a
system they do not understand. Scheduling the Interview Supervisors usually conduct a formal appraisal
interview at the end of an employee’s appraisal period. It should be made clear to the employee as to what the
meeting is about.46 Employees typically know when their interview should take place, and their anxiety tends
to increase if their supervisor delays the meeting. Interviews with top performers are often pleasant experiences
for all concerned. However, supervisors may be reluctant to meet face-to-face with poor performers. They tend
to postpone these anxiety-provoking interviews. Interview Structure A successful appraisal interview should be
structured in a way that allows both the supervisor and the subordinate to view it as a problem-solving rather
than a fault-finding session. The manager should consider three basic purposes when planning an appraisal
interview: 1. Discuss the employee’s performance. Focus on specific accomplishments.47 2. Assist the
employee in setting goals and personal-development plans for the next appraisal period. 3. Suggest means for
achieving established goals, including support from the manager and firm. For instance, a worker may receive
an average rating on a factor such as quality of production. In the interview, both parties should agree to the
specific improvement needed during the next appraisal period and specific actions that each should take.48
During performance reviews, managers might ask employees whether their current duties and roles are effective
in achieving their goals. In addition to reviewing job-related performance, they might also discuss subjective
topics, such as career ambitions. For example, in working on a project, perhaps an employee discovered an
unrealized aptitude. This awareness could result in a new goal or serve as a springboard to an expanded role in
the organization. The amount of time devoted to an appraisal interview varies considerably with company
policy and the position of the evaluated employee. Although costs are a consideration, there is merit in
conducting separate interviews for discussing: (1) employee performance and development and (2) pay. Many
managers have learned that as soon as the topic of pay emerges in an interview, it tends to dominate the
conversation, with performance improvement taking a back seat. For this reason, if pay increases or bonuses are
involved in the appraisal, it might be advisable to defer those discussions for one to several weeks after the
appraisal interview. Use of Praise and Criticism As suggested at the beginning of this section, conducting an
appraisal interview requires tact and patience on the part of the evaluator. Praise is appropriate when warranted,
but it can have limited value if not clearly deserved. If an employee must eventually be terminated because of
poor performance, a manager’s false praise could bring into question the “real” reason for being fired.49
Criticism, even if warranted, is especially difficult to give. The employee may not
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DEVELOPMENT perceive it as being constructive. It is important that discussions of these sensitive issues
focus on the deficiency, not the person. Effective managers minimize threats to the employee’s selfesteem
whenever possible. When giving criticism, managers should emphasize the positive aspects of performance;
criticize actions, not the person; and ask the employee how he or she would change things to improve the
situation. Also, the manager should avoid supplying all the answers and try to turn the interview into a win–win
situation so that all concerned gain. Employees’ Role From the employees’ side, two weeks or so before the
review, they should go through their diaries or files and make a note of all projects worked on, regardless of
whether or not they were successful.50 The best recourse for employees in preparing for an appraisal review is
to prepare a list of creative ways they have solved problems with limited resources. They will look especially
good if they can show how their work contributes to the value of the company. This information should be on
the appraising manager’s desk well before the review. Reminding managers of information they may have
missed should help in developing a more objective and accurate appraisal. A GLOBAL PERSPECTIVE Two
Cultures’ Views of Performance Appraisal Performance appraisal is an area of human resource management
that has special problems when translated into different cultural environments. Chinese managers often have a
different idea about what performance is than do Western managers, as Chinese companies tend to focus
appraisals on different criteria. Chinese managers appear to define performance in terms of personal
characteristics, such as loyalty and obedience, rather than outcome measurement. Chinese performance
appraisals place great emphasis on moral characteristics. Western performance appraisal seeks to help achieve
organizational objectives, and this is best obtained by concentrating on individual outcomes and behaviors that
are related to the attainment of those objectives.51 Chinese organizational objectives often differ widely from
the objectives of Western firms. Chinese firms have had to fulfill state political objectives such as maximizing
employment, and internal HR management practices are oriented to serve these objectives. Many overseas
Chinese business practices are grounded in the traditions of Chinese family business, in which a primary
objective is to maintain family control of the business. Even when the business is incorporated and publicly
traded, the family often maintains majority control, and this is a major organizational objective even to the
extent of tolerating less-than-optimal performance. One implication of this is that performance appraisals would
tend to favor workers who supported the family over workers who challenged family authority. These differing
objectives will influence the way in which appraisal judgments are made.52 There are other well-known
characteristics of the Chinese that also have a direct bearing on the practice of performance appraisal. Three
such characteristics are face (mianzi), fatalism, and the somewhat broad term Confucianism. Mianzi is the
social status that one has, and a person’s mianzi will have an effect on that person’s ability to influence others.
It is particularly important that performance reviews be held in private, since a poor review in public will cause
a subordinate to lose mianzi. It is for this reason that the Chinese tend to avoid the possibility of confrontation
and loss of face that could result from a formal appraisal process. This concern with mianzi also makes it
difficult to publicly act on performance problems.53 Fatalism also has a direct impact on performance appraisal.
Research has indicated that Chinese individuals are more likely to blame their own problems on external
factors, and since the outcome is due to things outside the individual’s control, poor achievement will not lead
to a loss of face. Such a defensive reaction is natural and occurs in all cultures, but appears to be stronger and
more formally ritualized in mainland China.54 One legacy of Confucianism is an emphasis on morality as a
basis for evaluation. Under the Confucian view, the most important characteristic of an individual was the moral
basis of his or her character. A quotation from the Confucian classic Da Xue (Great Wisdom) says, “Cultivate
oneself, bring order to the family, rule the country, and bring peace to the world.” Thus, peace, harmony, and
success all start with cultivating oneself, including the cultivation of one’s moral character. In the view of the
Chinese, a moral worker will also be an effective worker. Therefore, evaluation of performance and
achievement carries strong elements of judgments of the employee’s moral character.55
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MANAGEMENT AND APPRAISAL 257 Summary 1. Define performance management and describe the
importance of performance management. Performance management is a goal-oriented process that is directed
toward ensuring that organizational processes are in place to maximize productivity of employees, teams, and
ultimately, the organization. Whereas performance appraisal is a one-time event each year, performance
management is a dynamic, ongoing, continuous process. 2. Define performance appraisal and identify the uses
of performance appraisal. Performance appraisal is a system of review and evaluation of an individual’s or
team’s job performance. Performance appraisal data are potentially valuable for use in numerous human
resource functional areas, including human resource planning, recruitment and selection, training and
development, career planning and development, compensation programs, internal employee relations, and
assessment of employee potential. 3. Discuss the performance appraisal environmental factors. Legislation
requires that appraisal systems be nondiscriminatory. Unions have traditionally stressed seniority as the basis
for promotions and pay increases. A firm’s corporate culture can assist or hinder the process. 4. Describe the
performance appraisal process. The identification of specific goals is the starting point for the PA process and
the beginning of a continuous cycle. Then job expectations are established with the help of job analysis. The
next step involves examining the actual work performed. Performance is then appraised. The final step involves
discussing the appraisal with the employee. 5. Identify the various performance criteria (standards) that can be
established. The most common appraisal criteria include traits, behaviors, task outcomes, goal achievement, and
improvement potential. 6. Identify who may be responsible for performance appraisal and the performance
period. People who are usually responsible for performance appraisal include immediate supervisors,
subordinates, peers, groups, the employee, customers; and for the 360-degree feedback evaluation method,
perhaps all of the above. 7. Identify the various performance appraisal methods. Performance appraisal methods
include 360-degree feedback evaluation, rating scales, critical incidents, essay, work standards, ranking, forced
ranking, forced distribution, behaviorally anchored rating scales, and results-oriented approaches. 8. List the
problems that have been associated with performance appraisal. The problems associated with performance
appraisals include appraiser discomfort, lack of objectivity, halo/horn error, leniency/strictness, central tendency
error, recent behavior bias, personal bias (stereotyping), manipulating the evaluation, and employee anxiety. 9.
Explain the characteristics of an effective appraisal system. Characteristics include jobrelated criteria,
performance expectations, standardization, trained appraisers, continuous open communication, performance
reviews, and due process. 10. Describe the legal implications of performance appraisal. It is unlikely that any
appraisal system will be totally immune to legal challenge. However, systems that possess certain
characteristics are more legally defensible. 11. Explain how the appraisal interview should be conducted. A
successful appraisal interview should be structured in a way that allows both the supervisor and the subordinate
to view it as a problem-solving rather than a fault-finding session. Concluding the Interview Ideally, employees
will leave the interview with positive feelings about management, the company, the job, and themselves. If the
meeting results in a deflated ego, the prospects for improved performance will be bleak. Although you cannot
change past behavior, future performance is another matter. The interview should end with specific and
mutually agreedupon plans for the employee’s development. Managers should assure employees who require
additional training that it will be forthcoming and that they will have the full support of their supervisor. When
management does its part in employee development, it is up to the individual to perform in an acceptable
manner. M08_MOND2998_12_PIE_C08.QXD 1/19/11 11:37 PM Page 257 258 PART 4 • HUMAN
RESOURCE DEVELOPMENT Questions for Review 1. Define performance management and performance
appraisal. 2. What are the uses of performance appraisal? 3. What are the steps in the performance appraisal
process? 4. What aspects of a person’s performance might an organization evaluate? 5. Many different people
can conduct performance appraisals. What are the various alternatives? 6. Briefly describe each of the following
methods of performance appraisal: a. 360-degree feedback evaluation b. Rating scales c. Critical incidents d.
Essay e. Work standards f. Ranking g. Forced distribution h. Behaviorally anchored rating scales i. Results-
based systems 7. What are the various problems associated with performance appraisal? Briefly describe each.
8. What are the characteristics of an effective appraisal system? 9. What are the legal implications of
performance appraisal? 10. Explain why the following statement is often true: “The Achilles’ heel of the entire
evaluation process is the appraisal interview itself.” HRM INCIDENT 1 These Things Are a Pain “The dreaded
end of year appraisal is upon us!” Linda exclaimed. Like all employees in her organization, Linda was asked to
fill out an appraisal form and submit it to the HR department. Linda’s immediate supervisor was heard saying,
“Here we go again, the paper pushing session!” All employees were required to look back and reflect on the
tasks they did during the year, making sure that all value-added activities were documented and accounted for in
the appraisal forms. Linda’s boss, Irene, had hinted that it seemed like a hassle to appraise her subordinates. The
appraisal assessed employees on different criteria, including whether their goals are in line with the company’s
core values. Other criteria included efforts to improve teaching performance, participation in student and
college activities, research, and personal attributes. As Linda was a new lecturer in a private university in
Malaysia, she felt nervous. She had undergone the mid-year appraisal and had a negative experience from it. As
she filled in the appraisal form she wondered whether she had met all the targets set out for her. “Have I
improved in the areas I was told I was weak in?” she thought. Indeed, thinking back to the midyear performance
review Irene had mentioned a few areas of weaknesses. Among them was the need to remain alert about her
students’ performance and to improve her teaching performance and classroom management. Linda felt that
each of these criteria required a different measurement tool. Linda put down that during the semester she had
frequent discussions with her peers as an effort to improve her teaching performance. Linda thought about how
would this could be Key Terms employee engagement 234 performance management (PM) 236 performance
appraisal (PA) 236 competencies 241 360-degree feedback evaluation method 244 rating scales method 245
critical incident method 247 essay method 247 work standards method 247 ranking method 247 forced
distribution method 248 behaviorally anchored rating scale (BARS) method 248 results-based system 249 halo
error 250 horn error 250 leniency 250 strictness 250 central tendency error 251
M08_MOND2998_12_PIE_C08.QXD 1/19/11 11:37 PM Page 258 CHAPTER 8 • PERFORMANCE
MANAGEMENT AND APPRAISAL 259 HRM INCIDENT 2 Performance Appraisal? As the production
supervisor for Sweeny Electronics, Nakeisha Joseph was generally well regarded by most of her subordinates.
Nakeisha was an easygoing individual who tried to help her employees in any way she could. If a worker
needed a small loan until payday, she would dig into her pocket with no questions asked. Should an employee
need some time off to attend to a personal problem, Nakeisha would not dock the individual’s pay; rather, she
would take up the slack herself until the worker returned. Everything had been going smoothly, at least until the
last performance appraisal period. One of Nakeisha’s workers, Bill Overstreet, had been experiencing a large
number of personal problems for the past year. Bill’s wife had been sick much of the time, and her medical
expenses were high. Bill’s son had a speech impediment, and the doctors had recommended a special clinic.
Bill, who had already borrowed the limit the bank would loan, had become upset and despondent over his
circumstances. When it was time for Bill’s annual performance appraisal, Nakeisha decided she was going to do
as much as possible to help him. Although Bill could not be considered more than an average worker, Nakeisha
rated him outstanding in virtually every category. Because the firm’s compensation system was heavily tied to
performance appraisal, Bill would be eligible for a merit increase of 10 percent in addition to a regular cost-of-
living raise. Nakeisha explained to Bill why she was giving him such high ratings, and Bill acknowledged that
his performance had really been no better than average. Bill was very grateful and expressed this to Nakeisha.
As Bill left the office, he was excitedly looking forward to telling his work buddies about what a wonderful
boss he had. Seeing Bill smile as he left gave Nakeisha a warm feeling. Questions 1. From Sweeny Electronics’
standpoint, what difficulties might Nakeisha’s performance appraisal practices create? 2. What can Nakeisha do
now to diminish the negative impact of her evaluation of Bill? measured in the appraisal session. Most of the
discussions with her peers seemed to be about problematic students and an activity that was done to improve the
performance of students. Classroom management seemed more quantifiable. In her mind, the mix of students
differs from semester to semester and it so happened that during her mid-year review, she had a class of rowdy
students who presented some problems to her. These problems ranged from poor attendance to nonsubmission
of work. Being new, Linda felt that there were some instances where she had underperformed. As she was
filling in the appraisal form, she realised that she hadn’t participated in many college activities and had not
undertaken much research. Linda turned to her colleague, Paul, who had just finished his appraisal session.
“How did it go?” she asked. Paul replied, “Thank god that’s over. Irene’s not in the best of moods. I hope that it
doesn’t affect my appraisal.” Linda said, “Mine’s tomorrow.” Paul replied, “Well, good luck with it.” Questions
1. Why does Linda have a negative impression about the appraisal session? 2. What would have made the
appraisal session a more impressive session for Linda so that she could improve on her performance?
M08_MOND2998_12_PIE_C08.QXD 1/19/11 11:37 PM Page 259 260 PART 4 • HUMAN RESOURCE
DEVELOPMENT Notes 1. Ed Frauenheim, “Downturn Puts New Emphasis on Engagement,” Workforce
Management 88 (July 20, 2009): 8–10. 2. “In Football as in Business, Engagement Leads to Success,” Financial
Times, (March 23, 2010); “Managing Success,” Financial Times, (Jan 20, 2010); “How to Engage a Workforce
that Is Fearing the Worst,” Financial Times, (Feb 10, 2009); John Lewis, (2010):
http://www.johnlewispartnership. co.uk/Display.aspx?&MasterId=768e29e8-41aa-4716- bce2-
df302fa1c3d8&NavigationId=543; Tesco PLC, (2010): http://www.tescoplc.com/. 3. David F. Giannetto, “Get
Your Money’s Worth from Incentives,” Business Performance Management 7 (June 2009): 12. 4. Kathryn
Tyler, “Performance Art,” HRMagazine 50 (August 2005): 58–63. 5. “Make Staff Reviews Count,” Credit
Union Magazine 74 (January 2009): 12. 6. Jeffrey Russell and Linda Russell, “Talk Me Through It: The Next
Level of Performance Management,” T+D 64 (April 2010): 42–48. 7. Andy Houghton, “Performance Reviews:
It’s about ‘How,’ Not ‘Why’,” BusinessWeek Online (January 11, 2010): 11. 8. “Employees Care a Lot More
About Performance Reviews Than You May Think,” HR Focus 86 (July 2009): 9. 9. Adrienne Fox, “Curing
What Ails Performance Reviews,” HRMagazine 54 (January 2009): 52–56. 10. Jennifer Taylor Arnold, “Two
Needs, One Solution,” HRMagazine 54 (May 2009): 75–77. 11. Ibid. 12. Ibid. 13. Ibid. 14. Ibid. 15. Ibid. 16.
Hugh J. Watson and Jim Hill, “What Gets Watched Gets Done: How Metrics Can Motivate,” Business
Intelligence Journal 14 (2009): 4–7. 17. Susan Meisinger, “Adding Competencies, Adding Value,”
HRMagazine 48 (July 2003): 8. 18. “Self-Evaluation Key to Effective Staff Appraisals,” People Management
13 (July 12, 2007): 14. 19. Joan Lloyd, “Performance Reviews Never Easy,” Receivables Report for America’s
Health Care Financial Managers 24 (March 2009): 8–10. 20. Jena McGregor, “The Midyear Review’s Sudden
Impact,” BusinessWeek (July 6, 2009): 50–52. 21. “More Evidence That Performance Management Yields
Higher Profits,” HR Focus 84 (February 2007): 8–9. 22. Tracy Gallagher, “360-Degree Performance Reviews
Offer Valuable Perspectives,” Financial Executive 24 (December 2008): 61. 23. Sean Drakes, “Everybody
Counts” Black Enterprise 38 (May 2008): 58–59. 24. Tracy Maylette and Juan Riboldi, “Using 360° Feedback
to Predict Performance,” T&D 61 (September 2007): 48–52. 25. Patrick J. Kiger, “When People Practices
Damage Market Value,” Workforce Management (June 26, 2006): 42. 26. John F. Welch Jr., Jack: Straight
from the Gut (New York: Warner Business Books, 2001): 157–158. 27. Aliah D. Wright, “At Google, It Takes
A Village To Hire an Employee,” HRMagazine 53 (December 2008): 56–57. 28. Ibid. 29. D.G., “Driving the
Truth Into Performance Management,” Conference Board Review 45 (September/October 2008): 42. 30.
Stephen Garcia, “Forced Rankings of Employees Bad for Business,” Machine Design 79 (September 13, 2007):
4–5. 31. Welch, Jack: Straight from the Gut. 32. “Why HR Professionals Are Worried about Forced Rankings,”
HR Focus 81 (October 2004): 8–9. 33. Anne Fisher, “I’m Not Shedding Tears for Dot-Commers Facing
Reality,” Fortune 146 (December 9, 2002): 244. 34. Edward E. Lawler III, “Performance Management: The
Next Generation,” Compensation & Benefits Review 26 (May/June 1994): 16. 35. “Writing and Giving Job
Reviews: 8 Do’s and Don’ts,” HR Specialist 8 (February 2010): 6. 36. Joanne Sammer, “Calibrating
Consistency,” HRMagazine 53 (January 2008): 73–75. 37. Tom Krattenmaker, “Appraising Employee
Performance in a Downsized Organization,” Harvard Management Update 14 (May 2009): 3–5. 38. Jeffrey
Pfeffer, “Low Grades for Performance Reviews,” BusinessWeek (August 8, 2009): 68. 39. “Playing Favorites:
How to Avoid Unintended Partiality in Decisions, Reviews,” HR Specialist 7 (October 2009): 6. 40. Adrienne
Fox, “Curing What Ails Performance Reviews,” HRMagazine 54 (January 2009): 52–56. 41. Iris Randall,
“Performance Appraisal Anxiety,” Black Enterprise 25 (January 1995): 60. 42. Thomas S. Clausen, Keith T.
Jones, and Jay S. Rich, “Appraising Employee Performance Evaluation Systems,” CPA Journal 78 (February
 Establishing Strategic Pay Plans
Chapter-11 Establishing Strategic Pay Plans
19 April 2013
The main purpose of this chapter is to show you how to establish a pay plan. We explain job evaluation–
techniques for finding the relative worth of a job–and how to conduct online and offline salary surveys. We also
explain how to price the jobs in your firm by developing pay grades and an overall pay plan.
BASIC FACTORS IN DETERMINING PAY RATES
Employee compensation refers to all forms of pay going to employees and arising from their employment. It
has two main components, direct financial payments (wages, salaries, incentives, commissions, and bonueses)
and indirect financial payments (financial benefits like employer-paid insurance and vacations).
In turn, there are two basic ways to make direct financial payments to employees: base them on increments of
time or on performance.
Several factors determine the design of any pay plan: legal, union, company strategy and policy, and equity.
Legal Considerations in Compensation
Various laws specify things like minimum wages, overtime rates, and benefits. For example, Davis-Bacon Act
in 1931, Walsh-Healey Public Contract Act in 1936, Title VII of the 1964 Civil Rights Act.
The 1938 Fair Labor Standards Act (FLSA) contains minimum wage, maximum hours, overtime pay, equal
pay, record-keeping, and child labor provisions.
One familiar provision governs overtime pay. It says employers must pay overtime at a rate of at least one-and-
a-half times normal pay for any hours worked over 40 in a workweek.
The FLSA also sets a minimum wage, which sets a floor for employees covered by the act (and usually bumps
up wages for practically all workers when Congress raises the minimum).
Exempt/Nonexempt Specific categories of employees are exempt from the FLSA or certain provisions of the
act, and particularly from the at’s overtime provisions–they are “exempt employees”.
1963 Equal Pay Act an amendment to the FLSA, states that employees of one sex may not be paid wages at a
rate lower than that paid to employees of the opposite sex for doing roughly equivalent work.
1974 Employee Retirement Incomes Security Act provided fro the creation of government-run, employer-
financed corporations to protect employees against the failure of their employer’s pension plans.
Other Legislation Affecting Compensation For example, Age Discrimination in Employment Act, Americans
with Disabilities, Family and Medical Leave Act.
Union Influences on Compensation Decisions
Unions and labor relations laws also influence pay plan design. The National Labor Relations Act of
1935 (Wagner Act) gave unions legal protection, and granted employees the right to unionize, to bargain
collectively, and to engage in concerted activities for the purpose of collective bargaining or other mutual aid or
protection.
Competitive Strategy, Corporate Policies, and Compensation
The compensation plan should advance the firm’s strategic aims–management should produce an aligned
reward strategy.
Developing an Aligned Reward Strategy Questions to ask:
1. What must our company do (for instance interms of improving customer service), to be successful in
fulfilling its mission or achieving its desired competitive position?
2. What are the employee behaviors or actions necessary to successfuly implement this competitive
strategy?
3. What compensation programs should we use to reinforce those behaviors? What should be the purpose
of each program in reinforcing each desired behavior?
4. What measurable requirements should each compensation program meet to be deemed successful in
fulfilling it’s purpose?
5. How well do our current compensation programs match these requirements?
The employer’s compensation strategy will manifest itself in pay policies.
IBM Example IBM provides a classic example of how managers use compensation policy to support their
strategic aims. CEO–Louis Gerstner instituted four new incentive and other pay policies:
1. Pay to market.
2. Fewer, “broadband” jobs. 24 narrow wage grades –> 10 grades based on three factors (skills, leadership
requirements, and scope/impact)
3. Let managers manage.
4. Incentivize employees.
Types of Pay Policies emphasize seniority or performance.
Other pay policies usually cover how to award salary increases and promotions, overtime pay, probationary pay,
leaves for military service, jury duty, and holidays.
Salary and Incentive in Tough Times Not surprisingly, one way that employers deal with economically
challenging times is by cutting back on salary increases and merit pay.
Interestingly though, the challenging times were also prompting employers to pay closer attentiaon to their
highest performing employees.

Pay Raises Employers compute pay raises in one of two ways. merit pay(绩效工资) policies, award raises
across-the-board.
Salary Compression means longer-term employees’ salaries are lower than those of workers entering the firm
today, and is a creature of inflation.
Geography How to account for geographic differences in cost of living is another big pay policy issue.
Overseas, most multinational enterprises set expatriates’ salaries according to their home-country base pay. In
addition, the person typically gets allowances including cost-of-living, relocation, housing, education, and
hardship allowances.
Equity and Its Impact on Pay Rates
Equity Theory of Motivation postulates that people are strongly motivated to maintain a balance between
what they perceive as their inputs or contributions, and their rewards.
With respect to compensation, managers should address four forms of equity: external, internal, individual, and
procedural.
 External equity refers to how a job’s pay rate in one company compares to other job’s pay in other
companies.
 Internal equity refers to how fair the job’s pay rate is when compared to other jobs within the same
company.
 Individual equity refers to the fairness of an individual’s pay as compared with what his or her
coworkers are earning for the same or very similar jobs within the company, based on each individual’s
performance.
 Procedural equity refers to the “perceived fairness of the processes and procedures used to make
decisions regarding the allocation of pay.
Addressing Equity Issues Managers use salary surveys to monitor and maintain external equity. They use job
analysis and job evaluation comparisons of each job to maintain internal equity. They use performance appraisal
and incentive pay to maintain internal equity. And they use communications, grievance mechanisms, and
employee’s participation in developing the company’s pay plan to help ensure that employees view the pay
process as transparent and procedurally fair.
ESTABLISHING PAY RATES
The process of establishing pay rates while ensuring external, internal, and procedural equity consists of five
steps:
1. Conduct a salary survey of what other employers are paying for comparable jobs.
2. Determine the worth of each job in your organization through job evaluation.
3. Group similar jobs into pay grades.
4. Fine-tune pay rates.
Step 1. The Salary Survey
It’s difficult to set pay rates if you don’t know what others are paying, so salary surveys–surveys of what others
are paying–play a big role in pricing jobs. Salary surveys can be formal or informal. Informal phone or Internet
surveys are good for checking specific issues. Some large employers can afford to send out their own formal
surveys to collect compensation information from other employers.
Commercial, Professional, and Government Salary Surveys For example, the U.S. Department of Labor’s
Bureau of Labor Statistics’ (BLS) National Compensation Survey (NCS) (read
more: http://www.bls.gov/bls/wages.htm).
Using the Internet to Do Compensation Surveys Some Pay Data Web Sites:
 Salary.com
 www.wageweb.com
 www.opm.gov/oca/09Tables/index.asp
  http://jobstar.org/tools/salary/sal-prof.php
 cnnmoney.com
Step 2. Job Evaluation
Job evaluation aims to determin a job’s relative worth. The basic principle of job evaluation is this: Jobs that
require greater qualifications, more responsibilities, and more complex job duties should receive more pay than
jobs with lesser requirements.
Compensable Factors A fundamental, compensable element of a job, such as skills, effort, responsibility, and
working conditions. For example, Hay consulting firm emphasizes three factors: know-how, problem solving,
and accountability. Walmart bases its wage structure on knowledge, problem-sovling skills, and accountability
requirements.
Preparing for the Job Evaluation The main steps include identifying the need for the program, getting
cooperation, and then choosing an evaluation committee.
Job Evaluation Methods: Ranking There are several steps in the job ranking method.
1. Obtain job information.
2. Select and group jobs.
3. Select compensable factors.
4. Rank jobs.
5. Combine ratings.
Job Evaluation Methods: Job Classification Job classification (or job grading) is a simple, widely used
method in which raters categorize jobs into groups; all the jobs in each group are of roughly the same value for
pay purposes.
The most popular procedure is to choose compensable factors and then develop class or grade descriptions for
each class or grade in terms of the amount or level of the compensable factor(s) in those jobs.
Job Evaluation Methods: Point Method The point method is a quantitative technique. It involves identifying
(1) several compensable factors, each having several degrees, as well as (2) the degree to which each of these
factors is present in the job.
Job Evaluation Methods: Factor Comparison is a refinement of the ranking method.
Computerized Job Evaluations have two main componets: a structured questionnaire, and use statistical
models.
Step 3. Group Similar Jobs into Pay Grades
A pay grade is comprised of jobs of approximately equal difficulty or importance as established by job
evaluation.
Step 4. Price Each Pay Grade–Wage Curves
The wage curve shows the pay rates currently paid for jobs in each pay grade, relative to the points or rankings
assigned to each job or grade by the job evaluation.
Here is how to price jobs with a wage curve. First, find the average pay for each pay grade, since each of the
pay grades consists of several jobs. Next, plot the average pay rates for each pay grade. Then fit a line, called a
wage curve, through the points just plotted. Finally, price the jobs.
Step 5. Fine-Tune Pay Rates
Fine-tuning involves (1) developing pay ranges and (2) correcting out-of-line rates.
Developing Pay Ranges Pay ranges often appear as vertical boxes within each grade, showing minimum,
maximum, and midpoint pay rates for that grade.
Correcting Out-of-Line Rates
HR in Practice: Developing a Workable Pay Plan
Developing a pay plan is as important in a small firm as a large one.
Wage Surveys Four sources can be especially useful. Internet and Web sites, classified newspaper ads, Local
Job Service offices, and local employment agencies.
Job Evaluation split employees into three clusters–managerial/professional, office/clerical, and plant
personnel.
Pay Policies The better is to have a policy of once-a-year raises following a standard 1-week appraisal period,
preferably about 4 weeks before you produce the budget for next year.
Other required compensation policies include amount of holiday and vacation pay, overtime pay policy, method
of pay, garnishments, and time card or sign-in sheet procedures.
PRICING MANAGERIAL AND PROFESSIONAL JOBS
The basic aim is the same: to attract and keep good employees. Managerial jobs tend to stress harder-to-quantify
factors like judgment and problem solving more than do production and clerical jobs. There is also more
emphasis on paying managers and professionals based on results–based on their performance or on what they
can do–rahter than on the basis of static job demands like working conditions.
Compensating Executives and Managers
Compensation for a company’s top executives usually consists of four main elements: base pay, short-term
incentives, long-term incentives, and executive benefits/perquisites or “perks.”
What Determines Executive Pay?
three main factors: job complexity (span of control, the number of functional divisions over which the executive
has direct responsibility and management level), the employer’s ability to pay (total profit and rate of return),
and the executive’s human capital (educational level, field of study, work experience) accounted for about two-
thirds of executive compensation variance.
Elements of Executive Pay Salary is traditionally the cornerstone of executive compensation. On it, employers
layer benefits, incentives, and perquisites. Boards are boosting the emphasis on performance-based pay.
Managerial Job Evaluation The basic approach is to classify all executive and management positions into a
series of grades, each with a salary range.
Compensating Professional Employees
Compensable factors focus on problem solving, creativity, job scope, and technical knowledge and expertise.
Most employers use a market-pricing approach.
COMPETENCY-BASED PAY
Introduction
An increasing number of compensation experts and employers are moving away from assigning pay rates to
jobs based on the jobs’ numerically rated, intrinsic duties.
What is Competency-Based Pay?
In brief, competency-based pay means the company pays for the employee’s range, depth, and types of skills
and knowledge, rather than for the job title he or she holds. Two basic types of pay programs: pay for
knowledge or skilled pay.
In sum, probaly the biggest difference between traditional and competency-based pay is this:
 Traditional job evaluation-based pay plans tie the worker’s pay to the worth of the job based on the job
description–pay here is more job oriented.
 Competence-based pay ties the worker’s pay to his or her competencies–pay is more person
oriented.Employees here are paid based on what they know or can do–even if, at the moment, they don’t
have to do it.
Why Use Competency-Based Pay?
The main reason is that traditional pay plans may actually backfire if a high-performance work system is your
goal. The whole thrust of these systems is to encourage employees to work in a self-motivated way.
Competency-Based Pay in Practice
In practice, any skill/competency/knowledge-based pay program generally contains five main elements, which
are listed as follows:
1. A system for defining specific required skills.
2. A process for tying the person’s pay to his or her skill level.
3. A training system that lets employees acquire the skills.
4. A formal skills competency testing system.
5. A work design that lets employees move among jobs to permit work assignment flexibility.
General Mills Example four clusters of jobs: mixing, filling, packaging, and materials.
The Bottom Line on Competency-Based Pay
Competency-based pay has detractors. Some note that competency-based pay “ignores the cost implications of
paying [employees] for knowledge, skills and behaviors even if they are not used.”
SPECIAL TOPICS IN COMPENSATION
How employers pay employees has been evolving. We can sum up the main changes as follows:
 We’ve seen that there is somewhat less emphasis on the job’s duties, and more on the person’s skills and
competencies and how these fit with the firm’s strategic needs.
  We’ve seen that there is less emphasis on seniority, and more on the employee’s performance.
 There is less emphasis on narrowly defined pay ranges and jobs, and more on broader jobs and pay
ranges.
 There is increased interest in ensuring that men and women are paid comparably for essentially the same
work.
 There is more emphasis on board oversight and regulation of executive pay.
Broadbanding
Broadbanding means collapsing salary grades into just a few wide levels or bands, each of which contains a
relatively wide range of jobs and pay levels. Broadbanding breeds flexibility.
Use A survey of 783 employers found that about 15% were using broadbanding. Note that even with
competence/skill-based pay and broadbanding, 60% to 70% of U.S. firms use quantitative point and factor
comparison plans to create pay structures.
Comparable Worth
Comparable worth* refers to the requirement to pay men and women equal wages for jobs that are of
comparable value to the employer.
The Pay Gap Women in the United States earn only about 77% as much as men.
Board Oversight of Executive Pay
There are various reasons why boards are clamping down on executive pay.
Tomorrow’s Pay Programs
Companies around the world will continue to face severe economic and competitive challenges. consultants
McKinsey & Co. calls a “war for talent”. Younger “Generation Y” applicants will enter the workforce with
greater expectations for recognition and feedback than di their predecessors.
Improving Productivity Through HRIS: Automating Compensation Administration
Usually, the employer identifies set times during the year when all the firm’s managers review employees’
performance and match these with budgetary constraints and formulate pay raise recommendations for the
coming year.
CHAPTER SECTION SUMMARIES
1. In establishing strategic pay plans, managers first need to understand some basic factors in determining
pay rates. Employee compensation includes both direct financial payments and indirect financial
statements. The factors determining the design of any pay plan include legal, union, company
strategy/policy, and equity. Legal considerations include, most importantly, the Fair Labor Standards
Act, which governs matters such as minimum wages and overtime pay. Specific categories of employees
are exempt from the act or certain provisions of the act, particularly its overtime provisions. The Equal
Pay Act of 1963 and the Employee Retirement Income Security Act are other important laws.
2. The process of establishing pay rates while ensuring external, internal, and procedural equity consists of
five steps: conducting a salary survey, determining the worth of each job, doing a job evaluation,
grouping jobs comprised of approximately equal difficulty and pricing each pay grade with wage curves,
and fine-tuning pay rates.
 o Salary surveys may be informal phone or Internet surveys, or formal surveys conducted by the
employer or utilizing commercial, professional, and/or government salary surveys.
o Job evaluation is a systematic comparison done in order to determine the worth of one job
relative to another based on compensable factors.
o Compensable factors refer to compensable elements of a job such as skills and efforts.
o Popular job evaluation methods include ranking, job classification, the point method, and factor
comparison. With ranking, for instance, you conduct a job analysis, group jobs by department,
and have raters rank jobs.
o Once the commitee uses job evaluation to determine the relative worth of each job, it can turn to
the task of assigning pay rates to each job; it would usually first want to group jobs into pay
grades to streamline the process.
o The team can then use wage curves to price each grade and then fine-tune pay rates.
3. Pricing managerial and professional jobs involves some special issues. Managerial pay typically
consists of base pay, short-term incentives, long-term incentives, and executive benefits and, particularly
at the top levels, doesn’t lend itself to job evaluation but rather to understanding the job’s complexity,
the employer’s ability to pay, and the need to be competitive in attracting top talent.
4. More employers are moving from paying jobs based on their intrinsic duties toward paying jobs based
on the competencies the job requires. The main reason for doing so is to encourage employees to
develop the competencies they need to move seamlessly from job to job. At General Mills, for instance,
certain plant personnel are paid based on the skill levels they attain.
5. We addressed several important special topics in compensation. Broadbanding means consolidating
several rates and ranges into a few wide levels or “bands,” each of which contains a relatively wide
range of jobs in salary levels. Braodbanding encourages employees to move freely from job to job and
facilitates implementing team-based high-performance management systems. Comparable worth refers
to the requirement to pay men and women equal pay for jobs that are of comparable rather than strictly
equal value to the employee. With manay stockholders concerned with executive remuneration, board
oversight of executive pay has become an important issue, and boards of directors need to make sure
they use qualified advisers and exercise diligence and independence in formulating executive pay plants.

 Compensation and Benefits

Compensation & Benefits
Posted in Human Resources Terms, Total Reads: 38619
Definition: Compensation & Benefits
Compensation and benefits refers to the compensation/salary and other monetary and non-monetary
benefits passed on by a firm to its employees. Compensation and benefits is an important aspect of HRM
as it helps to keep the workforce motivated. It helps give benefits to employees based on their
performance and actions and brings the best out the employees at workplace.
Read Next
 Compensation
 Compensation Carve-out
  Compensation Plan
 Compensation Committee

Importance of compensation and benefits

Companies hire people individual to achieve their organizational goals and people join companies to earn
money & build their career. One of the biggest factors why people join companies in the compensation
and benefits, salaries, perks, incentives etc which is given to them. Apart from the company's reputation
and job profile, the money offered as a salary is pivotal in attracting people to work for the
organization. The more the compensation and benefits offered to employees, the more is their
loyalty, motivation to work and do well. However, companies which offer lesser salaries see a
high attrition rate and less productivity from employees. All these factors help in making compensation
and benefits an important factor in managing workforce. Salaries of employees are defined by several
parameters like experience, education background etc. In senior management, skills like team
management, communication management, leadership, time management etc are also considered while
finalizing the pay package.

Compensation and benefits components

There can be several ways where benefits can be given to employees. Mostly it is given in terms of a CTC
or gross salary. Some of the various components of compensation and benefits are mentioned below:
1. Fixed pay: This is the basic salary paid to the employee irrespective of any other factor. This is stated
clearly in the employment contract. This is the compensation or salary or wage which an employee or a
worker will definitely get as long as he or she is an employee of the company.
2. Variable Pay: This is the additional compensation paid to employee based on employee’s performance,
company performance etc. Since variable pay is based on the performance of an individual, it motivates
the employees to perform even better.
3. Equity Pay: Employees are awarded shares of the company, often at a discounted price. Employees are
expected to make money out of them by the appreciation of the stock price and the growth of the
company. This is mostly given to the senior management who have served the company for a long time.
4. Other benefits: Benefits such as medical facilities, insurance policies, company owned car of flat etc all
play an important role in motivating employees. These benefits are given by the company as a part of
recognizing the services of an employee.
Difference between compensation and benefits
Both the factors are important in motivating employees for doing their work and paying them for the
services they are doing for the company. However, there is a slight difference between compensation and
benefits. Compensation is completely related to the money which is being paid to an employee i.e.
salary. bonuses etc. On the other hand, benefits are the non-monetary incentives given to employees like
health benefits for which the employee doesn't have to pay.
Hence, this concludes the definition of Compensation & Benefits along with its overview.
Who is in charge of compensation, benefits and rewards schemes?
Most employees don’t just work for the love of their job. Most people also want a decent salary and other
incentives that will reward them for their hard work.
These remuneration packages need to be created, managed and distributed efficiently. This is where HR
professionals that specialise in compensation and benefits get involved.
Without these guys nobody would get that ‘just been paid’ feeling at the end of the month and Christmas
bonuses would certainly be a thing of the past. For many people, compensation and benefits professionals are
the most important guys in the HR department. Why? Well, because they control the money of course!
What are the responsibilities of someone in compensation, benefits and rewards?
Basically, people who work in compensation and benefits are responsible for devising policies for an
organisation’s salary, bonus and incentive schemes. These might include:
 Salaries
  Bonuses
 Commission
 Company cars
 Pensions
 Life assurance
 Profit sharing
 Dental plans
 Medical insurance
 Vouchers
 Capital bonds reward schemes.
They are then in charge of administering, managing and evaluating the payroll, salary structures, and incentive
schemes. Basically, they make sure that the right people get the right amount of money, at the right time.
Why is a good compensation, benefits and rewards scheme important?
The right compensation and benefits schemes ensure that hard-working employees are rewarded fairly and in
the most cost-effective way for the company. This in turn then motivates employees to sustain their
performance.
The compensation, benefits and reward schemes that these HR professionals manage are not only important for
retaining and motivating employees, but also for attracting new people to the company. Salary and incentive
packages are one of the main reasons why people apply for specific jobs. The more attractive compensation and
benefit schemes tend to generate more interest in new positions.
What skills do HR employers in this sector look for?
Compensation, benefits and reward careers are all about money. Consequently, HR professionals who work in
this area need to be numerate, commercially aware and have a detailed knowledge of financial laws and
regulations.
As well as monitoring their own company’s salary structures and benefits, these people may be required to
research and analyse the salary rates of their competitors.
However, it’s not all about numbers, paycheques and payrolls. These guys need excellent communication skills
to make recommendations to employees on pension and insurance schemes, and to liaise with government
departments and trade unions with regards to compensation and benefits issues.
Indeed, these roles have a strategic element too, as the needs of the company and employees need to be
balanced effectively. Furthermore, compensation and benefits are directly linked to market changes.
Consequently, difficult decisions regarding salary and benefits alterations may need to be made within this
department.
Would I be in charge of all compensation, benefits and reward schemes?
The size of the organisation determines what kind of work you might be doing in your compensation and
benefits career. In smaller organisations, some people might deal with the whole range of responsibilities,
whereas larger companies may offer careers which focus on one specific aspect of the compensation and
benefits remit, such as payroll management.
If you’re interested in an HR career that specialises in compensation, benefits and rewards, check out the
occupational profile of a Compensation and Benefits Manager. If a career in HR sounds perfect for you, take a
look at the various HR jobs listed on our jobs board!
NEXT CAREER PATH
Compensation and benefits (C&B) is a sub-discipline of human resources, focused on employee
compensation and benefits policy-making. While compensation and benefits are tangible, there are intangible
rewards such as recognition, work-life and development. Combined, these are referred to as total rewards[1] .
The term "compensation and benefits" refers to the discipline as well as the rewards themselves.

Contents
 1The basic components of employee compensation and benefits
 2Guaranteed pay
 3Variable pay
 4Benefits
 5Equity-based compensation
 6Intangible benefits
 7Pay aggregates
o 7.1External equity
o 7.2Internal equity
 8Organizational place
 9Main influencers
 10Bonus plans benefits
 11See also
 12References
The basic components of employee compensation and benefits[edit]
Employee compensation and benefits are divided into four basic categories:
1. Guaranteed pay – a fixed monetary (cash) reward paid by an employer to an employee. The most common
form of guaranteed pay is base salary. Guaranteed pay also includes cash allowances (housing allowance,
transport allowance, etc.), differentials (shift differentials, holiday differentials) and premiums (night shift, etc.)
2. Variable pay – a non-fixed monetary (cash) reward paid by an employer to an employee that is contingent
on discretion, performance, or results achieved. The most common forms of variable pay are bonuses and
incentives.
3. Benefits – programs an employer uses to supplement employees’ compensation, such as paid time off,
medical insurance, company car, and more.
4. Equity-based compensation – stock or pseudo stock programs an employer uses to provide actual or
perceived ownership in the company which ties an employee's compensation to the long-term success of the
company. The most common examples are stock options.
Guaranteed pay[edit]
Guaranteed pay is a fixed monetary (cash) reward.
The basic element of guaranteed pay is base salary which is paid on an hourly, daily, weekly, bi-weekly, semi-
monthly or monthly rate. Base salary is provided for doing the job the employee is hired to do. The size of the
salary is determined mainly by 1) the prevailing market salary level paid by other employers for that job, and 2)
the performance of the person in the job. Many countries, provinces, states or cities dictate a minimum wage.
Employees' individual skills and level of experience leave room for differentiating income levels within a job-
based pay structure.
In addition to base salary, allowances may be paid to an employee for specific purposes other than performing
the job. These can include allowances for transportation, housing, meals, cost of living, seniority, or as
payments in lieu of medical or pension benefits. The use of allowances varies widely by country, as well as job
level and the nature of job duties.
Variable pay[edit]
Variable pay is a non-fixed monetary (cash) reward that is contingent on discretion, performance, or results
achieved. There are different types of variable pay plans, such as bonus schemes, sales incentives (commission),
overtime pay, and more.
An example where this type of plan is prevalent is how the real estate industry compensates real estate agents. A
common variable pay plan might be the sales person receives 50% of every dollar they bring in up to a level of
revenue at which they then bump up to 85% for every dollar they bring in going forward. Typically, this type of
plan is based on an annual period of time requiring a "resetting" each year back to the starting point of 50%.
Sometimes this type of plan is administered so the sales person never resets or falls down to a lower level. It
also includes Performance Linked Incentive which is variable and may range from 130% to 0% as per
performance of the individual as per his key result areas (KRA).
Benefits[edit]
There is a wide variety of benefits offered to employees such as Paid Time-Off (PTO), various types of
insurance (such as life, medical, dental, and disability), participation in a retirement plan (such as pension or
401(k)), or access to a company car, among others. Some benefits are mandatory which are regulated by the
government while others are voluntarily offered to fulfill the need of a specific employee population. Benefit
plans are typically not provided in cash but form the basis of an employees' pay package along with base salary
and bonus.
In the United States, "qualified" employee benefit plans must be offered to all employees, while "non-qualified"
benefit plans may be offered to a select group such as executives or other highly-paid employees. When
implementing a benefit plan, HR Departments must ensure compliance with federal and state regulations. Many
states and countries dictate different minimum benefits such as minimum paid time-off, employer’s pension
contribution, sick pay, among others.
Equity-based compensation[edit]
Main article: Employee stock ownership
Equity-based compensation is an employer compensation plan using the employer’s shares as employee
compensation. The most common form is stock options, yet employers use additional vehicles such as restricted
stock, restricted stock units (RSU), employee stock purchase plan (ESPP), and stock appreciation rights (SAR).
A stock option is defined as "a contract right granted to an individual to purchase a certain number of shares of
stock at a certain price (and subject to certain conditions) over a defined period of time."[2]
Intangible benefits[edit]
An employee may receive intangible benefits, such as a desirable work schedule. That could be a schedule that
is controlled by the employee and can be adjusted to accommodate occasional non-work activities, or one that is
highly predictable, which makes it easier for the employee to arrange childcare or transportation to work.
Access to training programs, mentorship, opportunities to travel or to meet other people in the same field, and
similar experiences are all intangible benefits that may appeal to some employees.
Pay aggregates[edit]
Various combinations of the above four categories are referred to as pay aggregates. Common aggregates are
explained below.
Together, guaranteed and variable pay comprise total cash compensation. The ratio of base salary to variable
pay is referred to as the pay mix. For example, a person receiving a bonus equal to 25% of base salary would
have an 80/20 pay mix. Organizations often set the total cash compensation for sales people at a market level,
then they split the total cash compensation into the base salary component and the incentive component
following a 70/30 pay mix, while other (non-sales) employees may have a 90/10 pay mix.
Total guaranteed package or fixed cost to company are aggregates that include guaranteed pay and benefits.
This represents the total fixed cost of the reward package and is useful for budgeting. All forms of variable pay
(annual bonus and equity compensation) are excluded from this aggregate.
Total direct pay refers to total cash compensation plus equity compensation. Benefits are excluded from this
aggregate. Total direct pay includes all the elements that may be negotiated by a job candidate, especially for
senior executive positions where annual and long-term incentives are more substantial.
Total compensation would include all four categories: guaranteed pay (salary and allowances), variable pay,
benefits and equity compensation.
Remuneration is a term often used to refer to total cash compensation or total compensation.
As noted above, total rewards would include total compensation as well as intangible benefits such as culture,
leadership, recognition, workplace flexibility, development and career opportunity.
External equity[edit]
External equity refers to the similarity of the practices of other organization of the same sector. If perceived like
this, it can be said that the program is considered competitive or externally equitable. Usually, these
comparisons are done in external labor markets where the wages vary. There are various factors that contribute
to create these differences, for example, geographical location, education and work experience.
Internal equity[edit]
Internal equity is employees' perception of their duties, compensation, and work conditions as compared with
those of other employees in similar positions in the same organization. As this comparison is always made
within the company, problems with internal equity can result in conflict among employees, mistrust, low
morale, anger and even the adoption of legal actions. Workers can make the evaluation of internal equity
regarding two main points. On the one hand, procedural justice is the person’s perceived fairness of the process
(assigned tasks) and procedures used to make decisions about him/her. On the other hand, distributive justice
refers to the perceived fairness in the distribution of outcomes (salaries). The classic objectives of equity based
compensation plans are retention, attraction of new hires and aligning employees’ and shareholders’ interests
with the long-term success of the company.
Organizational place[edit]
In most companies, compensation & benefits (C&B) design and administration falls under the umbrella
of human-resources.
HR organizations in large companies are typically divided into three sub-divisions: HR business partners
(HRBPs), HR centers of excellence, and HR shared services. C&B is an HR center of excellence, like staffing
and organizational development (OD).
Main influencers[edit]
Employee compensation and benefits main influencers can be divided into two: internal (company) and external
influencers.
The most important internal influencers are the business objectives, labor unions, internal equity (the idea of
compensating employees in similar jobs and similar performance in a similar way), organizational
culture and organizational structure.
The most important external influencers are the state of the economy, inflation, unemployment rate, the
relevant labor market, labor law, tax law, and the relevant industry habits and trends.
Bonus plans benefits[edit]
Bonus plans are variable pay plans. They have three classic objectives:
1. Adjust labor cost to financial results – the basic idea is to create a bonus plan where the company is paying
more bonuses in ‘good times’ and less (or no) bonuses in ‘bad times’. By having bonus plan budget adjusted
according to financial results, the company’s labor cost is automatically reduced when the company isn’t doing
so well, while good company performance drives higher bonuses to employees.
2. Drive employee performance – the basic idea is that if an employee knows that his/her bonus depend on the
occurrence of a specific event (or paid according to performance, or if a certain goal is achieved), then the
employee will do whatever he/she can to secure this event (or improve their performance, or achieve the desired
goal). In other words, the bonus is creating an incentive to improve business performance (as defined through
the bonus plan).
3. Employee retention – retention is not a primary objective of bonus plans, yet bonuses are thought to bring
value with employee retention as well, for three reasons: a) a well designed bonus plan is paying more money to
better performers; a competitor offering a competing job-offer to these top performers is likely to face a higher
hurdle, given that these employees are already paid higher due to the bonus plan. b) if the bonus is paid
annually, employee is less inclined to leave the company before bonus payout; often the reason for leaving (e.g.
dispute with the manager, competing job offer) 'goes away' by the time the bonus is paid. the bonus plan 'buy'
more time for the company to retain the employee. c) employees paid more are more satisfied with their job (all
other things being equal) thus less inclined to leave their employer.
The concept saying bonus plans can improve employee performance is based on the work of Frederic Skinner,
perhaps the most influential psychologist of the 20th century. Using the concept of Operant Conditioning,
Skinner claimed that an organism (animal, human being) is shaping his/her voluntary behavior based on its
extrinsic environmental consequences – i.e. reinforcement or punishment.
This concept captured the hearts of many, and indeed most bonus plans nowadays are designed based on it, yet
since the late 1940s a growing body of empirical evidence has suggested that these if-then rewards do not work
in a variety of settings common to the modern workplace. The failings of the bonus plan often relate to
rewarding the wrong behaviour. For example, managers who keep to the status quo, fire valuable (expensive)
employees, and engage in immoral business practices can achieve better short-term financial outcomes (and
therefore a bonus) than a manager who is attempting to innovate his or her way to higher profits. When bonus
plans are poorly thought out, they have the potential to damage employee performance and cause regulatory
headaches. [3] However, despite their failings, employees (and many employers) still view an effective bonus
plan as the single greatest motivator in the workplace.
How to Become a Compensation and Benefits Manager
Compensation and benefits managers, also known as remuneration professionals, are responsible for overseeing
employee compensation, compensation databases, job descriptions, benchmark compensation, annual
performance reviews, and employee benefits.
Although the work of lower-level compensation and benefits specialists is generally focused primarily on
administrative tasks, the responsibilities of upper-level compensation and benefits managers are more strategic
in nature, with these HR professionals involved in the creation and management of compensation and benefits
plans. Therefore, the focus of senior-level compensation and benefits specialists is on compensation and
benefits as they relate to employee performance, company goals, sales incentive plans, and executive bonuses,
among others.
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The overall responsibility of compensation and benefits managers is to manage an organization’s compensation
and rewards program. Because compensation and benefits programs are designed to attract top talent and retain
valued employees, the work of these professionals is a crucial one within a company’s HR division.
Compensation and benefits managers must also ensure that the costs associated with compensation and benefits
are in line with the organization’s objectives, culture, and philosophy. As such, the strategic role fulfilled by
these HR professionals involves benchmarking, ensuring current documentation, and strategizing compensation
and benefits with performance.
Compensation and benefits specialists often enjoy more visibility and prestige because their work is linked
directly to the performance of the organization and they therefore work alongside the highest levels of
management.
Due to the highly specialized nature of this profession, compensation and benefits specialists work in larger
organizations that employ 1,000 employees or more. Otherwise, the responsibilities of compensation and
benefits fall to more generalized HR personnel or the finance department.
Job Responsibilities of Compensation and Benefits Specialists
Daily responsibilities and duties of compensation and benefits specialists include:
 Researching compensation and benefits policies and plans
 Ensuring compensation and benefits plans are cost-effective and competitive
 Monitoring and researching compensation and benefits trends
 Comparing benefits and compensation plans, job classifications, and salaries through data and cost
analyses
 Designing reports and recommendations based on research and analysis for senior executive team
 Preparing and updating job descriptions and occupational classifications
 Ensuring company is compliant with state and federal laws
 Collaborating with outside vendors, such as investment brokers and benefits vendors
Job duties for compensation and benefits managers, organized by HR area, include:
Compensation
 Assessing the organization’s pay structure
 Researching compensation trends and reviewing compensation surveys
 Evaluating compensation policies
 Ensuring that the pay practices comply with state and federal laws and regulations
Benefits
 Administering the organization’s benefits programs (e.g., retirement plans, leave policies, wellness
programs, insurance policies, etc.)
 Researching and analyzing benefits plans, programs, and policies
 Making recommendations based on data analyses
 Monitoring government regulations, legislation, and benefits trends
 Working with insurance brokers and benefits careers
 Managing the enrollment, renewal, and distribution processes
Job Analysis
 Writing and revising job descriptions
  Determining position classifications
 Preparing and updating salary scales
 Making recommendations to managers regarding job descriptions, salaries, and classifications
Some organizations assign specialists to all areas of compensation and benefits, (Some corporations have a
dozen or more compensation and benefits specialists.) while other organizations have separate specialists for
compensation, benefits, and job analyses work.
Traits and Qualities of Compensation and Benefits Specialists
The characteristics that best support the work of compensation and benefits specialists and managers include:
 Strong with numbers: Compensation and benefits specialists tend to be numbers-oriented, as this career
involves a great deal of quantitative analysis.
 Analytically inclined: The HR compensation and benefits profession requires professionals with strong
analytical capabilities, as they are required to analyze trends, surveys, and spreadsheets as to determine
compensation and benefits strategies.
 Detail-oriented: Compensation and benefits strategies are highly technical in nature, and the work
involves a considerable amount of research and the interpretation of data. Therefore, compensation and
benefits managers must be detail-oriented as to understand how compensation fits into the overall
objectives of the organization.
 Great communication: Compensation and benefits specialists must be able to communicate effectively
with employees and senior executives. They must also be comfortable presenting programs to employee
groups and members of senior management.
 Strong Ethics and Discretion: Because compensation and benefits managers deal with confidential
information, they must be stewards of ethics and discrete when it comes to handling sensitive
information.

Compensation and Benefits Specialist Education and Professional Certification

Career paths for compensation and benefits specialists are often varied, although most begin with a bachelor’s
degree in an HR- or finance-related field. Graduate work for compensation and benefits specialists is often
focused on master’s degrees in human resource management or a related field.
Because compensation and benefits specialists must understand the financial ramifications of particular business
decisions and about the general financial marketplace, Master of Business Administration (MBA) in Human
Resource Management degree programs are a typical pursuit among compensation and benefits specialists.
Many master’s degrees in human resource management allow students to focus their studies on compensation
and benefits. Coursework in compensation and benefits within a human resource management master’s degree
often includes:
 Compensation and benefits: strategy and plan design
 Foundations of human resource management
 Government and legal issues in compensation
 Performance appraisals in compensation decisions
  Pay-for-performance plans
Within the field of corporate compensation, there are a number of subspecialties, such as executive
compensation and sales incentive compensation; therefore, compensation and benefits specialists in these areas
must also have a comprehension foundation of knowledge in areas such as tax laws, Securities and Exchange
Commission requirements, and accounting regulations, just to name a few.
Most compensation specialists move from a generalist to a specialist at the entry- or mid-level point in their
careers.
Professional Certification
Although certification is not mandatory for compensation and benefits specialists, it is becoming more
commonplace, as it sets a minimum standard of knowledge and allows professionals to be seen as business
leaders who are committed to the profession.
There are compensation-related certifications designed specifically for compensation and benefits specialists:
o WorldatWork Society of Certified Professionals
 Certified Compensation Professional (CCP)
 Global Remuneration Professional (GRP)
 Master Certified Compensation Professional (MCCP)
 International Foundation of Employee Benefits Plans
o Certified Employee Benefits Specialist (CEBS)
o Compensation Management Specialist (CMS)
o Group Benefits Associate (GBA)
o Retirement Plans Associate (RPA)
There are also a number of general HR designations for compensation and benefits specialists:
o Society of Human Resource Management (SHRM)
 SHRM-CP (certified professional)
 SHRM-SCP (senior certified professional)
 HR Certification Institute (HRCI)
o Professional in Human Resources (PHR)
o Senior Professional in Human Resources (SPHR)
o Global Professional in Human Resources (GPHR)
o Human Resource Management Professional (HRMP)
o Human Resource Business Professional (HRBP)
o California Certification for PHR and SPHR certified professionals
Salary Data for Compensation and Benefits Managers and Specialists
The Bureau of Labor and Statistics (BLS) reported that compensation and benefits managers earned a median
salary of $95,250, as of May 2012. Compensation and benefits specialists earned a median salary of $59,090
during the same period.
The top 10 percent of compensation and benefits managers earned more than $172,450 in May 2012, while the
top 10 percent of compensation and benefits specialists earned more than $92,520 during the same period.
The 2013 Human Resources Compensation Survey Report-U.S. by Towers Watson revealed the average salaries
for the following HR professionals working in compensation and benefits:
 Compensation and benefits specialist: $101,500
 Compensation generalist: $81,900
 Compensation and benefits executive: $232,000
 Compensation executive: $183,000
 Benefits executive: $168,200
Employee Benefits and Compensation (Employee Pay)
© Copyright Carter McNamara, MBA, PhD, Authenticity Consulting, LLC.
Adapted from the Field Guide to Leadership and Supervision in Business and Field Guide to Leadership and
Supervision for Nonprofit Staff.

Sections of This Topic Include

Employee Benefits
Compensation
Salary Surveys

Also consider
Related Library Topics

Learn More in the Library's Blogs Related to Benefits and Compensation

In addition to the articles on this current page, also see the following blogs that have posts related to Benefits
and Compensation. Scan down the blog's page to see various posts. Also see the section "Recent Blog Posts" in
the sidebar of the blog or click on "next" near the bottom of a post in the blog. The blog also links to numerous
free related resources.

Library's Career Management Blog

Library's Human Resources Blog
Employee Benefits
Employee benefits typically refers to retirement plans, health life insurance, life insurance, disability insurance,
vacation, employee stock ownership plans, etc. Benefits are increasingly expensive for businesses to provide to
employees, so the range and options of benefits are changing rapidly to include, for example, flexible benefit
plans.

Benefits are forms of value, other than payment, that are provided to the employee in return for their
contribution to the organization, that is, for doing their job. Some benefits, such as unemployment and worker's
compensation, are federally required. (Worker's compensation is really a worker's right, rather than a benefit.)

Prominent examples of benefits are insurance (medical, life, dental, disability, unemployment and worker's
compensation), vacation pay, holiday pay, and maternity leave, contribution to retirement (pension pay), profit
sharing, stock options, and bonuses. (Some people would consider profit sharing, stock options and bonuses as
forms of compensation.)

You might think of benefits as being tangible or intangible. The benefits listed previously are tangible benefits.
Intangible benefits are less direct, for example, appreciation from a boss, likelihood for promotion, nice office,
etc. People sometimes talk of fringe benefits, usually referring to tangible benefits, but sometimes meaning both
kinds of benefits.

You might also think of benefits as company-paid and employee-paid. While the company usually pays for
most types of benefits (holiday pay, vacation pay, etc.), some benefits, such as medical insurance, are often
paid, at least in part, by employees because of the high costs of medical insurance.

Planning an Employee Benefits Program (Various Perspectives)

Benefits Planning and Outreach
BenefitsLink (search for "plan" in the search window on that page)
5 Atypical Employee Benefits

Buying an Employee Benefits Program

About.com's many resources
Buying Life Insurance -- Small Businesses
Health Benefits, Retirement Standards, and Workers’ Compensation: Employee Benefit Plans

General Resources
Employee Benefits Links We Like, by Topic
Complete Guide to Human Resources for Small Business
BenefitsLink(tm) - The National Employee Benefits Website
Benefits - Human Resources Net Links (search for "benefits" in the search window at this site)

Additional Information About Employee Benefits for Nonprofits

Nonprofits Can Complete for Employee Benefits

Employee Compensation
Compensation includes topics in regard to wage and/or salary programs and structures, for example, salary
ranges for job descriptions, merit-based programs, bonus-based programs, commission-based programs, etc.
(Also see the Related Info (including Benefits).)

Compensation is payment to an employee in return for their contribution to the organization, that is, for doing
their job. The most common forms of compensation are wages, salaries and tips.

Compensation is usually provided as base pay and/or variable pay. Base pay is based on the role in the
organization and the market for the expertise required to conduct that role. Variable pay is based on the
performance of the person in that role, for example, for how well that person achieved his or her goals for the
year. Incentive plans, for example, bonus plans, are a form of variable pay. (Some people might consider
bonuses as a benefit, rather than a form of compensation.) Some programs include a base pay and a variable
pay.

Organizations usually associate compensation/pay ranges with job descriptions in the organization. The ranges
include the minimum and the maximum amount of money that can be earned per year in that role.

Employees have certain monies withheld from their payroll checks, usually including federal income tax, state
income tax, FICA (social security) contributions, and employee contributions to the costs of certain benefits
(often medical insurance and retirement).

Exempt and Non-Exempt

Jobs in organizations have two classifications, exempt and non-exempt.

Professional, management and other types of skilled jobs are classified as exempt. Exempt jobs get a salary, that
is, a fixed amount of money per time interval, usually a fixed amount per month. It's not uncommon for exempt
positions to receive higher compensation and benefits than non-exempt jobs, although non-exempt jobs often
can make more money than exempt jobs simply by working more hours.

Unskilled or entry-level jobs are usually classified as non-exempt. Non-exempt jobs usually get a wage, or an
amount of money per hour. Non-exempt jobs also get paid over-time, that is, extra pay for hours worked over
40 hours a week or on certain days of the week or on holidays.

Each job must have the same pay range for anyone performing that job, that is, one person can't have a higher
maximum pay than someone else doing that same job.

General Resources About Compensation

Compensation: Outline and Definitions
7 Hidden Perks Not In Employee Paychecks
Can You Be Fired For Asking For a Raise?
Merit Pay Doesn’t Work

Also consider
Rewarding Employees

Salary Surveys
It is extremely useful to reference salary surveys when determining salaries. The surveys lend tremendous
credibility and fairness to the process of determining compensation. Be sure that surveys are somewhat current.
Reference them to find the salaries for the job roles that are the closest match to the roles you are deciding the
compensation for. The closer you can match the role to the type of services, locale and job title of the role you
are deciding compensation for, the more useful the survey is likely to be to you, especially if the survey was
generated in the past five years or less.

Sites With Salary Survey Information

Surfing for Salaries (from monster.com, helps to find salaries in wide range of fields)
Occupational Outlook Handbook
List of salary survey sites
State Occupational Employment and Wage Estimates
List of salary survey sites and articles
JobStar Profession Specific Salary Surveys
Compensation and Benefits: Definition and Importance
Compensation, Benefits, Employee Benefits, fringe benefits, compensation and benefits
Posted by Numan Nazir on Friday, 02-12-2010 12:07 am

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Human Resource Management (HRM) has never been as significant as it is today. Companies want to attract,
retain and motivate brains to meet objectives. Today Humans are regarded as one of every company’s assets so
they need to be efficiently and effectively managed. One of the tools companies use to attract, retain and
motivate its people is Compensation Management. In this article, I shall define compensation and benefits along
with their advantages for a company and its workers. Suppose, you own a boutique. Let’s call it myWear - or
you can give it any name of your liking. You have hired three salespersons and a receptionist. The salespeople
are responsible to look after the sales affairs. The receptionist's duties are to handle the cash and manage the
account books. I shall refer to this illustration throughout the article. Compensation: Would the three
salespersons and the receptionist work for free? No. They would, like us all, expect something in return. You
must...
How to Become a Compensation and Benefits Manager/Specialist

Featured Programs:
The online Master of Science in Human Resources program from Pepperdine’s Graziadio Business
School prepares students to engage in strategic business decisions at all levels of an organization. The program
is aligned with official curriculum requirements of the Society for Human Resource Management. GRE/GMAT
scores are not required to apply.
The University of Dayton’s top-ranked online Master of Science in Education (MSE) in Educational Leadership
program prepares students to become effective leaders in grades pre-k to 12. The MSE in Educational
Leadership program can be completed in as few as two years, or a little over two years if pursuing the optional
path to principal licensure. No GRE scores are required to apply.
Topics Covered
 Job Duties
  Career Requirements
 Career Outlook & Salary Expectations
Compensation and benefits managers and specialists are trained professionals who work on a company’s
compensation and benefits program or package. They also evaluate and assess different employment positions
to determine how they should be classified and what is an appropriate salary based on that classification.
Here is an overview of compensation and benefits managers/specialists, including what this career entails, how
to become one and career outlook for both compensation and benefits specialists and managers.
Job Duties
Compensation and benefits managers and specialists plan, create and supervise programs to compensate
employees. They set up an organization’s pay and benefits package(s) and also manage insurance brokers,
benefits vendors, investment managers and similar outside vendors.
Depending on if it’s a small organization or a large organization, the compensation and benefits manager may
administer both the benefits program and the compensation program or oversee one or the other.
They also coordinate with the company’s human resource managers, financial officers and senior staff to offer
their expertise and make recommendations regarding the compensation and benefits packages.
Although compensation and benefits managers are grouped together here with compensation and benefits
specialists, they are two separate individuals despite having similar duties.
While they also work together, the compensation and benefits manager typically oversees the specialist. Other
job duties of the compensation and benefits manager include the following.
 Supervise the work activities of the specialists and support staff
 Establish wages to modify or create competitive compensation packages
 Supervise the distribution of benefits and payroll information to employees
 Ensure the pay and benefits packages are in compliance with state and federal laws
 Analyze data to establish the best pay and benefits for the company
 Monitor trends affecting compensation and benefits to assess how the company can improve policies
and procedures
 Prepare company budgets while making sure they stay within the company’s budget
 Make recommendations to other managers based on data they’ve obtained from database, analytical and
presentation software
 Monitor government regulations and market conditions to ensure wage rates are competitive and current
 Administer the company’s leave policies, retirement plans, insurance policies and wellness programs
Career Requirements
To work as a compensation and benefits manager or specialist requires having at least a bachelor’s degree. The
degree may be in human resources, business management, business administration or finance. The degree may
also have a specialization or concentration in compensation and benefits. Not every college offers a
baccalaureate degree in human resources, but some offer degrees in benefits administration, compensation
analysis or human resources management.
Now, you can find programs online to further your education while you work or manage things at home, as
human resources is a growing field and more and more colleges and universities are offering this as a degree
option. Individuals who have degrees in other fields may benefit from taking courses in accounting, business,
finance or management.
While the bachelor degree is the minimum requirement, some candidates choose to pursue a master’s degree in
human resource management or related field. Another popular option is the Master of Business Administration
(MBA) with a major in human resource management, sometimes referred to as the MBA-HRM.
This is a career where work experience is almost as important as the education. Managers generally start off as
specialists and obtain experience working in finance, human resources, business administration, insurance or
management positions.
Although certification is not a requirement to be hired as a compensation and benefits manager, or a
compensation, benefits, and job analysis specialists, it’s a way to demonstrate, knowledge, expertise and a
commitment to the field. Many employers look highly on individuals who have taken the time to obtain
professional certifications.
The following organizations offer different types of certifications specifically for these professionals:
International Foundation of Employee Benefits Plans
 Certified Employee Benefits Specialist (CEBS)
 Compensation Management Specialist (CMS)
 Retirement Plans Associate (RPA)
 Group Benefits Associate (GBA)
WorldatWork Society of Certified Professionals
 Certified Compensation Professional (CCP)
 Master Certified Compensation Professional (MCCP)
 Global Remuneration Professional (GRP)
There are also general designations for human resources professionals. The two most well known and widely
accepted are from the HR Certification Institute and the Society for Human Resource Management.
These include:
HR Certification Institute (HRCI)
 Professional in Human Resources (PHR)
 Senior Professional in Human Resources (SPHR)
 Global Professional in Human Resources (GPHR)
 Human Resource Business Professional (HRBP)
 Human Resource Management Professional (HRMP)
Society for Human Resource Management (SHRM)
 SHRM-CP (certified professional)
  SHRM-SCP (senior certified professional)
Some of the certifications require not just education but also several years of work experience in this field. In
addition to meeting education and experience requirements, individuals working in this field should possess the
following traits or qualifications.
 Good with numbers – This career entails a lot of quantitative analysis and number usage, so the
candidate should be strong with numbers.
 Detail-oriented – Benefit and compensation packages are very technical and require a lot of research and
data interpretation, so the individual must be a stickler for details to understand how the packages meet
the organization’s goals.
 Great communication skills – This individual will be communicating with management and employees,
which requires good communication skills.
 Capable of discretion and possess good ethics – Must companies require that compensation and benefits
packages be confidential, so the compensation and benefits manager/specialist must be capable of these
qualities.
 Analytically inclined – Compensation and benefit numbers usually come from surveys, spreadsheets and
a lot of analyzing numbers.
After obtaining sufficient training and work experience, compensation, benefits, and job analysis specialists can
advance to become compensation and benefits managers, which generally includes a much higher annual wage.
Career Outlook & Salary Expectations
The U.S. Bureau of Labor Statistics (BLS) predicts that compensation and benefits managers can expect an
employment growth of five percent for the 2016-2026 decade, while compensation, benefits, and job analysis
specialists could experience a nine percent job growth.
Companies and organizations will continue to need these professionals to help them develop competitive wages
and good wellness programs – two things that employees look for when choosing a company in which they
want to work. According to a May 2017 wage report by the BLS, compensation, benefits and job analysis
specialists earned an average annual wage of $67,170, and compensation and benefits managers earned an
average annual wage of $130,010.
The average hourly wage for these two was $32.29 and $62.50, respectively. Factors that can affect wage
potential include work experience, training obtained, certifications, employer and geographical location.
Below are the top paying states for compensation, benefits, and job analysis specialists along with the wage as
of May 2017.
 District of Columbia – $89,590
 New Jersey – $78,060
 Maryland – $77,630
 Connecticut – 75,710
 New York – $75,380
Here are the top-paying states and wages for compensation and benefits managers for that same time period.
 Rhode Island – $166,730
  New Jersey – $163,600
 Delaware – $163,410
 New York – $157,120
 Connecticut – $148.990
Working in the field of human resources gives you an opportunity to impact many parts of an organization, and
one of the most important areas in any organization is within compensation and benefits. In these areas, you
make a difference with employees who feel well taken care of, secu
ecure and happy, and you bring loyalty to the organization with employees who feel this way about their jobs.
What Does a Compensation Manager Do?
Learn About the Salary, Required Skills, & More
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•••
BY SUSAN M. HEATHFIELD

Updated May 01, 2019

Compensation managers are responsible for researching, establishing, and maintaining a company's pay system.
This involves researching and understanding the current and upcoming competitive markets for employee pay
and benefits. A compensation manager must find ways to ensure that pay rates are fair and equitable in order to
retain and recruit employees.
Compensation Manager Duties & Responsibilities
The job generally requires the ability to perform the following duties:
 Develop and evolve an organization’s pay scale and structure
 Determine competitive wage rates and change as necessary
 Ensure that the company's pay scale complies with changing state and federal laws and regulations
 Oversee the distribution of pay to employees
 Work with managers to help develop promotion and retention strategies for existing employees
 Develop a department budget and keep operations within that budget
 Oversee compensation and payroll support team
A compensation manager's duties depend to some extent on the nature of the company they work for. In larger
organizations, a compensation manager might specialize in specific areas such as job classification or market
pay studies. They're often assisted by staff specialists.
It's the compensation manager's responsibility to see that the company's pay scale complies with ever-changing
state and federal laws and regulations. Depending on the needs of the organization, compensation managers
might oversee their company's performance evaluation system as well. They might handle employee benefits, as
well as employee reward systems such as bonuses, merit raises, and pay-for-performance plans.
Compensation managers may work closely with individual managers as well as human resources business
partners and the payroll department to ensure that raises are handled correctly and fairly.
Compensation Manager Salary
A compensation manager's salary can vary depending on location, experience, and employer.
 Median Annual Salary: $121,010
 Top 10% Annual Salary: $205,470
 Bottom 10% Annual Salary: $70,560
Source: U.S. Bureau of Labor Statistics, 2018
Education, Training, & Certification
Employers often seek a mix of education and relative experience for compensation managers. Certification is
usually optional.
 Education: This position generally requires a four-year bachelor's degree with a major in a related field,
such as economics, accounting, or human resources.
 Experience: Employers often prefer or require previous experience in a human resources or finance
department or in a similar occupation.
 Certification: This isn't required, but it can help boost your chances of getting a job. Certification
options for compensation managers are plentiful, and they include the Certified Compensation
Professional® program from WorldatWork and the Certified Compensation and Benefits Manager®
program from the Human Resource Management Institute.
Compensation Manager Skills & Competencies
To be successful in this role, you’ll generally need the following skills and qualities:
 Communication skills: Compensation managers must be able to effectively talk and write about a
company's pay strategy and system and address any concerns that come from executives and employees.
 Analytical skills: People in this position must be able to collect, weigh, and analyze data on many
factors to determine the best compensation plan for a company.
 Mathematical skills: Calculating compensation can be complicated and requires solid working
knowledge of math and statistics.
Job Outlook
The U.S. Bureau of Labor Statistics (BLS) projects that employment in this field will grow 5 percent through
2026, which is slightly slower than the overall employment growth of 7 percent for all occupations in the
country.
Work Environment
Compensation managers can work in almost every industry, and they usually work in an office. The role is often
seen as vital to employee retention in business because they're responsible for making pay competitive, fair,
legal, and rewarding. Because of this, the job can be somewhat stressful at times.
Work Schedule
Most compensation managers work full time during regular business hours, and according to the BLS, about
one in 3 people in this position work more than 30 hours per week.
Comparing Similar Jobs
People who are interested in becoming [job name] may also consider other careers with these median salaries:
 Ethics, Justice, and Fair Treatment in HR Management
The Ethics of Justice & Fair Treatment in HR Management
by Audra Bianca

Related Articles
 1Reasons for Wrongful Termination
 2OSHA Inspection Strategies
 3Moral Obligation in Business Law
 4Basic Federal Employee Rights
Human resources (HR) managers ensure that all organizational policies and procedures conform with modern
employment law and other laws, such as the Sarbanes-Oxley Act of 2002. These professionals also employ
broad knowledge of employment practices, and a key concept is that employees are entitled to justice and fair
treatment in personnel policies and procedures.
Policies and Procedures
Policies and procedures defining employee rights and responsibilities can be found in a firm's personnel
manual. An example of one such right is that an employee can file a complaint of discrimination against a
supervisor with the HR department. An example of a responsibility is when an employee notifies the HR
department and supervisor upon obtaining outside employment.
HR Manager's Role
It is the HR manager's role to encourage his company to implement ethics laws and other employment laws
justly and fairly. For example, the HR manager must protect employees from being retaliated against for actions
that comply with the Sarbanes-Oxley Act. This act states, for example, that the names of any accountants
associated with the company who participate in or contribute to audit report preparation must be given to the
Public Company Accounting Oversight Board.
Due Process
An HR manager consults managers and supervisors on sensitive personnel matters, such as employee discipline
and termination. He suggests ways to handle these matters while respecting an employee's right to fair
treatment, including due process. For instance, if a special committee investigates an employee's misconduct,
the HR manager should be notified of the investigation and charges. He should also be able to present evidence,
have a representative present and be informed of the investigation's findings. This is an example of how an
employee receives equitable treatment throughout a personnel matter.
Individual Rights
HR managers also investigate allegations that employee rights are violated. According to Richard L. Daft and
Dorothy Marcic, authors of "Understanding Management," a manager or coworker should not violate basic
human rights -- such as the right to privacy, free consent, freedom of conscience, free speech and life and
safety. Managers shouldn't ask employees to do anything that violates their basic rights, such as performing an
action that endangers their personal safety -- unless specifically outlined in their job description.
The Ethics of Justice & Fair Treatment in HR Management
by Jackie Lohrey

RELATED ARTICLES
 Ethical Issues HR Managers Face in an Organization's Culture
 What Is a Leader's Role in an Organization With Respect to Diversity?
 HR Practices That Can Contribute to Ethical Behavior
 The Emergence of Organizational Culture
 Effective Response and Resolution of a Personnel Complaint
 How Does Diversity Affect HR Functions?
Human resource policies and procedures affect employees' jobs and their future employment potential. HR
managers, which in the case of a small business can mean the business owner, must continually balance the
need to ensure the business meets it objectives but also ensure that the business follows and maintains ethical
employment practices and standards. Among these is a key concept relating to an employee’s right to justice
and fair treatment.
The Ethics of Behavior
Ethics are the moral principles that govern business behavior. It’s critical for HR personnel to understand that
compliance with federal and state employment regulations doesn’t necessarily mean the business is practicing
ethical behaviors. One problem is that while laws and regulations create definite standards of behavior, the
concept of ethics is more subjective and perceptions about what constitutes ethical behavior often differs
between individuals. To build an ethical behavior framework, HR employment practices must not only adhere
to legal guidelines but also model and adhere to the business’s core values.
HR Ethical Issues
The lack of or a loosely enforced small-business ethics policy often leads to business owners continually
struggling with a multitude of common fair-treatment issues. These include -- but aren’t limited to -- favoritism
in hiring practices, employee training and promotion, and inconsistent disciplinary measures, which may lead to
increased instances of workplace harassment. Other issues include a lack of confidentiality surrounding an
employee’s personal and performance information, wage discrimination and basing annual reviews on factors
unrelated to an employee’s role.
Trust and Mutual Respect
HR can foster an environment where justice and fair treatment is the norm by creating and living up to an
expectation of trust and mutual respect. Trust is fostered when information-sharing is accurate, timely and
complete, and when clear, specific and measurable goals are set for the business and its employees, and
employees at all levels are encouraged to share their ideas and concerns. Mutual respect develops when dignity
is a behavioral standard, when the business owner and management team encourage initiative and creativity,
and when diversity isn’t simply tolerated but appreciated and promoted.
Maintaining an Ethical Environment
HR has the power to influence the company culture. It often takes more, however, than creating and adhering to
a company ethics policy. Ongoing and open communication is essential to maintaining an environment that
promotes ethical behaviors such as justice and fair treatment. After setting ethical behavioral expectations, a
next step is the establishment of a communication platform, such as an open-door policy and focus group
meetings, that ensures a forum for discussing ethical issues exists.
Presentation on theme: "Ethics, Justice, and Fair Treatment in HR Management"— Presentation transcript:
1 Ethics, Justice, and Fair Treatment in HR Management
Part 5 | Employee RelationsChapter 14Ethics, Justice, and Fair Treatment in HR Management© 2008 Prentice
Hall, Inc. All rights reserved.
2 After studying this chapter, you should be able to:
Explain what is meant by ethical behavior at work.Discuss important factors that shape ethical behavior at
work.Describe at least four specific ways in which HR management can influence ethical behavior at
work.Employ fair disciplinary practices.List at least four important factors in managing dismissals effectively.©
2008 Prentice Hall, Inc. All rights reserved.
3 Ethics and Fair Treatment at Work
The Meaning of EthicsThe principles of conduct governing an individual or a group.The standards you use to
decide what your conduct should be.Ethical behavior depends on a person’s frame of reference.Ethical
DecisionsNormative judgmentsMorality© 2008 Prentice Hall, Inc. All rights reserved.
4 What Is Organizational Culture?
The characteristic values, traditions, and behaviors a company’s employees share.How is culture is
revealed?Ceremonial eventsWritten rules and spoken commandsOffice layoutOrganizational structureDress
codesCultural symbols and behaviorsFigureheads© 2008 Prentice Hall, Inc. All rights reserved.
5 HRM-Related Ethics Activities
SelectionFostering the perception of fairness in the processes of recruitment and hiring of people.Formal
proceduresInterpersonal treatmentProviding explanationsSelection toolsTwo-way communicationTrainingHow
to recognize ethical dilemmas.How to use ethical frameworks to resolve problems.How to use HR functions in
ethical ways.© 2008 Prentice Hall, Inc. All rights reserved.
6 HRM-Related Ethics Activities (cont’d)
Performance AppraisalAppraisals that make it clear that the company adheres to high ethical standards by
measuring and rewarding employees who follow those standards.Reward and Disciplinary SystemsThe
organization swiftly and harshly punishes unethical conduct.Workplace Aggression and ViolenceTaking care
that HR actions do not foster perceptions of inequities that translate into dysfunctional behaviors by
employees.© 2008 Prentice Hall, Inc. All rights reserved.
7 Discipline Without Punishment (Nonpunitive Discipline)
Issue an oral reminder.Should another incident arise within six weeks, issue a formal written reminder, a copy
of which is placed in the employee’s personnel file.Give a paid, one-day “decision-making leave.”If no further
incidents occur in the next year, then purge the one-day paid suspension from the person’s file. If the behavior
is repeated, the next step is dismissal.© 2008 Prentice Hall, Inc. All rights reserved.
8 Employee Privacy Employee privacy violations upheld by courts:
IntrusionPublication of private mattersDisclosure of medical recordsAppropriation of an employee’s name or
likenessActions triggering privacy violations:Background checksMonitoring off-duty conduct and lifestyleDrug
testingWorkplace searchesMonitoring of workplace© 2008 Prentice Hall, Inc. All rights reserved.
9 Managing Dismissals Dismissal Terminate-at-Will Rule
Involuntary termination of an employee’s employment with the firm.Terminate-at-Will RuleWithout a contract,
the employee can resign for any reason, at will, and the employer can similarly dismiss the employee for any
reason (or no reason), at will.© 2008 Prentice Hall, Inc. All rights reserved.
10 Avoiding Wrongful Discharge Suits
Bases for Wrongful Discharge SuitsDischarge does not comply with the law.Discharge does not comply with
the contractual arrangement stated or implied by the firm via its employment application forms, employee
manuals, or other promises.Avoiding Wrongful Discharge SuitsSet up employment policies and dispute
resolution procedures that make employees feel treated fairly.Do the preparatory work that helps to avoid such
suits.© 2008 Prentice Hall, Inc. All rights reserved.
11 Termination Assistance
Outplacement CounselingA systematic process by which a terminated employee is trained and counseled in the
techniques of conducting a self-appraisal and securing a new job appropriate to his or her needs and
talents.Does not imply that the employer takes responsibility for placing the person in a new job.Is part of the
terminated employee’s support or severance package and is often done by specialized outside firms.© 2008
Prentice Hall, Inc. All rights reserved.
12 Interviewing Departing Employees
Exit InterviewIts aim is to elicit information about the job or related matters that might give the employer a
better insight into what is right—or wrong—about the company.The assumption is that because the employee is
leaving, he or she will be candid.The quality of information gained from exit interviews is questionable.© 2008
Prentice Hall, Inc. All rights reserved.
13 The Plant Closing LawWorker Adjustment and Retraining Notification Act (1989)Requires employers of
100 or more employees to give 60 days notice before closing a facility or starting a layoff of 50 people or
more.The law does not prevent the employer from closing down, nor does it require saving jobs.The law is
intended to give employees time to seek other work or retraining by giving them advance notice of the
shutdown.© 2008 Prentice Hall, Inc. All rights reserved.
14 K E Y T E R M S ethics ethics code distributive justice
procedural justiceinteractional (interpersonal) justiceorganizational culturenonpunitive disciplineElectronic
Communications Privacy Act (ECPA)dismissalwrongful dischargeunsatisfactory
performancemisconductinsubordinationtermination interviewoutplacement counselingexit
interviewsbumping/layoff proceduresdownsizing© 2008 Prentice Hall, Inc. All rights reserved.
ETHICS, JUSTICE, AND FAIR TREATMENT IN HR MANAGEMENT
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The Meaning of Ethics

 The principles of conduct governing an individual or a group.
 The standards you use to decide what your conduct should be.
 Ethical behavior depends on a person’s frame of reference.
Ethical Decisions
 Normative judgments
 Morality

What Is Organizational Culture?

Organizational culture:The characteristic values, traditions, and behaviors a company’s employees share.
How is culture is revealed?
 Ceremonial events
 Written rules and spoken commands
 Office layout
 Organizational structure
 Dress codes
 Cultural symbols and behaviors
 Figureheads
HRM-Related Ethics Activities
Selection
 Fostering the perception of fairness in the processes of recruitment and hiring of people.
 Formal procedures
 Interpersonal treatment
 Providing explanations
  Selection tools
 Two-way communication
Training
 How to recognize ethical dilemmas.
 How to use ethical frameworks to resolve problems.
 How to use HR functions in ethical ways.
Performance Appraisal
Appraisals that make it clear that the company adheres to high ethical standards by measuring and rewarding
employees who follow those standards.
Reward and Disciplinary Systems
The organization swiftly and harshly punishes unethical conduct.
Workplace Aggression and Violence
Taking care that HR actions do not foster perceptions of inequities that translate into dysfunctional behaviors by
employees.
Discipline Without Punishment (Nonpunitive Discipline)
1.Issue an oral reminder.
2.Should another incident arise within six weeks, issue a formal written reminder, a copy of which is placed in
the employee’s personnel file.
3.Give a paid, one-day “decision-making leave.”
4.If no further incidents occur in the next year, then purge the one-day paid suspension from the person’s file. If
the behavior is repeated, the next step is dismissal.
Employee Privacy
Employee privacy violations upheld by courts:
 Intrusion
 Publication of private matters
 Disclosure of medical records
 Appropriation of an employee’s name or likeness

Actions triggering privacy violations:

 Background checks
 Monitoring off-duty conduct and lifestyle
 Drug testing
 Workplace searches
  Monitoring of workplace
Managing Dismissals
Dismissal
Involuntary termination of an employee’s employment with the firm.
Terminate-at-Will Rule
Without a contract, the employee can resign for any reason, at will, and the employer can similarly dismiss the
employee for any reason (or no reason), at will.
Avoiding Wrongful Discharge Suits
Bases for Wrongful Discharge Suits
 Discharge does not comply with the law.
 Discharge does not comply with the contractual arrangement stated or implied by the firm via its
employment application forms, employee manuals, or other promises.
Avoiding Wrongful Discharge Suits
 Set up employment policies and dispute resolution procedures that make employees feel treated fairly.
 Do the preparatory work that helps to avoid such suits.

Termination Assistance
Outplacement Counseling
 A systematic process by which a terminated employee is trained and counseled in the techniques of
conducting a self-appraisal and securing a new job appropriate to his or her needs and talents.
 Does not imply that the employer takes responsibility for placing the person in a new job.
 Is part of the terminated employee’s support or severance package and is often done by specialized
outside firms.

Interviewing Departing Employees

Exit Interview
 Its aim is to elicit information about the job or related matters that might give the employer a better
insight into what is right—or wrong—about the company.
 The assumption is that because the employee is leaving, he or she will be candid.
 The quality of information gained from exit interviews is questionable.
AFRREV IJAH, Vol.2 (1) February, 2013 Copyright © IAARR 2013: www.afrrevjo.net/ijah 157 AFRREV
IJAH An International Journal of Arts and Humanities Bahir Dar, Ethiopia Vol. 2 (1), Serial 5, February,
2013:157-179 ISSN: 2225-8590 (Print) ISSN 2227-5452 (Online) Application of Ethics, Justice and Fair
Treatment in Human Resource Management for Sustainable Peace in Nigerian Work Organizations Okere,
Loveday, Ph.D, MNIM, MABEN Department of Management Faculty of Business Studies Rivers State
University Of Education Port Harcourt E-mail: okerelovedayu@yahoo.com Nwabueze, Chibuzor Chile
Department of History & Diplomatic Studies Faculty of Humanities Ignatius Ajuru University of Education
Port Harcourt E-mail: chibuzornwobueze@yahoo.com & Nweke, Onyinyechi Department of Economics
Faculty of the Social Sciences Ignatius Ajuru University of Education Port Harcourt E-mail:
onyinyetext@yahoo.com AFRREV IJAH, Vol.2 (1) February, 2013 Copyright © IAARR 2013:
www.afrrevjo.net/ijah 158 Abstract For many managers, recruitment and placement, training and development,
and compensation are the heart of human resource management. But people expect something more. They
expect their employers to treat them fairly, and to have a safe work environment. This paper deals with ethics,
justice, and fair treatment in human resource management, matters essential for positive employer and
employee peaceful con-existence. Literature survey method was adopted to discuss the issues raised in the
study. The paper observed that ethics and fair treatment play important roles in managing employees at work.
The paper also noticed that moral awareness, the managers themselves, moral engagement, morality, unmet
goals, and rewards all influence ethical behaviour. The paper further recommended that employees‟ fair
treatment at work should reflect concrete actions, and they should be treated with respect. Also managers should
discipline employees who observe unethical behaviour, and perpetrators of indiscipline at work, not innocent
workers. Key Words: Ethics, Justice, Fair Treatment, Human Resource Management, Organizations, managers,
Work. Introduction People face ethical choices every day. Almost everybody rightfully views himself or herself
as an ethical person, so we should start by asking, ―Why include ethics in human resource management
discussions?‖ First ethics is not theoretical. Instead, it greases the wheels that make businesses work. Managers
who promise raises but don‘t deliver, sales people who say ―The order are coming‖, when they are not,
production managers who take kickbacks from suppliers – they all corrode the trust that day-to-day business
transactions depend on, and eventually run the businesses into the ground. According to one lawsuit, marketers
for Pfizer Inc, influenced Pfizer to suppress unfavourable studies about one of its drugs (Keith, 2008), Plaintiffs
are suing for billions. Second, and more specifically, managers‘ human resource decisions are usually replete
with ethical consequences (Dennis, 2006). For example Sean (2006) found that 6 of the 10 most serious ethical
work issues such as work place safety, employee records security, employee theft, affirmative action,
comparable work, and employee privacy rights, were human resource related. Another survey of human
resource professionals by Paul (2004) found that 54% had observed misconduct ranging from violations of Title
VII to violations of the Occupational Safety AFRREV IJAH, Vol.2 (1) February, 2013 Copyright © IAARR
2013: www.afrrevjo.net/ijah 159 and health Act. Therefore, all managers should understand the basics of ethics
and the ethical dimensions of their people-related decisions. Purpose of the Study The purpose of this study is
to: 1) Examine the issue of ethics in workplaces; 2) Assess ethics and the law in work organizations; 3)
Examine ethics, justice, and fair treatment in work organizations; 4) Evaluate employee rights in work
organizations; 5) Assess what determines ethical behaviour at work; 6) Evaluate how managers use personnel
methods to promote ethics and fair treatment; 7) Identify how employee discipline and privacy are managed; 8)
Examine how dismissals are managed in work organizations. Assumptions of the Study The assumptions made
for the purpose of this study are: 1) That the works of authors consulted are sincere manifestations of their
opinions concerning ethics, justice and fair treatment in human resource management in work organizations. 2)
That the authors‘ assessments were fair and reliable for drawing conclusion about the research topic. Ethics in
Workplaces Ethics refers to ―the principles of conduct governing an individual or a group; specifically, the
standards one use to decide what his conduct should be (Ferrell, 2008). Making ethical decisions always involve
two things. First, it always involves normative judgments (Manual, 1992). A normative judgment means that
something is good or bad, right or wrong, better or worse. Second, ethical decisions always involve questions of
morality. Morality is society‘s highest accepted standards of behaviour. Moral standards guide behaviours of the
most serious consequence to society‘s well-being, such as murder, tying, and slander. Authoritative bodies like
Application of Ethics, Justice & Fair Treatment in Human Resource Management … AFRREV IJAH, Vol.2 (1)
February, 2013 Copyright © IAARR 2013: www.afrrevjo.net/ijah 160 legislatures cannot change what morality
means. Moral judgments also trigger strong emotions. Violating moral standards may therefore make someone
feel ashamed or remorseful (Tom, 2001). It would simplify things if it were always clear when one‘s decision
were ethical. Unfortunately, it is not. If the decision makes the person feel ashamed or remorseful, or involves
doing something with serious consequence such as murder, then, chances are, it‘s unethical. Ethics and the Law
in Work Organizations Firing a 39-year-old employee with 20 years‘ tenure without cause may be legal, but
some would view it as unethical. Richard (2000) put it this way: ―Ethics means making decisions that
represent what you stand for, not just what the laws are‖. But some behaviour are both illegal and unethical. For
example, one huge meat processor had to respond to a federal indictment charging it with smuggling illegal
immigrants from Mexico to cut factory costs (Carroll, 2002). Ethics, Justice, and Fair treatment in Work
Organizations Similarly, fairness is an issue in most human resource decisions. You hire one candidate and
reject another, and promote one and demote another. How employees react to these decisions depends, to some
extent, on whether they think the decisions and the processes that led up to them were fair. Fairness is
inseparable from what most people think of as ―Justice‖. A company that is just is, among other things,
equitable, fair, impartial, and unbiased in how it does things. With respect to employee relations, experts
generally defined organizational justice in terms of at least two components – distributive justice and procedural
justice. Distributive Justice refers to the fairness and justice of the decision‘s result. For instance, did I get an
equitable pay raise? Procedural Justice refers to the fairness of the process (Daniel and Robert, 2003). For
instance, is the process my company uses to allocate merit raises fair? In practice, fair treatment reflects
concrete actions (Gary and Linda, 2001). These include employees are treated with respect (Michelle, 1998). In
theory, ethics, justice, and fair treatment may be separate but related concepts. But in practice most employees
probably cannot and won‘t unscramble what is ethical, fair, or just when it comes to how they are treated at
work (Gary and Linda, 2001). AFRREV IJAH, Vol.2 (1) February, 2013 Copyright © IAARR 2013:
www.afrrevjo.net/ijah 161 Employee Right in Work Organizations Of course, few societies rely on managers‘
ethics or sense of fairness to ensure that they do what is right by their employees. They also put in place various
laws. For example, the Occupational Safety and Health Act gives employees the right to refuse to work under
unsafe conditions (Kenneth, 1999). Aside from legislation, employees also have certain rights under common
law. For example, under common law, an employer may have the right to sue the employer whose supervisor
published embarrassing private and personal information about the employee. Determinants of Ethical
Behaviour at Work Several experts reviewed the research concerning things that influence ethical behaviour in
organizations (Linda et al, 2006). They found that: - Ethical behaviour starts with moral awareness. In other
words, does the person even recognize that a moral issue exists in the situation? - Managers can do a lot to
influence employee ethics by carefully cultivating the right norms, leadership, reward systems, and culture. -
Ethics slide when people undergo moral disengagement. Doing so frees them from the guilt that would
normally go with violating one‘s ethical standards. - The most powerful morality comes from within. - Beware
the seductive power of an unmet goal. Unmet goals pursued blindly can contribute to the intrinsic value of
ethical behaviour. - Offering rewards for ethical behaviour can backfire. Doing so may actually undermine the
intrinsic value of ethical behaviour. - Don‘t inadvertently reward someone for bad behaviour. - Employers
should punish unethical behaviour. - Employees who observe unethical behaviour expect the manager to
discipline the perpetrators. - The degree to which employees openly talk about ethics is a good predictor of
ethical conduct. Conversely, organizations characterized by moral muteness suffer more ethically problematic
behaviour. Application of Ethics, Justice & Fair Treatment in Human Resource Management … AFRREV
IJAH, Vol.2 (1) February, 2013 Copyright © IAARR 2013: www.afrrevjo.net/ijah 162 - People tend to alter
their moral compasses when they join organizations. Based on these evidences, things that determine ethical
behaviour at work include: The Person: The most powerful morality comes from within. Because people bring
to their jobs their own ideas of what is morally right and wrong, the individual must shoulder much of the credit
(or blame), for ethical choices. For example, Sara et al (1995) in a survey of CEO‘s explored their intention to
engage or not to engage in soliciting a competitor‘s technical secrets and bribing foreign officials. The
researchers concluded that personal inclinations more strongly affected decisions than did environmental
pressures or organizational characteristics. The Boss: Managers do a lot to influence ethics. It is hard to resist
even subtle pressure, let alone coercion, from your boss. According to one report, for instance, ―the level of
misconduct at work dropped dramatically when employees said their supervisors exhibited ethical behaviour‖.
Only 25% of employees who agreed that their supervisors ―set a good example of ethical business behaviour‖
said they had observed misconduct in the last year, compared with 72% of those who did not feel that their
supervisors set good examples (Vikas, 2004). Umphress (2009) has given examples how supervisors knowingly
or unknowingly can lead subordinates to go astray: - Tell staffers to do whatever is necessary to achieve results.
- Overload top performers to ensure that the work is done. - Look the other way when wrong doing occurs. -
Take credit for others‘ work or shift blame. These examples illustrate an important feature of the boss‘s
influence. The influence is often subliminal. He or she sends signals about the appropriate way to behave. Those
signals then create the culture to which employees respond. We can define organizational culture as the
―characteristic values, traditions, and behaviours a company‘s employees share‖. A value is a basic belief
about what is right or wrong, or about what you should or should not do. ―Honesty is the best policy‖ would be
a value. Values are important because they guide and channel behaviour. Managing people and shaping their
behaviour therefore, depends on shaping the values they use as behavioural guides. The firms culture should
therefore send clean signals AFRREV IJAH, Vol.2 (1) February, 2013 Copyright © IAARR 2013:
www.afrrevjo.net/ijah 163 about what is and is not acceptable behaviour. For example, if management really
believes ―Honesty is the best policy‖, the written values they follow and the things they do should reflect this
value. Managers therefore have to send the right signals to their employees. Guidelines include the following: -
Clarifying expectations: First, make clear your expectations with respect to the values you think are critical. -
Walk the talk: Employees take their signals from the boss actions. Managers need to ―walk the talk‖. They
cannot say, ―Don‘t fudge the financials‖, and then do so themselves. - Provide Physical Support: The physical
manifestations of the manager‘s values, that is, the incentives, appraisal criteria, and disciplinary procedures he
or she uses, for instance, send strong signals regarding what employees should and should not do. The
Company: People tend to alter their ethical compasses when they join organizations. Is there such as thing as an
ethically toxic company? Some think so. An ethically toxic company is one in which all the usual procedures
that normally diminish bad behaviour are simply missing. For example, managers pressure or even reward
employees for bad behaviour; no one publicizes ethical standards such as ―don‘t bribe officials‖; and no, takes
the time to follow up on or audit bad behaviour. How Managers Use Personnel Methods to Promote Ethics and
Fair Treatment Many of the actions managers can take to promote ethics fall within the realm of human
resources management practices. Some specific examples include: Selection: Deborah and Marshall (2001):
Krohe (1997), says ―The simplest way to turn up an organization, ethically speaking, is to hire more ethical
people‖. Employers can start before the applicant even applies by creating recruitment materials that emphasize
ethics. Use tools such as honesty tests and background checks to screen out undesirables (William, 2004).
Fairness: Managers interviewing applicants also need to make sure the screening process is fair. ―If
prospective, employees perceive that the hiring process does not treat people fairly, they may also assume that
ethical behaviour is not important (Linda, 2005). Keep several things in mind here: Application of Ethics,
Justice & Fair Treatment in Human Resource Management … Application of Ethics, Justice & Fair Treatment
in Human Resource Management … AFRREV IJAH, Vol.2 (1) February, 2013 Copyright © IAARR 2013:
www.afrrevjo.net/ijah 164 - Applicants tend to view the formal procedure such as the interview, as fair to the
extent that it tests job-related criteria and provides an opportunity to demonstrate competence. - Applicants
expect respect. Interpersonal treatment reflects such things as the propriety of the questions, the politeness of
the person doing the assessing, and the degree of two-way communication. - Applicants see a selection system
as fair to the extent that the employer provides useful feedback about the employee‘s or candidate‘s own
performance. Ethics Training: For all practical purposes, ethics training is mandatory. Ethics training usually
includes showing employees how to recognize ethical dilemmas, how to use ethical frameworks such as codes
of conduct to resolve problems, and how to use human resource activities such as interviews and disciplinary
practices in ethical ways. Performance Appraisal: How an organization conduct appraisals is important. Studies
and practical experience confirm that, in practice, some managers ignore accuracy in performance appraisals
and instead use the process for political purposes such as encouraging employees with whom they don‘t get
along to leave the firm. Few things can send a more damaging signal about how fair and ethical the company is.
To send the signal that fairness is paramount standards should be clear, employees should understand the basis
upon which a company is going to appraise them, and the appraisal itself should be objective. Reward and
Disciplinary Systems: To the extent that behaviour is a function of its consequences, the manager needs to
reward ethical behaviour and penalize unethical behaviour. Tom (2009) suggests, ―Employees expect the
organization to dole out relatively harsh punishment for unethical conduct‖. If the company does not deal
swiftly with unethical behaviour, often the ethical employees feel punished. Personnel – Related Methods for
Ensuring Fair Treatment For most people the answer to ―Why treat employees fairly?‖ is obvious, since most
learn, early on, some version of the golden rule. But there are also concrete reasons managers should treat
employees fairly. Arbitrators and the courts will consider the fairness of the employer‘s disciplinary AFRREV
IJAH, Vol.2 (1) February, 2013 Copyright © IAARR 2013: www.afrrevjo.net/ijah 165 procedures when
reviewing disciplinary decisions. Fairness also relates to a wide range of positive employee outcomes. These
include enhanced employee commitment and enhanced satisfaction with the organization, job and leader and
more ―organizational citizenship behaviours‖, the steps employees take to support their employers‘ interests.
Job applicants who felt treated unfairly expressed more desire to appeal the outcome. Those who view the
firm‘s testing programmes as fair react more favourably to the selection procedure, and view the company and
the job as more attractive (Russell and Thomas, 2003). There are thus, many practical reasons beyond the
golden rule, for treating employees fairly. Managing Employee Discipline and Privacy The purpose of
discipline is to encourage employees to behave sensibly at work that is, where sensible means adhering to rules
and regulations. Thomas (2008) posits that ―discipline is necessary when an employee violates a rule‖. Proper
disciplinary procedures are important for several reasons, that is, beyond the fact that it is the right thing to do.
In a study, David (1995) surveyed 45 published arbitration awards in which tardiness had triggered discipline
and/or discharge. When arbitrators overturned employers‘ decisions, it was usually because the employer had
failed to clarify what it meant by ―tardy‖. A lack of clarity regarding how often an employee may be late and
an inappropriately severe penalty were other problems. Unfair disciplinary procedures can backfire in other
ways. For example, an unfair disciplinary procedure can trigger retaliatory employee mischief, and thus actually
encourage misbehaviour. Therefore, establishing a fair disciplinary process is not as easy as it might appear.
Basics of a Fair and Just Disciplinary Process The employer may want its discipline process to be both
effective, in terms of discouraging unwanted behaviour, and fair. Employers do base such a process on three
pillars: Clear rules and regulations, a system of progressive penalties, and an appeals process. Rule and
Regulations: First, rules and regulations address issues such as theft, destruction of company property, drinking
on the job, and insubordination. Examples include: - Poor performance is not acceptable. Each employee is
expected to perform his or her work properly and effectively. Application of Ethics, Justice & Fair Treatment in
Human Resource Management … AFRREV IJAH, Vol.2 (1) February, 2013 Copyright © IAARR 2013:
www.afrrevjo.net/ijah 166 - Alcohol and drugs do not mix with work. The use of either during working hours
and reporting for work under the influence of either are both prohibited. Rules inform employees ahead of time
what is and is not acceptable behaviour. Upon hiring tell employees, preferably in writing, what is not
permitted. The employees handbook usually contains the rule and regulations. Progressive Penalties: A system
of progressive penalties is a second pillar of effective discipline. Penalties typically range from oral warnings to
written warnings to suspension from the job to discharge. The severity of the penalty is usually a function of the
type of offence and the number of times it has occurred. For example, most companies issue warnings for the
first unexcused lateness. For a fourth offence, discharge is the usual disciplinary action. Formal Disciplinary
Appeals Processes: In additions to rules and progressive penalties, the disciplinary process requires an appeals
procedure. Virtually all union agreements contain disciplinary appeal procedures, but such procedures are not
limited to unionized firms. Discipline without Punishment: Traditional discipline has two potential drawbacks.
First, no one likes to be punished. Second, punishment tends to gain short-term compliance, but not the sort of
long-term cooperation employers often prefer. Discipline without punishment, or non-punitive discipline aims
to avoid these drawbacks. It does this by gaining employees‘ acceptance of the rules while reducing the punitive
nature of the discipline itself (Dick, 2001). Hot Stove Role: Supervisors traditionally apply the four points of
what they call the ―hot stove rule‖ when applying discipline. When touching a hot stove that says, ―Don‘t
touch‖, the person has warning, and the pain is consistent, impersonal, and immediate. Employee Privacy: For
most people, invasions of privacy are neither ethical nor fair (Milton, 2001). The four main types of employee
privacy violations upheld by courts are intrusion, publication of private matters, disclosure of medical records,
and appropriation of an employee‘s name or likeness for commercial purposes (Morris, 2001). Rita (2008) in a
survey of security professionals ranked human resources last among departments securing such confidential
data. In practice, background checks, monitoring off-duty conduct and lifestyle, drug testing, workplace
scarches, and monitoring of AFRREV IJAH, Vol.2 (1) February, 2013 Copyright © IAARR 2013:
www.afrrevjo.net/ijah 167 workplace activities trigger most privacy violations (Declan and Angela, 2003).
Employee Monitoring: Employee monitoring is widespread. More than half of employers monitor e-mail
activity, three-quarters monitor employee internet use, and about 40% monitor phone calls (Eileen, 2002).
Employers say they do so mostly to improve productivity and protect themselves from computer viruses, leaks
of confidential information, and harassment suits (Gundars, 2007). Furthermore, employees who use company
computers to do things like swap and download music can ensnare employers in illegal activities (Bill, 2008).
Employers routinely use special software to monitor what their employees are doing online. Managing
Dismissals in Work Organizations Dismissal is the most drastic disciplinary step the employer can take.
Because of this, it requires special care. There should be sufficient reason for the dismissal, and as a rule,
organization should only dismiss someone after taking reasonable steps to rehabilitate or salvage the employee.
However, there will undoubtedly be times when dismissal is required, perhaps at once. The best way to handle a
dismissal is to avoid it in the first place. Many dismissals start with bad hiring decisions. Using effective
selection practices including assessment tests, reference and background checks, drug testing and clearly
defined job descriptions can reduce the need for many dismissals. Termination at Will and Wrongful Discharge
For more than 100 years, termination at will was the prevailing dismissalrelated rule. Termination at will means
that without a contract, either the employer or the employee could terminate at will the employment
relationship. The employee can resign for any reason, at will, and the employer can dismiss an employee for
any reason, at will (Joseph, 1982; Carolyn, 2008). Today, however, dismissed employees are increasingly
taking their cases to court, and many employers are discovering they no longer have a blanket right to fire.
Instead, Equal Employment Opportunity (EED) and other laws and court rulings limit management‘s right to
dismiss. For example, firing a whistleblower might trigger ―public policy‖ exceptions to firing at will. Or a
statement in an employee handbook may imply a contractual agreement to keep an employee. Michael (2007),
pointed out how Business Week Magazine described how some employers, even when faced with employee
theft, were reluctant to terminate disruptive employees AFRREV IJAH, Vol.2 (1) February, 2013 Copyright ©
IAARR 2013: www.afrrevjo.net/ijah 168 for fear of lawsuits. In practice, though, plaintiffs only win a tiny
fraction of such suits. However, the cost of defending the suits is still huge. Wrongful Discharge: Wrongful
discharge refers to a dismissal that violates the law or that fails to comply with contractual arrangements stated
or implied by the employer, for instance, in employee manuals. Three main protections against wrongful
discharge have eroded the termination-at-will doctrine, such as statutory exceptions, common law exceptions,
and public policy exceptions. First, in terms of statutory exceptions, equal employment and workplace laws
prohibit specific types of dismissals. As just one example, occupational safety laws prohibit firing employees
for reporting dangerous workplace conditions (Robert and Martin, 2005). Second, numerous common law
exceptions exist. For example, courts recognize the concept of implied contracts in employment. Thus, a court
may decide that an employee handbook promising termination only ―for just cause‖ may create an exception to
the at-will rule. Finally, under the public policy exception, courts have held a discharge to be wrongful when it
was against an explicit, well-established public policy, for instance, the employer fired the employee for
refusing to break the law. Grounds for Dismissal: There are four bases for dismissal: unsatisfactory
performance, misconduct, lack of qualifications for the job, and changed requirements of (or elimination of) the
job. Unsatisfactory Performance means persistent failure to perform assigned duties or to meet prescribed job
standards (Joseph 1982). Specific grounds include excessive absenteeism, tardiness, a persistent failure to meet
normal job requirements, or an adverse attitude towards the company, supervisor, or fellow employees.
Misconduct is deliberate and willful violation of the employer‘s rule and may include stealing, rowdy
behaviour, and insubordination. Sometimes the misconduct is more serious, as when it causes someone else
harm. Lack of qualifications for the job is an employee‘s inability to do the assigned work although he or she is
diligent. If the employee may be trying to do the job, it is reasonable to do what is possible to salvage him or
her, perhaps by assigning the person to another job. A changed requirement of the job refers to an employee‘s
inability to do the job after the employer changed the nature of the job. Again, the employee may be industrious,
so it is reasonable to retain or transfer this person, if possible. Insubordination: Insubordination is a form of
misconduct, and basically refers to disobedience and/or rebelliousness. While things like stealing, AFRREV
IJAH, Vol.2 (1) February, 2013 Copyright © IAARR 2013: www.afrrevjo.net/ijah 169 chronic tardiness, and
poor-quality work are easily understood grounds for dismissal, insubordination is sometimes harder to translate
into words. However, some acts are usually clearly insubordinate. These include, for instance: - Direct disregard
of the boss‘s authority; - Direct disobedience of, or refusal to obey, the boss‘s orders, particularly in front of
others; - Deliberate defiance of clearly stated company policies, rules, regulations, and procedures; - Public
criticism of the boss; - Blatant disregard of reasonable instructions; - Contemptuous display of disrespect; -
Disregard for the chain of command, shown by frequently going around the immediate supervisor with
complaints, suggestions, or political maneuvers. - Participation in or leadership of an effort to undermine or
remove the boss. Fairness in Dismissals: Dismissals are never pleasant. However, there are three things
organizations can do to make sure they are fair (Nancy, 2007). First ―Individuals who said that they were
given full explanations of why and how termination decisions were made were more likely to perceive their
layoff as fair, and indicate that they did not wish to take the past employer to court. Second, institute a formal
multi-step procedure, including warning and a neutral appeal process. Third, who actually does the dismissing is
important. Security Measures: Security measures are important whenever dismissal occur. Common sense
requires using a checklist to ensure that dismissed employees return all keys and company property, and often
accompanying them out of their offices and out of the building. The employer should disable Internet-related
passwords and accounts of former employees, plug holders that could allow an ex-employee to gain illegal
online access, and have rules for return of company laptops and handhelds. Measures range from simply
disabling access and changing passwords to reconfiguring the Application of Ethics, Justice & Fair Treatment in
Human Resource Management … AFRREV IJAH, Vol.2 (1) February, 2013 Copyright © IAARR 2013:
www.afrrevjo.net/ijah 170 network and changing 1P addresses, remote access procedures, and telephone
numbers (Jaikumar, 2001). Avoiding Wrongful Discharge Suits: Wrongful discharge occurs when an
employee‘s dismissal does not comply with the law or with the contractual arrangement stated or implied by the
employer. Avoiding wrongful discharge suits requires a three-pronged approach (Betty, 2005). First create
employment policies including grievance procedures that help make employees feel you treated them fairly.
Similarly, employers can use severance pay to blunt a dismissal‘s sting (Richard, 2008). In the words of
Jonathan (2008), there is no way to make termination pleasant, but the first line of defense is to handle it justly.
Second, review and refine all employment – related policies, procedures, and documents to limit changes. Have
applicants sign the employment application. Make sure it contains a statement that employment is for no fixed
term, and that the employer can terminate employee at any time. Pay particular attention to the employee
handbook. It should include an acknowledgement form. Consider deleting statements such as ―employees can
be terminated only for just cause‖. Keep careful confidential records of all actions such as employee appraisals,
warnings or notices, and memos outlining how improvement should be accomplished. Third, make sure you
clearly communicate job expectations to the employees, failing to do so triggers many wrongful termination
claims. Personal Supervisory Liability Courts sometimes hold managers personally liable for supervisory
actions, including discipline and dismissal, particularly with respect to actions covered by the Labour Act and
Family and Medical Leave Act. The former defines employer to include ―any person acting directly or
indirectly in the interest of an employer in relation to any employee‖. This can mean the individual supervisor.
There are several ways to avoid personal liability. Managers should be fully familiar with applicable federal,
state, and local statutes. Follow company policies and procedures, since an employee may allege that the
organization did not follow company policies and procedures. The essence of many charges is that the plaintiff
was treated differently than others, so consistent application of the rule is important. Administer the discipline
in a manner that does not add to the emotional hardship on the employee as dismissing them publicly would
tantamount to abuse of employment rights. Most employees will try to present their side of the story, and
allowing them to do so can provide the employee some measure of AFRREV IJAH, Vol.2 (1) February, 2013
Copyright © IAARR 2013: www.afrrevjo.net/ijah 171 satisfaction. Do not act in anger, since doing so
undermines any appearance of objectivity. Finally, utilize the human resource department for advice on how to
handle difficult disciplinary matters. Termination Interview: Dismissing an employee is one of the most
difficult tasks a manager faces at work. During one 5 – year period, physicians interviewed 791 working people
who had just undergone heart attacks to find out what might have triggered them. The researchers concluded
that the stress associated with firing doubled the usual risk of a heart attack for the person doing the firing,
during the week following the dismissal (Kemba, 2001). Furthermore, the dismissed employee, even if
forewarned many times, may still react with disbelief or even violence. Guidelines for the termination interview
itself are as follows: 1. Plan the interview carefully; 2. Get to the point; 3. Describe the situation; 4. Listen; 5.
Review all elements of the severance package; 6. Identify the next step. Layoffs, Downsizing, and the Plant
Closing Law: Non disciplinary separations are a fact of corporate life. For the employer, reduced sales or profits
may require layoffs or downsizing. Layoff generally refers to having selected employees take time off, with the
expectation that they will come back to work. Downsizing refers to permanently dismissing a relatively large
proportion of employees in an attempt to improve productivity and competitiveness. Other employees may
resign to retire or to look for better jobs. Stephen and Donald (2003), posits that sensible layoff steps to take
therefore include these: 1. Identify objectives and constraints. 2. Form a downsizing team. 3. Address legal
issues 4. Plan post-implementation actions. 5. Address security concerns. Application of Ethics, Justice & Fair
Treatment in Human Resource Management … Application of Ethics, Justice & Fair Treatment in Human
Resource Management … AFRREV IJAH, Vol.2 (1) February, 2013 Copyright © IAARR 2013:
www.afrrevjo.net/ijah 172 6. Try to remain informative. Layoffs, Downsizing Alternatives: Layoffs and
downsizings are usually painful for all involved, and have the added disadvantages of stripping away trained
personnel. Employers therefore, often try to find alternatives. There are various alternatives. Suggestions
include finding volunteers who are interested in reducing hours or part-time work, using attrition, and even
networking with local employers concerning temporary or permanent redeployments. With the voluntary
reduction in pay plan, all employees agree to reductions in pay to keep everyone working. Other employers
arrange for all or most employees to concentrate their variations during slow periods. They don‘t have to hire
temporary help for vacationing employees during peak periods, and staffing automatically declines when
business declines (Rita, 2008). Many employers hire employees with the understanding that their work is
temporary. When layoffs are required they are the first to leave. Some seek volunteers as an alternative to
dismissing large numbers of employees. Adjusting to Downsizings and Mergers Firms usually downsize to
improve their financial position. Yet many firms discover that profits don‘t improve after major personnel cuts.
Low morale among those remaining is often part of the problem. It therefore makes sense to think through how
the firm is going to reduce the surviving employees‘ uncertainty and boost their morale (Leon, 2006). Merger
Guidelines: In terms of dismissal, mergers and acquisitions are usually one-sided. In such situations, the
acquired firm‘s surviving employees may be hypersensitive to mistreatment of their soon-to-be former
colleagues. It thus behooves the merger to treat those whom the organization let go fairly. As a rule, therefore: -
Avoid the appearance of power and domination. - Avoid win-lose behaviour. - Remain business like and
professional in all dealings. - Maintain as positive a feeling about the acquired company as possible. AFRREV
IJAH, Vol.2 (1) February, 2013 Copyright © IAARR 2013: www.afrrevjo.net/ijah 173 - Remember that the
degree to which your organization treats the acquired group with care and dignity will affect the confidence,
productivity, and commitment of those who remain (Steve, 2001). Method Adopted This study relies heavily on
views expressed in available literature with respect to ethics, justice, and fair treatment in human resource
management. Accordingly, literature survey was employed to discuss the issues raised in the study. The issues
were critically and widely analyzed with a view to addressing the challenges of ethics, justice and fair treatment
in managing human resources in work organizations. It is therefore, imperative to note that the nature of the
information gathered makes qualitative analysis more appropriate for this study. Justification of the Study This
study is justified on the grounds that: - Managers in Nigerian work organizations will benefit from the study by
understanding the rudiments involved in ethical behaviour at work. - The study will guide managers in various
organizations to know the important factors that shape ethical behaviour at work. - Managers in various
Nigerian work organizations will also by this study be acquainted with the specific ways in which human
resource management can influence ethical behaviour at work. - The study will assist managers in Nigerian
work organizations to be able to employ fair disciplinary practices. - The study will also expose to the managers
in Nigerian work organizations the important factors in managing employees dismissals effectively. Conclusion
Ethics and fair treatment play important roles in managing employees at work. Ethics refers to the principles of
conduct governing an individual or a group. The concepts of ethics, justice, and fair treatment are intertwined.
For examples, fairness is inseparable from what most people think of as ―justice‖ from the individual
employee‘s point of view. Few societies rely AFRREV IJAH, Vol.2 (1) February, 2013 Copyright © IAARR
2013: www.afrrevjo.net/ijah 174 solely on managements‘ ethics or sense of fairness, and therefore legislate
employee rights. Many things influence ethical behaviour at work. From the research, we know that moral
awareness, the managers themselves, moral engagement, morality, unmet goals, and rewards all influence
ethical behaviour. The person is important, in that people bring to their jobs their own ideas of what is morally
right or wrong. The boss and how he or she molds the organizational culture have a prevailing effect on ethical
behaviour, because it is difficult to resist even subtle pressure from your boss. Employers themselves can take
steps to support ethical behaviour, for instance via training, whistle blower programmes, and ethics codes.
Managers can use personnel methods to promote ethics and fair treatment. For example, in selection, the
manager can hire ethical people and emphasize the fairness of selection procedures. Similarly, ethics training,
conducting fair and just performance appraisals, rewarding ethical behaviour, and generally treating employees
fairly all promotes ethics and the perception of fair treatment. Communication plays an important role in fair
treatment. For example, ask questions and listen carefully, set aside your defensive actions, and ask, ―what
would you like me to do?‖. Managing employee discipline and privacy are important management skills. The
basics of a fair and just disciplinary process include clear rules and regulations, a system of progressive
penalties, and an appeals process. Some employers use non punitive discipline, which usually involves a system
of oral warning and paid ―Decision-making Leaves‖. The ―hot stove rule‖ means administering discipline in
such a way that the person has warning, and the pain is consistent, impersonal, and immediate. Dismissals are
usually traumatic for both the manager and the dismissed employee, and so managers need to take special care
in managing dismissals. Termination at will means that without a contract, either the employer or the employee
could terminate at will, the employment relationship. Wrongful discharge refers to a dismissal that violates the
law or that fails to comply with contractual arrangements stated or implied by the employer. Grounds for
dismissal include unsatisfactory performance, misconduct, including insubordination, lack of qualifications for
the job, and changed requirements of the job. Fairness in dismissal is enhanced when employees get
explanations of why and how termination decisions were made; there is a formal multi-step procedure,
including warnings; and the supervisor rather than a third person does the dismissing. Supervisors can be held
personally liable for unjust dismissals, and so it is advisable that the supervisors not to act in anger, follow
company policies and procedures, and avoid adding to the emotional hardship on the employee. AFRREV
IJAH, Vol.2 (1) February, 2013 Copyright © IAARR 2013: www.afrrevjo.net/ijah 175 The termination
interview should be planned carefully, and the supervisor should then get to the point, describe the situation,
listen, review all elements of the severance package, and then identify the next step. Some employers use
outplacement counselors to facilitate the process. To avoid wholesale dismissals during what may turn out to be
short-term downturns, some employers are using attrition or voluntary reductions in pay plans.
Recommendations The following recommendations are made to improve ethics, justice and fair treatments in
human resource management at work in Nigerian organizations - Employees‘ fair treatment at work should
reflect concrete actions, and they should be treated with respect. - Managers should at work understand the
basics of ethics and the ethical dimensions of their people – related decisions. - Managers should discipline
employees who observe unethical behaviour, and perpetrators of indiscipline at work, not the innocent workers.
- Managing people at work and shaping their behaviour should depend on shaping the values they use as
behavioural guides. - Companies should urge their employees to apply a quick ethic test to evaluate whether
what they are about to do fits the company‘s code of conduct. - Fairness should relate to a wide range of
positive employee outcomes which should include enhanced employee commitment and enhanced satisfaction
with the organization, job, and leader and more organizational citizenship behaviours. - Using effective
selection practices including assessment tests, reference and background checks, drug testing, and clearly
defined job descriptions will assist organizations to reduce the need for many employees‘ dismissals at work. -
Mainstreaming non formal peace education as conflict prevention, peace building and conflict transformation
strategy is central at providing knowledge that can enable workers to relate with one another peacefully.
Application of Ethics, Justice & Fair Treatment in Human Resource Management … Application of Ethics,
Justice & Fair Treatment in Human Resource Management … AFRREV IJAH, Vol.2 (1) February, 2013
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Treatment in Human Resource Management …
 Labor Relations and Collective Bargaining
Summary of "Collective Bargaining and Labor Relations"
Summary of
Collective Bargaining and Labor Relations
By Terry Leap
Summary written by Conflict Research Consortium Staff

Citation: Leap, Terry. Collective Bargaining and Labor Relations. Englewood Cliffs, New Jersey: Prentice
Hall, 1995, 752 pp.

Collective Bargaining and Labor Relations is a college-level text which explores the history and current
practice of union-management relations, and collective bargaining.
Collective Bargaining and Labor Relations will be of interest to those who seek a better understanding of
contemporary labor relations, and of the role of unions in collective bargaining. This work is divided into
eighteen chapters grouped into eight parts. Each chapter ends with discussion questions and exercises.
Part One introduces collective bargaining and labor relations. Chapter One presents an overview of labor
relations. The author recounts the origins and purposes of unions. He describes three levels of union-
management interaction: contract negotiations, contract administration, and informal joint consultations. He
also examines the impact of collective bargaining on employers, employees, and society. Chapter two recounts
the U.S. history of collective bargaining and labor relations.
The second part focuses on establishing the collective bargaining relationship. Chapter Three explains the legal
bases of collective bargaining, describing federal labor acts from the Railway Labor Act of 1926 to the present.
Chapter Four focuses on the bargaining unit. The author begins by explaining the doctrine of exclusive
representation. He presents the National Labor Relations Board criteria for determining appropriate bargaining
units, and describes several common bargaining unit structures. Finally, the formation of bargaining units is
further explored via four case studies. Chapter Five then describes the union organization process. The author
describes the factors which prompt interest in unionization, and the process of unionization campaigns
including the formal certification process.
Part Three describes the organizational structures, goals and policies for collective bargaining of unions and of
management. The author first examines unions. He reviews the organization and concerns of the AFL-CIO, of
international unions and of local unions. This chapter also investigates unions as democratic institutions, and
unions relation to organized crime. This chapter concludes by describing typical union goals in collective
bargaining. Chapter Seven turns its attention to management, opening with the basic goals and strategies of the
management. Differences between unionized and non-unionized firms are explored. The author describes
strategies for balancing power between unions and management, and for creating cooperative efforts between
union and management.
Part Four explores the collective bargaining process. Chapter Eight presents an overview of a number of
bargaining theories, and compares them giving particular attention to the points the have in common. Drawing
upon these theories, the author presents a model of collective bargaining power and bargaining tactics, and
suggests techniques for evaluating collective bargaining outcomes. Chapter Nine takes a more practical
approach, focusing on collective bargaining preparation, tactics, and issues. The chapter opens with an overview
of the stages of the bargaining process. It then describes the preparation stage in greater detail. The chapter
closes with discussion of the strategies and tactics appropriate at various stages of the bargaining process.
Part Five focuses on two types of disputes which arise within the collective bargaining process: interest disputes
and rights disputes. Chapter ten discusses interest disputes. It opens with a discussion of the role and sources of
conflict in labor-management relations, and explores the role of mediation in preventing labor disputes. Interests
disputes may escalate into strikes or lockouts. The author describes several forms of labor strike, and discusses
the federal regulation of strikes under the National Emergencies section of the Taft-Hartley Act. Chapters
Eleven and Twelve focus on rights disputes. Rights disputes "arise over the interpretation of an existing
collective bargaining agreement"[327] The author describes the role of contract administration in labor
relations, and investigates some of the sources of grievance in labor relations. He then describes the basic
elements of grievance procedures, and closes by suggesting criteria for evaluating grievance procedures.
Chapter Twelve examines the final stage of most grievance procedures: binding arbitration. The author
describes the process of labor arbitration, from arbitrator selection to evaluation of final arbitration awards. This
chapter also discusses common errors in arbitration, and suggests guidelines for determining which cases are
appropriate for resolution through arbitration.
Part Six turns to the substantive provisions of negotiated labor agreements. Chapter Thirteen describes
economic and compensation provisions of labor agreements. Such economic provisions include setting pay
levels and pay structure, group or individual incentive programs, and sex discrimination compensation. The
chapter closes with two case studies in compensation, and an appendix describing four major methods of job
evaluation. Chapter Fourteen describes employee benefit programs. Such benefits include life, accidental death
and health insurance, retiremen programs, vacations and leaves, and child- or elder-care. This chapter concludes
with an appendix on calculating the cost of compensation and benefits packages. Chapters Fifteen and Sixteen
consider institutional issues which are addressed in the collective bargaining agreement, exploring both
management rights and employee security. The author discusses management rights, seniority arrangements,
workplace health and safety, technological changes resulting in worker displacement, and the use of
subcontracting and temporary labor. Chapter Sixteen focuses on employee discipline, discussing the sources
and types of disciplinary problems, and forms of disciplinary policies and procedures.
Part Seven explores public sector labor relations. This section sketches the history of public- sector unions, and
contrasts collective bargaining in the public-sector to private-sector bargaining. It then describes the collective
bargaining process at the federal, state and local levels. This section closes with a case study of a public sector
strike.
Part Eight concludes the text with an overview of future challenges facing collective bargaining and labor
relations. Currently, unions are losing membership. Chapter Eighteen examines the causes for this decline, and
outlines strategic choices for unions in the future.
Collective Bargaining and Labor Relations is a comprehensive yet accessible review of collective bargaining in
contemporary labor relations. Questions and exercises at the end of each chapter provide helpful study tools.
The phrase ‘Collective Bargaining' is coined by famous authors Sydney and Beatrice Webb in their celebrated treatise
a method of determining the terms and conditions of employment and settling disputes arising from those terms by nego
their trade union. The very fact that the parties reserve the ultimate right to use economic weapons of strike and lock out
agreement.

Meaning of collective bargaining

The term collective bargaining is made up of two words, ‘collective’ – which means a ‘group action’ through representa
involves proposals and counter-proposals, offers and counter-offers. Thus it means collective negotiations between the e
situations. The success of these negotiations depends upon mutual understanding and give and take principles between th

In the work situation, an individual worker has to face many problems such as, low wages, long hours of work, loss ince
individuals cannot attract the attention of the employer because of their less bargaining power. The growth of trade unio
enables them to bargain for their better conditions collectively.

Collective bargaining is a source of solving the problems of employees in the work situation collectively. It provides a g
with their employers. The employees put their demands before the employers and the employers also give certain conces
cannot take unilateral decision concerning the work ignoring the workers. It also helps the workers to achieve responsibl
benefits etc. It provides them a collective strength to bargain with employer. It also provides the employers some control
The process of collective bargaining is bipartite in nature, i.e. the negotiations are between the employers and employees
bargaining serves to bridge the emotional and physiological gulf between the workers and employers though direct discu

The HR Labor Relations Manager directs the organization's labor relations agreement in accordance with executive le
relations support staff and serve as the management representative in labor negotiation, bargaining, or interpretive meeti

Definitions

The phrase collective bargaining is made up of two words collective which implies group action through its representativ
negotiating. The phrase, therefore, implies collective negotiation of a contract between the management’s representative
Thus collective bargaining is defined as a process of negotiation between the employer and the organized workers repres
and conditions of employment.

Stevens: Collective Bargaining as a ‘social control technique for reflecting and transmitting the basic power relationship
industrial relations system.’

Prof. Allan Flanders: Collective Bargaining is primarily a political rather than an economic process. He describes colle
trade union organization and the management organization. The agreement arrived at is a compromise settlement of pow
described as “the great social invention that has institutionalized industrial conflict” Dubin

Richardson says, “Collective bargaining takes place when a number of work people enter into negotiation as a bargainin
the object of reaching agreement on conditions of the employment of the work people”.

Encyclopedia Britannica defined collective bargaining as a process of discussion and negotiation between an employer
reach agreement on working conditions. If negotiations are between an employer and a group of his work-people, the de
job weakens their bargaining power, and therefore, collective bargaining is more usually understood to be negotiation be
group or association of employers".

Ludwig Teller states the “Definition and General Nature of Collective Bargaining” in these terms.
“The collective bargaining agreement has been variously interpreted, but its essential nature is the subject of general und
between a single employer or an association of employers at the one hand and a labour union on the other, which regulat

The ILO has defined collective bargaining as "negotiations about working conditions and terms of employment between
more employees' organizations with a view to reaching an agreement wherein the terms serve as a code of defining the r
employment relations with one another; fix a large number of detailed conditions of employment, and derivatives validit
circumstances be given as a ground for a dispute concerning an industrial worker".
Constitutional Guarantee:

Article 19(1) (c) of the Constitution of India guaranteed to all citizens the right to form association or unions.

In All India Bank Employers Association vs. National Industrial Tribunal, it was argued that Article 19(1) (c) guarantees
unions, a right to effective collective bargaining and a right to strike. But the Supreme Court rejected the argument and s
clause (c) of clause (1) of Art. 19 cannot lead the conclusion that the trade unions have a guaranteed right to an effective

Collective Bargaining in India:

The collective bargaining as a policy has been in vogue in the United Kingdom, the United States of America, Australia,
the trade unions have more to learn from these countries to tackle the industrial problems. The Govt, of India, through it
practice of collective bargaining. The Second Five Year Plan, 1956 stated, “For the development of an understanding o
Obviously this can best be achieved by the parties themselves... The best solution to common problems, however, can be

The Fourth Five Year Plan recognised that “greater emphasis sholuld be placed on collective bargaining and on strengt
labour management relations supported by recourse in large measure to voluntary arbitration”.

A collective bargaining process generally consists of four types of activities

Distributive bargaining:
It involves haggling over the distribution of surplus. Under it, the economic issues like wages, salaries and bonus are dis
another party’s loss. This is most commonly explained in terms of a pie. Disputants can work together to make the pie bi
much as they want, or they can focus on cutting the pie up, trying to get as much as they can for themselves. In general,
This type of bargaining is also known as conjunctive bargaining.

Integrative bargaining:
This involves negotiation of an issue on which both the parties may gain, or at least neither party loses. For example, rep
bargain over the better training programme or a better job evaluation method. Here, both the parties are trying to make m
cooperative than distributive bargaining. This type of bargaining is also known as cooperative bargaining.

Attitudinal restructuring:
This involves shaping and reshaping some attitudes like trust or distrust, friendliness or hostility between labor and mana
between both the parties, attitudinal restructuring is required to maintain smooth and harmonious industrial relations. It d
and cooperation among the parties.

Intra-organizational bargaining:
It generally aims at resolving internal conflicts. This is a type of maneuvering to achieve consensus with the workers and
differences between groups. For example, skilled workers may feel that they are neglected or women workers may feel t
Within the management also, there may be differences. Trade unions maneuver to achieve consensus among the conflict
Characteristics Of Collective Bargaining
 It is a group process, wherein one group, representing the employers, and the other, representing the employees,
 Negotiations form an important aspect of the process of collective bargaining i.e., there is considerable scope for
collective bargaining.
 Collective bargaining is a formalized process by which employers and independent trade unions negotiate terms
certain employment-related issues are to be regulated at national, organizational and workplace levels.
 Collective bargaining is a process in the sense that it consists of a number of steps. It begins with the presentation
agreement, which would serve as the basic law governing labor management relations over a period of time in an
fixed or static. Mutual trust and understanding serve as the by products of harmonious relations between the two
 It a bipartite process. This means there are always two parties involved in the process of collective bargaining. Th
employees and the management. It is a form of participation.
 Collective bargaining is a complementary process i.e. each party needs something that the other party has; labor
better for their efforts.
 Collective bargaining tends to improve the relations between workers and the union on the one hand and the emp
 Collective Bargaining is continuous process. It enables industrial democracy to be effective. It uses cooperation a
and confrontation.
 Collective bargaining takes into account day to day changes, policies, potentialities, capacities and interests.
 It is a political activity frequently undertaken by professional negotiators.

Collective bargaining process comprises of five core steps:

1. Prepare: This phase involves composition of a negotiation team. The negotiation team should consist of representative
skills for negotiation. In this phase both the employer’s representatives and the union examine their own situation in ord
important. The first thing to be done is to determine whether there is actually any reason to negotiate at all. A correct und
intimate knowledge of operations, working conditions, production norms and other relevant conditions is required.

2. Discuss: Here, the parties decide the ground rules that will guide the negotiations. A process well begun is half done a
An environment of mutual trust and understanding is also created so that the collective bargaining agreement would be r

3. Propose: This phase involves the initial opening statements and the possible options that exist to resolve them. In a wo
The exchange of messages takes place and opinion of both the parties is sought.

4. Bargain: negotiations are easy if a problem solving attitude is adopted. This stage comprises the time when ‘what ifs’
agreements take place.

5.Settlement: Once the parties are through with the bargaining process, a consensual agreement is reached upon wherein
regarding the problem or the issue. This stage is described as consisting of effective joint implementation of the agreeme
negotiated change.
Functions of Collective bargaining

Prof. Butler has viewed the functions as:

1. a process of social change
2. a peace treaty between two parties
3. a system of industrial jurisprudence
1. Collective bargaining as a process of social change
 Collective bargaining enhances the status of the working class in the society. Wage earners have enhanced their s
groups.
 Employers have also retained high power and dignity through collective bargaining.

2. Collective bargaining as a peace treaty

Collective bargaining serves as a peace treat between the employers and employees. However the settlement between th

3 Collective bargaining as an industrial jurisprudence

Collective bargaining creates a system of “Industrial Jurisprudence”. It is a method of introducing civil rights into indust
traditional authority exercised by employers over their employees placing part of the authority under joint control of unio

In addition to the above, its functions include:

 Increasing the economic strength to employers and employers.
 Improving working conditions and fair wages.
 Maintaining peace in industry
 Prompt and fair redressel of grievances.
 Promoting stability and prosperity of the industry.

Confirming Pages 420 Collective Bargaining and Labor Relations Introduction The costs of health care are
skyrocketing. As we discussed in the previous chapter, individuals, insurance companies, and government
agencies that pick up the tab are crying out that mounting increases must be slowed. So health care providers
are looking for ways to improve efficiency. At many hospitals, cost control involves asking fewer workers to do
more. Nurses and other workers are expected to handle more patients, perform more tasks, and work more
hours. Often, health professionals are troubled by these changes. They worry that they will burn out and that
patient care will suffer. Or they worry that their employer will control costs by laying them off or refusing pay
increases. These changes and pressures have led some health care workers to join labor unions. Recently, union
membership among professional and technical health care workers, such as registered nurses and laboratory
technologists, increased by more than 10 percent. 1 The presence of unions at a hospital changes some aspects
of human resource management by directing more attention to the interests of employees as a group. In general,
employees and employers share the same interests. They both benefit when the organization is strong and
growing, providing employees with jobs and employers with profits. But although the interests of employers
and employees overlap, they obviously are not identical. In the case of pay, workers benefit from higher pay,
but high pay cuts into the organization’s profits, unless pay increases are associated with higher productivity or
better customer service. Workers may negotiate differences with their employers individually, or they may form
unions to negotiate on their behalf. This chapter explores human resource activities in organizations where
employees belong to unions or where employees are seeking to organize unions. What Do I Need to Know?
After reading this chapter, you should be able to: LO1 Define unions and labor relations and their role in
organizations. LO2 Identify the labor relations goals of management, labor unions, and society. LO3
Summarize laws and regulations that affect labor relations. LO4 Describe the union organizing process. LO5
Explain how management and unions negotiate contracts. LO6 Summarize the practice of contract
administration. LO7 Describe more cooperative approaches to labor-management relations. 14 chapter PART 5
Meeting Other HR Goals noe30468_ch14_419-455.indd 420 8/5/10 11:17 PM Confirming Pages CHAPTER 14
Collective Bargaining and Labor Relations 421 We begin by formally defining unions and labor relations, and
then describe the scope and impact of union activity. We next summarize government laws and regulations
affecting unions and labor relations. The following three sections detail types of activities involving unions:
union organizing, contract negotiation, and contract administration. Finally, we identify ways in which unions
and management are working together in arrangements that are more cooperative than the traditional
labormanagement relationship. Role of Unions and Labor Relations In the United States today, most workers
act as individuals to select jobs that are acceptable to them and to negotiate pay, benefits, flexible hours, and
other work conditions. Especially when there is stiff competition for labor and employees have hard-to-replace
skills, this arrangement produces satisfactory results for most employees. At times, however, workers have
believed their needs and interests do not receive enough consideration from management. One response by
workers is to act collectively by forming and joining labor unions , organizations formed for the purpose of
representing their members’ interests and resolving conflicts with employers. Unions have a role because some
degree of conflict is inevitable between workers and management. 2 As we commented earlier, for example,
managers can increase profits by lowering workers’ pay, but workers benefit in the short term if lower profits
result because their pay is higher. Still, this type of conflict is more complex than a simple trade-off, such as
wages versus profits. Rising profits can help employees by driving up profit sharing or other benefits, and
falling profits can result in layoffs and a lack of investment. Although employers can use programs like profit
sharing to help align employee interests with their own, some remaining divergence of interests is inevitable.
Labor unions represent worker interests and the collective bargaining process provides a way to manage the
conflict. In other words, through systems for hearing complaints and negotiating labor contracts, unions and
managers resolve conflicts between employers and employees. As unionization of workers became more
common, universities developed training in how to manage union-management interactions. This specialty,
called labor relations , emphasizes skills that managers and union leaders can use to foster effective labor-
management cooperation, minimize costly forms of conflict (such as strikes), and seek win-win solutions to
disagreements. Labor relations involves three levels of decisions: 3 1. Labor relations strategy —For
management, the decision involves whether the organization will work with unions or develop (or maintain)
nonunion operations. This decision is influenced by outside forces such as public opinion and competition. For
unions, the decision involves whether to fight changes in how unions relate to the organization or accept new
kinds of labor-management relationships. 2. Negotiating contracts —As we will describe later in the chapter,
contract negotiations in a union setting involve decisions about pay structure, job security, work rules,
workplace safety, and many other issues. These decisions affect workers’ and the employer’s situation for the
term of the contract. 3. Administering contracts —These decisions involve day-to-day activities in which union
members and the organization’s managers may have disagreements. Issues include complaints of work rules
being violated or workers being treated unfairly in particular situations. A formal grievance procedure is
typically used to resolve these issues. LO1 Define unions and labor relations and their role in organizations.
Unions Organizations formed for the purpose of representing their members’ interests in dealing with
employers. Labor Relations Field that emphasizes skills that managers and union leaders can use to minimize
costly forms of conflict (such as strikes) and seek win-win solutions to disagreements. noe30468_ch14_419-
455.indd 421 8/5/10 11:17 PM Confirming Pages 422 PART 5 Meeting Other HR Goals Later sections in this
chapter describe how managers and unions carry out the activities connected with these levels of decisions, as
well as the goals and legal constraints affecting these activities. National and International Unions Most union
members belong to a national or international union. Figure 14.1 shows the membership of the 10 largest
national unions in the United States. Half of these have memberships of over a million workers. These unions
may be either craft or industrial unions. The members of a craft union all have a particular skill or occupation.
Examples include the International Brotherhood of Electrical Workers for electricians and the United
Brotherhood of Carpenters and Joiners of America for carpenters. Craft unions are often responsible for training
their members through apprenticeships and for supplying craft workers to employers. For example, an employer
would send requests for carpenters to the union hiring hall, which would decide which carpenters to send out. In
this way, craft workers may work for many employers over time but have a constant link to the union. A craft
union’s bargaining power depends greatly on its control over the supply of its workers. Craft Union Labor union
whose members all have a particular skill or occupation. Figure 14.1 10 Largest Unions in the United States 0.0
Service Employees International Union National Education Association United Food and Commercial Workers
International Union International Brotherhood of Teamsters International Brotherhood of Electrical Workers
American Federation of State, County and Municipal Employees United Steel, Paper and Forrestry, Rubber,
Manufacturing, Energy, Allied Industrial, and Service Workers International Union Laborers’ International
Union of North America International Association of Machinists and Aerospace Workers American Federation
of Teachers 0.5 1.0 1.5 2.0 2.5 3.0 3.5 Number of Members (Millions) SOURCE: C. D. Gifford, Directory of
U.S. Labor Organizations (Washington, DC: Bureau of National Affairs, 2008). noe30468_ch14_419-455.indd
422 8/5/10 11:17 PM Confirming Pages CHAPTER 14 Collective Bargaining and Labor Relations 423 In
contrast, industrial unions consist of members who are linked by their work in a particular industry. Examples
include the United Steelworkers of America and the Communication Workers of America. Typically, an
industrial union represents many different occupations. Membership in the union is the result of working for a
particular employer in the industry. Changing employers is less common than it is among craft workers, and
employees who change employers remain members of the same union only if they happen to move to other
employers covered by that union. Another difference is that whereas a craft union may restrict the number of
skilled craftsmen—say, carpenters— to maintain higher wages, industrial unions try to organize as many
employees in as wide a range of skills as possible. Most national unions are affiliated with the American
Federation of Labor and Congress of Industrial Organizations (AFL-CIO) . The AFL-CIO is not a labor union
but an association that seeks to advance the shared interests of its member unions at the national level, much as
the Chamber of Commerce and the National Association of Manufacturers do for their member employers.
Approximately 55 national and international unions are affiliated with the AFL-CIO. An important
responsibility of the AFL-CIO is to represent labor’s interests in public policy issues such as labor law,
economic policy, and occupational safety and health. The organization also provides information and analysis
that member unions can use in their activities. In 2005, several unions broke away from the AFL-CIO to form
an alliance called Change to Win. This group includes seven unions representing a membership of 5 to 6 million
workers. Since the split, both groups have increased national unions’ focus on strategy and organizing. 4 Local
Unions Most national unions consist of multiple local units. Even when a national union plays the most critical
role in negotiating the terms of a collective bargaining contract, negotiation occurs at the local level for work
rules and other issues that are locally determined. In addition, administration of the contract largely takes place
at the local union level. As a result, most day-to-day interaction between labor and management involves the
local union. Membership in the local union depends on the type of union. For an industrial union, the local may
correspond to a single large facility or to a number of small facilities. In a craft union, the local may cover a city
or a region. Typically, the local union elects officers, such as president, vice president, and treasurer. The
officers may be responsible for contract negotiation, or the local may form a bargaining committee for that
purpose. When the union is engaged in bargaining, the national union provides help, including background data
about other settlements, technical advice, and the leadership of a representative from the national office.
Individual members participate in local unions in various ways. At meetings of the local union, they elect
officials and vote on resolutions to strike. Most of workers’ contact is with the union steward , an employee
elected by union members to represent them in ensuring that the terms of the contract are enforced. The union
steward helps to investigate complaints and represents employees to supervisors and Industrial Union Labor
union whose members are linked by their work in a particular industry. American Federation of Labor and
Congress of Industrial Organizations (AFL-CIO) An association that seeks to advance the shared interests of its
member unions at the national level. Union Steward An employee elected by union members to represent them
in ensuring that the terms of the labor contract are enforced. Dennis Van Roekel is president of the National
Education Association, the nation’s largest labor union with 3.2 million members. noe30468_ch14_419-
455.indd 423 8/5/10 11:17 PM Confirming Pages 424 PART 5 Meeting Other HR Goals other managers when
employees file grievances alleging contract violations. 5 When the union deals with several employers, as in the
case of a craft union, a business representative performs some of the same functions as a union steward.
Because of union stewards’ and business representatives’ close involvement with employees, it is to
management’s advantage to cultivate positive working relationships with them. Trends in Union Membership
Union membership in the United States peaked in the 1950s, reaching over one-third of employees. Since then,
the share of employees who belong to unions has fallen. It now stands at 12.1 percent overall and 7.5 percent of
private-sector employment. 6 As Figure 14.2 indicates, union membership has fallen steadily since the 1980s.
The decline has been driven by falling union membership in the private sector, while the share of government
workers in unions has mostly held steady. The decline in union membership has been attributed to several
factors: 7 • Change in the structure of the economy —Much recent job growth has occurred among women and
older workers in the service sector of the economy, while union strength has traditionally been among urban
blue-collar workers, especially middle-aged workers. Women have been less likely than men to belong to
unions, and services industries such as finance, insurance, and real estate have lower union representation than
manufacturing. Also, much business growth has been in the South, where workers are less likely to join unions.
8 Figure 14.2 Union Membership Density among U.S. Wage and Salary Workers, 1973–2009 40% 25 35 30 20
15 10 5 0 73 Year 78 83 88 93 98 03 08 09 Percentage Union Membership Public Total Private Private Public
Total a Percentage of total, private-sector, and public-sector wage and salary workers who are union members.
Beginning in 1977, workers belonging to “an employee association similar to a union” are included as
members. SOURCE: Data for 1973–2001 from B. T. Hirsch and D. A. MacPherson, Union Membership and
Earnings Data Book 2001 (Washington, DC: Bureau of National Affairs, 2002), using data from U.S. Current
Population Surveys. Data for 2002 through 2009 from Bureau of Labor Statistics, “Union Affiliation Data from
the Current Population Survey,” http://data.bls.gov , accessed May 3, 2010. noe30468_ch14_419-455.indd 424
8/5/10 11:17 PM Confirming Pages CHAPTER 14 Collective Bargaining and Labor Relations 425 •
Management efforts to control costs —On average, unionized workers receive higher pay than their
nonunionized counterparts, and the pressure is greater because of international competition. In the past, union
membership across an industry such as automobiles or steel resulted in similar wages and work requirements for
all competitors. Today, U.S. producers must compete with companies that have entirely different pay scales and
work rules, often placing the U.S. companies at a disadvantage. • Human resource practices —Competition for
scarce human resources can lead employers to offer much of what employees traditionally sought through union
membership. • Government regulation —Stricter regulation in such areas as workplace safety and equal
employment opportunity leaves fewer areas in which unions can show an advantage over what employers must
already offer. As Figure 14.3 indicates, the percentage of U.S. workers who belong to unions is lower than in
many other countries. More dramatic is the difference in “coverage”— the percentage of employees whose
terms and conditions of employment are governed by a union contract, whether or not the employees are
technically union members. In Western Europe, it is common to have coverage rates of 80 to 90 percent, so the
influence of labor unions far outstrips what membership levels would imply. 9 Also, Figure 14.3 Union
Membership Rates and Coverage in Selected Countries 0% 10% 20% 30% 50% 70% 90% 40% 60% 80%
100% United States Membership Coverage Canada Belgium Denmark Germany United Kingdom Note: Data
for 2007, except U.S. coverage rate for 2005. SOURCES: Eurofund, “Industrial Relations Context,” European
Industrial Relations Dictionary, updated July 24, 2009, www.eurofund.europa.eu ; Organization for Economic
Cooperation and Development, “Trade Union Density (%) in OECD Countries 1960–2007,” February 25, 2009,
www.oecd.org ; Statistics Canada, “Union Coverage Rates,” modified November 25, 2008, www.statcan.gc.ca ;
and Lawrence Mishel, Jared Bernstein, and Sylvia Allegretto, The State of Working America 2006/2007
(Ithaca, NY: ILR Press, 2007), Figure 3W, accessed at Economic Policy Institute’s State of Working America
Web site, www.stateofworkingamerica.org . noe30468_ch14_419-455.indd 425 8/5/10 11:17 PM Confirming
Pages 426 employees in Western Europe tend to have a larger formal role in decision making than in the United
States. This role, including worker representatives on boards of directors, is often mandated by the government.
But as markets become more and more global, pressure to cut labor costs and increase productivity is likely to
be stronger in every country. Unless unions can help companies improve productivity or organize new
production facilities opened in lower-wage countries, union influence may decline in countries where it is now
strong. Although union members are a smaller share of the U.S. workforce, they are a significant part of many
industries’ labor markets. Along with strength in numbers, large unions have strength in dollars. Union
retirement funds, taken together, are huge. Unions try to use their investment decisions in ways that influence
businesses. The “Did You Know?” box presents some statistics on union members. Unions in Government
Unlike union membership for workers in businesses, union membership among government workers has
remained strong. Union membership in the public sector grew during the 1960s and 1970s and has remained
steady ever since. Over onethird of government employees are union members, and a larger share are covered
Did You Know? Compared with the overall U.S. workforce, union workers are more likely to have a
government job and a college degree. They are less likely to have a manufacturing job and to be younger than
35. How well do the data fit your picture of a typical union worker? Source: Data from John Schmitt and Kris
Warner, The Changing Face of Labor, 1983–2008 (Washington, DC: Center for Economic and Policy Research,
November 2009), accessed at www.cepr.net . Many Union Workers Hold Government Jobs Total Workforce
Union Members 0 10 20 30 40 50 In Government Jobs 48.9% 16.5% 25.4% 37.1% 37.5% 31.3% Workers
Under 35 Completed College 11.0% 12.4% In Manufacturing Jobs noe30468_ch14_419-455.indd 426 8/5/10
11:17 PM Confirming Pages CHAPTER 14 Collective Bargaining and Labor Relations 427 by collective
bargaining agreements. One reason for this strength is that government regulations and laws support the right of
government workers to organize. In 1962 Executive Order 10988 established collective bargaining rights for
federal employees. By the end of the 1960s, most states had passed similar laws. An interesting aspect of union
growth among government workers is that much of it has occurred in the service industry and among white-
collar employees—groups that have been viewed as difficult to organize. The American Federation of State,
County and Municipal Employees (AFSCME) has about 1.6 million members. Among them are nurses, park
rangers, school librarians, corrections officers, and many workers in clerical and other white-collar occupations.
10 Labor relations with government workers is different in some respects, such as regarding the right to strike.
Strikes are illegal for federal workers and for state workers in most states. At the local level, all states prohibit
strikes by police (Hawaii being a partial exception) and firefighters (Idaho being the exception). Teachers and
state employees are somewhat more likely to have the right to strike, depending on the state. Legal or not,
strikes by government workers do occur. Of the 39 strikes involving 1,000 or more workers in 2000, eight
involved workers in state and local government. Impact of Unions on Company Performance Organizations are
concerned about whether union organizing and bargaining will hurt their performance, in particular, unions’
impact on productivity, profits, and stock performance. Researchers have studied the general relationship
between unionization and these performance measures. Through skillful labor relations, organizations can
positively influence outcomes. There has been much debate regarding the effects of unions on productivity. 11
One view is that unions decrease productivity because of work rules and limits on workloads set by union
contracts and production lost to such union actions as strikes and work slowdowns. At the same time, unions
can have positive effects on productivity. 12 They can reduce turnover by giving employees a route for
resolving problems. 13 Unions emphasize pay systems based on seniority, which remove incentives for
employees to compete rather than cooperate. The introduction of a union also may force an employer to
improve its management practices and pay greater attention to employee ideas. Although there is evidence that
unions have both positive and negative effects on productivity, most studies have found that union workers are
more productive than nonunion workers. Still, questions remain. Are highly productive workers more likely to
form unions, or does a union make workers more productive? The answer is unclear. In theory, if unions caused
greater productivity, we would expect union membership to be rising, not falling as it has been. 14 Even if
unions do raise productivity, a company’s profits and stock performance may still suffer if unions raise wage
and benefits costs by more than the productivity gain. On average, union members receive higher wages and
more generous benefits than nonunion workers, and evidence shows that unions have a large negative effect on
profits. Also, union coverage tends to decline faster in companies with a lower return to shareholders. 15 In
summary, companies wishing to become more competitive must continually monitor their labor relations
strategy. Harley-Davidson and the International Association of Machinists and Aerospace Workers have
cooperated to produce good results. In general, though, companies wishing to become more competitive need to
continually monitor their labor relations strategies. noe30468_ch14_419-455.indd 427 8/5/10 11:17 PM
Confirming Pages 428 PART 5 Meeting Other HR Goals The studies tend to look at the average effects of
unions, not at individual companies or innovative labor relations. Some organizations excel at labor relations,
and some have worked with unions to meet business needs. For example, even though U.S. manufacturers have
outsourced or automated many jobs, a study by the National Association of Manufacturers found that 8 out of
10 had at least a moderate shortage of production workers, machinists, and craft workers. Many of these
companies traditionally depended on unions to recruit and train new workers through apprenticeship programs.
Some still do. Great River Energy in Bismarck, North Dakota, is one of the electric power companies that
benefits from an apprenticeship program run by the North Central States Regional Council of Carpenters. A
share of union members’ dues funds the program for training carpenters and millwrights in trade and safety
skills. Similarly, the companies that belong to the Mechanical Contractors Association of Chicago benefit from
the skills taught to apprentices in the apprenticeship program of UA Pipefitters Local 597. 16 Goals of
Management, Labor Unions, and Society Resolving conflicts in a positive way is usually easiest when the
parties involved understand each other’s goals. Although individual cases vary, we can draw some general
conclusions about the goals of labor unions and management. Society, too, has goals for labor and business,
given form in the laws regulating labor relations. Management Goals Management goals are to increase the
organization’s profits. Managers tend to prefer options that lower costs and raise output. When deciding
whether to discourage employees from forming a union, a concern is that a union will create higher costs in
wages and benefits, as well as raise the risk of work stoppages. Managers may also fear that a union will make
managers and workers into adversaries or limit management’s discretion in making business and employment
decisions. When an employer has recognized a union, management’s goals continue to emphasize restraining
costs and improving output. Managers continue to prefer to keep the organization’s operations flexible, so they
can adjust activities to meet competitive challenges and customer demands. Therefore, in their labor relations
managers prefer to limit increases in wages and benefits and to retain as much control as they can over work
rules and schedules. Labor Union Goals In general, labor unions have the goals of obtaining pay and working
conditions that satisfy their members and of giving members a voice in decisions that affect them. Traditionally,
they obtain these goals by gaining power in numbers. The more workers who belong to a union, the greater the
union’s power. More members translates into greater ability to halt or disrupt production. Larger unions also
have greater financial resources for continuing a strike; the union can help to make up for the wages the workers
lose during a strike. The threat of a long strike—stated or implied—can make an employer more willing to meet
the union’s demands. As we noted earlier, union membership is indeed linked to better compensation. In 2009,
private-sector unionized workers received, on average, wages 19 percent higher LO2 Identify the labor relations
goals of management, labor unions, and society. noe30468_ch14_419-455.indd 428 8/5/10 11:17 PM
Confirming Pages CHAPTER 14 Collective Bargaining and Labor Relations 429 than nonunion workers. 17 In
addition, the impact of unionization on benefits packages was dramatic: Employer costs for benefits granted to
union workers averaged almost 90 percent higher. Taking into account other influences, such as the greater ease
with which unions are able to organize relatively highly paid, productive workers, researchers estimate that the
total “union effect” on wages is about 10 to 15 percent. 18 In other words, a union worker would earn $1.10 to
$1.15 for every dollar earned by a nonunion worker. Unions typically want to influence the way pay and
promotions are determined. Unlike management, which tries to consider employees as individuals so that pay
and promotion decisions relate to performance differences, unions try to build group solidarity and avoid
possible arbitrary treatment of employees. To do so, unions focus on equal pay for equal work. They try to have
any pay differences based on seniority, on the grounds that this measure is more objective than performance
evaluations. As a result, where workers are represented by a union, it is common for all employees in a
particular job classification to be paid at the same rate. The survival and security of a union depend on its ability
to ensure a regular flow of new members and member dues to support the services it provides. Therefore,
unions typically place high priority on negotiating two types of contract provisions with an employer that are
critical to a union’s security and viability: checkoff provisions and provisions relating to union membership or
contribution. Under a checkoff provision , the employer, on behalf of the union, automatically deducts union
dues from employees’ paychecks. Security provisions related to union membership are closed shop, union shop,
agency shop, and maintenance of membership. The strongest union security arrangement is a closed shop ,
under which a person must be a union member before being hired. Under the National Labor Relations Act,
discussed later in this chapter, closed shops are illegal. A legal membership arrangement that supports the goals
of labor unions is the union shop , an arrangement that requires an employee to join the union within a certain
time (30 days) after beginning employment. A similar alternative is the agency shop , which requires the
payment of union dues but not union membership. Maintenance of membership rules do not require union
membership but do require that employees who join the union remain members for a certain period of time,
such as the length of the contract. As we will discuss later in the chapter, some states forbid union shops,
agency shops, and maintenance of membership. All these provisions are ways to address unions’ concern about
“free riders”— employees who benefit from union activities without belonging to a union. By law, all members
of a bargaining unit, whether union members or not, must be represented by the union. If the union must offer
services to all bargaining unit members but some of them are not dues-paying union members, the union may
not have enough financial resources to operate successfully. Societal Goals The activities of unions and
management take place within the context of society, with society’s values driving the laws and regulations that
affect labor relations. As long ago as the late 1800s and early 1900s, industrial relations scholars saw unions as
a way to make up for individual employees’ limited bargaining power. 19 At that time, clashes between workers
and management could be violent, and many people hoped that unions would replace the violence with
negotiation. Since then, observers have expressed concern that unions in certain industries have become too
strong, Checkoff Provision Contract provision under which the employer, on behalf of the union, automatically
deducts union dues from employees’ paychecks. Closed Shop Union security arrangement under which a person
must be a union member before being hired; illegal for those covered by the National Labor Relations Act.
Union Shop Union security arrangement that requires employees to join the union within a certain amount of
time (30 days) after beginning employment. Agency Shop Union security arrangement that requires the
payment of union dues but not union membership. Maintenance of Membership Union security rules not
requiring union membership but requiring that employees who join the union remain members for a certain
period of time. noe30468_ch14_419-455.indd 429 8/5/10 11:17 PM Confirming Pages 430 PART 5 Meeting
Other HR Goals achieving their goals at the expense of employers’ ability to compete or meet other objectives.
But even Senator Orrin Hatch, described by BusinessWeek as “labor’s archrival on Capitol Hill,” has spoken of
a need for unions: There are always going to be people who take advantage of workers. Unions even that out, to
their credit. We need them to level the field between labor and management. If you didn’t have unions, it would
be very difficult for even enlightened employers not to take advantage of workers on wages and working
conditions, because of [competition from lessenlightened] rivals. I’m among the first to say I believe in unions.
20 Senator Hatch’s statement implies that society’s goal for unions is to ensure that workers have a voice in
how they are treated by their employers. As we will see in the next section, this view has produced a set of laws
and regulations intended to give workers the right to join unions if they so wish. Laws and Regulations
Affecting Labor Relations The laws and regulations pertaining to labor relations affect unions’ size and
bargaining power, so they significantly affect the degree to which unions, management, and society achieve
their varied goals. These laws and regulations set limits on union structure and administration and the ways in
which unions and management interact. National Labor Relations Act (NLRA) Perhaps the most dramatic
example of labor laws’ influence is the 1935 passage of the Wagner Act (also known as the National Labor
Relations Act , or NLRA ), which actively supported collective bargaining. After Congress passed the NLRA,
union membership in the United States nearly tripled, from 3 million in 1933 to 8.8 million (19.2 percent of
employment) in 1939. 21 Before the 1930s, the U.S. legal system was generally hostile to unions. The courts
tended to view unions as coercive organizations that hindered free trade. Unions’ focus on collective voice and
collective action (such as strikes and boycotts) did not fit well with the U.S. emphasis on capitalism,
individualism, freedom of contract, and property rights. 22 Then the Great Depression of the 1930s shifted
public attitudes toward business and the free-enterprise system. Unemployment rates as high as 25 percent and a
steep fall in production between 1929 and 1933 focused attention on employee rights and the shortcomings of
the economic system of the time. The nation was in crisis, and President Franklin Roosevelt responded
dramatically with the New Deal. On the labor front, the 1935 NLRA ushered in an era of public policy for labor
unions, enshrining collective bargaining as the preferred way to settle labor-management disputes. Section 7 of
the NLRA sets out the rights of employees, including the “right to self-organization, to form, join, or assist
labor organizations, to bargain collectively through representatives of their own choosing, and to engage in
other concerted activities for the purpose of collective bargaining.” 23 Employees also have the right to refrain
from these activities, unless union membership is a condition of employment. The following activities are
among those protected under the NLRA: • Union organizing. • Joining a union, whether recognized by the
employer or not. • Going out on strike to secure better working conditions. • Refraining from activity on behalf
of the union. LO3 Summarize laws and regulations that affect labor relations. National Labor Relations Act
(NLRA) Federal law that supports collective bargaining and sets out the rights of employees to form unions.
noe30468_ch14_419-455.indd 430 8/5/10 11:17 PM Confirming Pages CHAPTER 14 Collective Bargaining
and Labor Relations 431 Most employees in the private sector are covered by the NLRA. However, workers
employed under the following conditions are not covered: 24 • Employed as a supervisor. • Employed by a
parent or spouse. • Employed as an independent contractor. • Employed in the domestic service of any person or
family in a home. • Employed as agricultural laborers. • Employed by an employer subject to the Railway Labor
Act. • Employed by a federal, state, or local government. • Employed by any other person who is not an
employer as defined in the NLRA. State or local laws may provide additional coverage. For example,
California’s 1975 Agricultural Labor Relations Act covers agricultural workers in that state. In Section 8(a), the
NLRA prohibits certain activities by employers as unfair labor practices. In general, employers may not
interfere with, restrain, or coerce employees in exercising their rights to join or assist a labor organization or to
refrain from such activities. Employers may not dominate or interfere with the formation or activities of a labor
union. They may not discriminate in any aspect of employment that attempts to encourage or discourage union
activity, nor may they discriminate against employees for providing testimony related to enforcement of the
NLRA. Finally, employers may not refuse to bargain collectively with a labor organization that has standing
under the act. For more guidance in complying with the NLRA, see the examples in the “HR How To” box.
When employers or unions violate the NLRA, remedies typically include ordering that unfair labor practices
stop. Employers may be required to rehire workers, with or without back pay. The NLRA is not a criminal law,
and violators may not be assigned punitive damages (fines to punish rather than merely make up for the harm
done). Laws Amending the NLRA Originally, the NLRA did not list any unfair labor practices by unions. In
later amendments to the NLRA—the Taft-Hartley Act of 1947 and the Landrum-Griffin Act of 1959—Congress
established some restrictions on union practices deemed unfair to employers and union members. Under the
Taft-Hartley Act, unions may not restrain employers through actions such as the following: 25 • Mass picketing
in such numbers that nonstriking employees physically cannot enter the workplace. • Engaging in violent acts in
connection with a strike. • Threatening employees with physical injury or job loss if they do not support union
activities. • During contract negotiations, insisting on illegal provisions, provisions that the employer may hire
only workers who are union members or “satisfactory” to the union, or working conditions to be determined by
a group to which the employer does not belong. • Terminating an existing contract and striking for a new one
without notifying the employer, the Federal Mediation and Conciliation Service, and the state mediation service
(where one exists). noe30468_ch14_419-455.indd 431 8/5/10 11:17 PM Confirming Pages 432 The Taft-
Hartley Act also allows the states to pass so-called right-to-work laws , which make union shops, maintenance
of membership, and agency shops illegal. The idea behind such laws is that requiring union membership or the
payment of union dues restricts the employees’ right to freedom of association. In other words, employees
should be free to choose whether they join a union or other group. Of course, unions have a different point of
view. The union perspective is that unions provide services to all members of a bargaining unit (such as all of a
company’s workers), and all members who receive the benefits of a union should pay union dues. Figure 14.4
indicates which states currently have right-towork laws. The Landrum-Griffin Act regulates unions’ actions
with regard to their members, including financial disclosure and the conduct of elections. This law establishes
and protects rights of union members. These include the right to nominate candidates for union office,
participate in union meetings and secret-ballot elections, and examine unions’ financial records. The National
Labor Relations Act prohibits employers and unions from engaging in unfair labor practices. For employers,
this means they must not interfere with employees’ decisions about whether to join a union and engage in
union-related activities. Employers may not discriminate against employees for being involved in union
activities or testifying in court about actions under the NLRA. Here are some specific examples of unfair labor
practices that employers must avoid: • Threatening employees with loss of their jobs or benefits if they join or
vote for a union. • Threatening to close down a plant if it is organized by a union. • Questioning employees
about their union membership or activities in a way that restrains or coerces them. • Spying or pretending to spy
on union meetings. • Granting wage increases timed to discourage employees from forming or joining a union. •
Taking an active part in organizing a union or committee to represent employees. • Providing preferential
treatment or aid to one of several unions trying to organize employees. • Discharging employees for urging
other employees to join a union. • Refusing to hire applicants because they are union members. • Refusing to
reinstate workers when job openings occur, on the grounds that the workers participated in a lawful strike. •
Ending operations at one facility and opening the same operations at another facility with new employees
because employees at the first joined a union. • Demoting or firing employees for filing an unfair labor practice
complaint or testifying at an NLRB meeting. • Refusing to meet with employees’ representatives because the
employees are on strike. • Refusing to supply the employees’ representative with cost and other data concerning
a group insurance plan covering employees. • Announcing a wage increase without consulting the employees’
representative. • Failing to bargain about the effects of a decision to close one of the employer’s facilities.
Sources: National Labor Relations Board, Basic Guide to the National Labor Relations Act (Washington, DC:
U.S. Government Printing Office, 1997); and National Labor Relations Board, “The National Labor Relations
Board and You: Unfair Labor Practices,” www.nlrb.gov , accessed May 4, 2010. AVOIDING UNFAIR
LABOR PRACTICES HR How To Right-to-Work Laws State laws that make union shops, maintenance of
membership, and agency shops illegal. noe30468_ch14_419-455.indd 432 8/5/10 11:17 PM Confirming Pages
CHAPTER 14 Collective Bargaining and Labor Relations 433 National Labor Relations Board (NLRB)
Enforcement of the NLRA rests with the National Labor Relations Board (NLRB) . This federal government
agency consists of a five-member board, the general counsel, and 52 regional and other field offices. Because
the NLRB is a federal agency, its enforcement actions are limited to companies that have an impact on interstate
commerce, but as a practical matter, this extends to all but purely local businesses. For federal government
workers under the Civil Service Reform Act of 1978, Title VII, the Federal Labor Relations Authority has a role
similar to that of the NLRB. Many states have similar agencies to administer their laws governing state and
local government workers. The NLRB has two major functions: to conduct and certify representation elections
and to prevent unfair labor practices. It does not initiate either of these actions but responds to requests for
action. The “ HR Oops!” box shows how managers’ comments and actions can be considered by the NLRB as
illegally interfering with union organizing. Representation Elections The NLRB is responsible for ensuring that
the organizing process follows certain steps, described in the next section. Depending on the response to
organizing efforts, the NLRB conducts elections. When a majority of workers vote in favor of a union, the
NLRB certifies it as the exclusive representative of a group of employees. The NLRB also conducts elections to
decertify unions, following the same process as for representation elections. The NLRB is also responsible for
determining the appropriate bargaining unit and the employees who are eligible to participate in organizing
activities. As we stated earlier, bargaining units may not include certain types of employees, such as agricultural
laborers, independent contractors, supervisors, and managers. Beyond this, the NLRB attempts to group
together employees who have a community of interest Figure 14.4 States with Right-toWork Laws SOURCE:
National Right to Work Legal Defense Foundation, “Right to Work States,” www.nrtw.org , accessed May 3,
2010. National Labor Relations Board (NLRB) Federal government agency that enforces the NLRA by
conducting and certifying representation elections and investigating unfair labor practices.
noe30468_ch14_419-455.indd 433 8/5/10 11:17 PM Confirming Pages 434 in their wages, hours, and working
conditions. A unit may cover employees in one facility or multiple facilities within a single employer, or the
unit may cover multiple employers. In general, employees on the payroll just before the ordering of an election
are eligible to vote, although this rule is modified in some cases, for example, when employment in the industry
is irregular. Most employees who are on strike and who have been replaced by other employees are eligible to
vote in an election (such as a decertification election) that occurs within 12 months of the onset of the strike.
Prevention of Unfair Labor Practices The handling of complaints regarding unfair labor practices begins when
someone files a charge. The deadline for filing a charge is six months after the alleged unfair practice. All
parties must be served with a copy of the charge. (Registered mail is recommended.) The charge is investigated
by a regional office. If, after investigating, the NLRB finds the charge has merit and issues a complaint, two
actions are possible. The NLRB may defer to a grievance procedure agreed on by the employer and the union;
grievances are discussed later in this chapter. Or a hearing may be held before an administrative law judge. The
judge makes a recommendation, which either party may appeal. The NLRB has the authority to issue cease-and-
desist orders to halt unfair labor practices. It also can order the employer to reinstate workers, with or without
back pay. The NLRB can set aside the results of an election if it believes either the union HR Oops! Community
Health Center La Clinica is a nonprofit health clinic located in Pasco, a city in southeastern Washington State.
Its employees are represented by the Office and Professional Employees International Union Local 8. La
Clinica hired Carl Walters II to be its chief executive after several turbulent years marked by employee lawsuits
and complaints of corruption. Walters dedicated himself to getting La Clinica on a firmer financial foundation,
and in so doing, he assembled employees to discuss the organization’s current situation and future prospects. In
one such meeting, Walters outlined the clinic’s financial health and expressed concerns that the economic
recession and cuts in state funding would make it necessary to find ways to cut its expenses. Among the
possible actions, La Clinica would have to evaluate staffing levels and compensation, hoping to make cuts that
would avoid layoffs. Some of the unionized employees interpreted Walters’s comments to mean he was
threatening them that if they didn’t agree to reduce their compensation or vote out the union, they would be laid
off. The union complained to the NLRB that La Clinica was engaging in unfair labor practices by threatening
employees. The NLRB found evidence to file a complaint and potentially a lawsuit but offered La Clinica a
chance to settle instead. La Clinica agreed to the settlement, under which it does not admit wrongdoing but
agrees to abide by and post a list of actions it will not take, including threats of job loss and creation of
employee policies that should be the subject of collective bargaining. Source: Based on Michelle Dupler, “La
Clinica Settles over Union Complaints,” Tri-City Herald (Kennewick, WA), March 13, 2010, Business &
Company Resource Center, http://galenet .galegroup.com ; Community Health Center La Clinica Web site,
www. laclinicanet.org , accessed May 5, 2010. Questions 1. How can a company communicate with unionized
employees about its financial situation without seeming to issue threats? 2. How could HRM professionals at La
Clinica help management avoid missteps such as the one described here? Thou Shalt Not Threaten
noe30468_ch14_419-455.indd 434 8/5/10 11:17 PM Confirming Pages CHAPTER 14 Collective Bargaining
and Labor Relations 435 or the employer has created “an atmosphere of confusion or fear of reprisals.” 26 If an
employer or union refuses to comply with an NLRB order, the board has the authority to petition the U.S. Court
of Appeals. The court may enforce the order, recommend it to the NLRB for modification, change the order
itself, or set it aside altogether. Union Organizing Unions begin their involvement with an organization’s
employees by conducting an organizing campaign. To meet its objectives, a union needs to convince a majority
of workers that they should receive better pay or other employment conditions and that the union will help them
do so. The employer’s objectives will depend on its strategy—whether it seeks to work with a union or
convince employees that they are better off without union representation. The Process of Organizing The
organizing process begins with authorization cards, such as the example shown in Figure 14.5 . Union
representatives make contact with employees, present their message about the union, and invite them to sign an
authorization card. For the organization process to continue, at least 30 percent of the employees must sign an
authorization card. If over half the employees sign an authorization card, the union may request that the
employer voluntarily recognize the union. If the employer agrees, the NLRB certifies the union as the exclusive
representative of employees. If the employer refuses, or if only 30 to 50 percent of employees signed cards, the
NLRB conducts a secret-ballot election. The arrangements are made in one of two ways: 1. For a consent
election, the employer and the union seeking representation arrive at an agreement stating the time and place of
the election, the choices included on the ballot, and a way to determine who is eligible to vote. LO4 Describe
the union organizing process. Figure 14.5 Authorization Card I, the undersigned employee of Name (print) Date
Home Address Phone City State Zip Job Title Sign Here Dept. Shift (Company) Note: This authorization to be
SIGNED and DATED in employee’s own handwriting. YOUR RIGHT TO SIGN THIS CARD IS
PROTECTED BY FEDERAL LAW. RECEIVED BY (Initial) YES, I WANT THE IAM authorize the
International Association of Machinists and Aerospace Workers (IAM) to act as my collective bargaining agent
for wages, hours and working conditions. I agree that this card may be used either to support a demand for
recognition or an NLRB election, at the discretion of the union. SOURCE: From J. A. Fossum, Labor Relations:
Development, Structure and Process, 2002. Copyright © 2002 The McGraw-Hill Companies, Inc. Reprinted
with permission. noe30468_ch14_419-455.indd 435 8/5/10 11:17 PM Confirming Pages 436 PART 5 Meeting
Other HR Goals 2. For a stipulation election, the parties cannot agree on all of these terms, so the NLRB
dictates the time and place, ballot choices, and method of determining eligibility. On the ballot, workers vote for
or against union representation, and they may also have a choice from among more than one union. If the union
(or one of the unions on the ballot) wins a majority of votes, the NLRB certifies the union. If the ballot includes
more than one union and neither gains a simple majority, the NLRB holds a runoff election. As noted earlier, if
the NLRB finds the election was not conducted fairly, it may set aside the results and call for a new election.
Conduct that may lead to an election result’s being set aside includes the following examples: 27 • Threats of
loss of jobs or benefits by an employer or union to influence votes or organizing activities. • A grant of benefits
or a promise of benefits as a means of influencing votes or organizing activities. • Campaign speeches by
management or union representatives to assembled groups of employees on company time less than 24 hours
before an election. • The actual use or threat of physical force or violence to influence votes or organizing
activities. After certification, there are limits on future elections. Once the NLRB has certified a union as the
exclusive representative of a group of employees, it will not permit additional elections for one year. Also, after
the union and employer have finished negotiating a contract, an election cannot be held for the time of the
contract period or for three years, whichever comes first. The parties to the contract may agree not to hold an
election for longer than three years, but an outside party (another union) cannot be barred for more than three
years. Management Strategies Sometimes an employer will recognize a union after a majority of employees
have signed authorization cards. More often, there is a hotly contested election campaign. During the campaign,
unions try to persuade employees that their wages, benefits, treatment by employers, and chances to influence
workplace decisions are too poor or small and that the union will be able to obtain improvements in these areas.
Management typically responds with its own messages providing an opposite point of view. Management
messages say the organization has provided a valuable package of wages and benefits and has treated
employees well. Management also argues that the union will not be able to keep its promises but will instead
create costs for employees, such as union dues and lost income during strikes. Employers use a variety of
methods to oppose unions in organizing campaigns. 28 Their efforts range from hiring consultants to
distributing leaflets and letters to presenting the company’s viewpoint at meetings of employees. Some
management efforts go beyond what the law permits, especially in the eyes of union organizers. Why would
employers break the law? One explanation is that the consequences, such as reinstating workers with back pay,
are small compared to the benefits. 29 If coercing workers away from joining a union saves the company the
higher wages, benefits, and other costs of a unionized workforce, management may feel an incentive to accept
costs like back pay. noe30468_ch14_419-455.indd 436 8/5/10 11:17 PM Confirming Pages CHAPTER 14
Collective Bargaining and Labor Relations 437 Supervisors have the most direct contact with employees. Thus,
as Table 14.1 indicates, it is critical that they establish good relationships with employees even before there is
any attempt at union organizing. Supervisors also must know what not to do if a union drive takes place. They
should be trained in the legal principles discussed earlier in this chapter. Union Strategies The traditional union
organizing strategy has been for organizers to call or visit employees at home, when possible, to talk about
issues like pay and job security. Local unions of the Teamsters have contacted dock workers at UPS Freight
terminals in 11 states and invited them to sign authorization cards. When a majority of the workers at a terminal
sign cards, UPS agrees to bargain with the Teamsters at that location. 30 Beyond encouraging workers to sign
authorization cards and vote for the union, organizers use some creative alternatives to traditional organizing
activities. They sometimes offer workers associate union membership , which is not linked to an employee’s
workplace and does not provide representation in collective bargaining. Rather, an associate member receives
other services, such as discounts on health and life insurance or credit cards. 31 In return for these benefits, the
union receives membership dues and a broader base of support for its activities. Associate membership may be
attractive to employees who wish to join a union but cannot because their workplace is not organized by a
union. Table 14.1 What Supervisors Should and Should Not Do to Discourage Unions WHAT TO DO: Report
any direct or indirect signs of union activity to a core management group. Deal with employees by carefully
stating the company’s response to pro-union arguments. These responses should be coordinated by the company
to maintain consistency and to avoid threats or promises. Take away union issues by following effective
management practices all the time: Deliver recognition and appreciation. Solve employee problems. Protect
employees from harassment or humiliation. Provide business-related information. Be consistent in treatment of
different employees. Accommodate special circumstances where appropriate. Ensure due process in
performance management. Treat all employees with dignity and respect. WHAT TO AVOID: Threatening
employees with harsher terms and conditions of employment or employment loss if they engage in union
activity. Interrogating employees about pro-union or anti-union sentiments that they or others may have or
reviewing union authorization cards or pro-union petitions. Promising employees that they will receive
favorable terms or conditions of employment if they forgo union activity. Spying on employees known to be, or
suspected of being, engaged in pro-union activities. SOURCE: From J. A. Segal, “Unshackle Your Supervisors
to Stay Union Free,” HR Magazine, June 1998. Copyright © 1998 by Society for Human Resource
Management. Reproduced with permission of Society for Human Resource Management via Copyright
Clearance Center. Associate Union Membership Alternative form of union membership in which members
receive discounts on insurance and credit cards rather than representation in collective bargaining.
noe30468_ch14_419-455.indd 437 8/5/10 11:17 PM Confirming Pages 438 PART 5 Meeting Other HR Goals
Another alternative to traditional organizing is to conduct corporate campaigns —bringing public, financial, or
political pressure on employers during union organization and contract negotiation. 32 The Amalgamated
Clothing and Textile Workers Union (ACTWU) corporate campaign against textile maker J. P. Stevens during
the late 1970s was one of the first successful corporate campaigns and served as a model for those that
followed. The ACTWU organized a boycott of J. P. Stevens products and threatened to withdraw its pension
funds from financial institutions where J. P. Stevens officers acted as directors. The company eventually agreed
to a contract with ACTWU. 33 Another winning union organizing strategy is to negotiate employer neutrality
and card-check provisions into a contract. Under a neutrality provision, the employer pledges not to oppose
organizing attempts elsewhere in the company. A card-check provision is an agreement that if a certain
percentage—by law, at least a majority—of employees sign an authorization card, the employer will recognize
their union representation. An impartial outside agency, such as the American Arbitration Association, counts
the cards. Evidence suggests that this strategy can be very effective for unions. 34 Decertifying a Union The
Taft-Hartley Act expanded union members’ right to be represented by leaders of their own choosing to include
the right to vote out an existing union. This action is called decertifying the union. Decertification follows the
same process as a representation election. An election to decertify a union may not take place when a contract is
in effect. When decertification elections are held, unions often do not fare well. 35 During the past few years,
unions have lost between 54 and 64 percent of decertification elections. In another blow to unions, the number
of decertification elections has increased from about 5 percent of all elections in the 1950s and 1960s to more
than double that rate in recent years. Collective Bargaining When the NLRB has certified a union, that union
represents employees during contract negotiations. In collective bargaining , a union negotiates on behalf of its
members with management representatives to arrive at a contract defining conditions of employment for the
term of the contract and to resolve differences in the way they interpret the contract. Typical contracts include
provisions for pay, benefits, work rules, and resolution of workers’ grievances. Table 14.2 shows typical
provisions negotiated in collective bargaining contracts. Collective bargaining differs from one situation to
another in terms of bargaining structure —that is, the range of employees and employers covered by the
contract. A contract may involve a narrow group of employees in a craft union or a broad group in an industrial
union. Contracts may cover one or several facilities of the same employer, or the bargaining structure may
involve several employers. Many more interests must be considered in collective bargaining for an industrial
union with a bargaining structure that includes several employers than in collective bargaining for a craft union
in a single facility. The majority of contract negotiations take place between unions and employers that have
been through the process before. In the typical situation, management has come to accept the union as an
organization it must work with. The situation can be Corporate Campaigns Bringing public, financial, or
political pressure on employers during union organization and contract negotiation. LO5 Explain how
management and unions negotiate contracts. Collective Bargaining Negotiation between union representatives
and management representatives to arrive at a contract defining conditions of employment for the term of the
contract and to administer that contract. noe30468_ch14_419-455.indd 438 8/5/10 11:17 PM Confirming Pages
CHAPTER 14 Collective Bargaining and Labor Relations 439 Table 14.2 Typical Provisions in Collective
Bargaining Contracts Establishment and administration of the agreement Bargaining unit and plant supplements
Contract duration and reopening and renegotiation provisions Union security and the checkoff Special
bargaining committees Grievance procedures Arbitration and mediation Strikes and lockouts Contract
enforcement Functions, rights, and responsibilities Management rights clauses Plant removal Subcontracting
Union activities on company time and premises Union–management cooperation Regulation of technological
change Advance notice and consultation Wage determination and administration General provisions Rate
structure and wage differentials Allowances Incentive systems and production bonus plans Production standards
and time studies Job classification and job evaluation Individual wage adjustments General wage adjustments
during the contract period Job or income security Hiring and transfer arrangements Employment and income
guarantees Reporting and call-in pay Supplemental unemployment benefit plans Regulation of overtime, shift
work, etc. Reduction of hours to forestall layoffs Layoff procedures; seniority; recall Worksharing in lieu of
layoff Attrition arrangements Promotion practices Training and retraining Relocation allowances Severance pay
and layoff benefit plans Special funds and study committees Plant operations Work and shop rules Rest periods
and other in-plant time allowances Safety and health Plant committees Hours of work and premium pay
practices Shift operations Hazardous work Discipline and discharge Paid and unpaid leave Vacations and
holidays Sick leave Funeral and personal leave Military leave and jury duty (Continued ) noe30468_ch14_419-
455.indd 439 8/5/10 11:17 PM Confirming Pages 440 PART 5 Meeting Other HR Goals very different when a
union has just been certified and is negotiating its first contract. In over one-fourth of negotiations for a first
contract, the parties are unable to reach an agreement. 36 Bargaining over New Contracts Clearly, the outcome
of contract negotiations can have important consequences for labor costs, productivity, and the organization’s
ability to compete. Therefore, unions and management need to prepare carefully for collective bargaining.
Preparation includes establishing objectives for the contract, reviewing the old contract, gathering data (such as
compensation paid by competitors and the company’s ability to survive a strike), predicting the likely demands
to be made, and establishing the cost of meeting the demands. 37 This preparation can help negotiators develop
a plan for how to negotiate. Different situations and goals call for different approaches to bargaining, such as
the following alternatives proposed by Richard Walton and Robert McKersie: 38 • Distributive bargaining
divides an economic “pie” between two sides—for example, a wage increase means giving the union a larger
share of the pie. • Integrative bargaining looks for win-win solutions, or outcomes in which both sides benefit. If
the organization’s labor costs hurt its performance, integrative bargaining might seek to avoid layoffs in
exchange for work rules that improve productivity. • Attitudinal structuring focuses on establishing a
relationship of trust. The parties are concerned about ensuring that the other side will keep its part of any
bargain. • Intraorganizational bargaining addresses conflicts within union or management groups or objectives,
such as between new employees and workers with high seniority or between cost control and reduction of
turnover. The collective bargaining process may involve any combination of these alternatives. Negotiations go
through various stages. 39 In the earliest stages, many more people are often present than in later stages. On the
union side, this may give all the various internal interest groups a chance to participate and voice their goals.
Their input helps communicate to management what will satisfy union members and may help the union
achieve greater solidarity. At this stage, union negotiators often present a long list of proposals, partly to satisfy
members and partly to introduce enough Employee benefit plans Health and insurance plans Pension plans
Profit-sharing, stock purchase, and thrift plans Bonus plans Special groups Apprentices and learners Workers
with disabilities and older workers Women Veterans Union representatives Nondiscrimination clauses
SOURCE: T. A. Kochan, Collective Bargaining and Industrial Relations (Homewood, IL: Richard D. Irwin,
1980), p. 29. Original data from J. W. Bloch, “Union Contracts—A New Series of Studies,” Monthly Labor
Review 87 (October 1964), pp. 1184–85. Table 14.2 Concluded noe30468_ch14_419-455.indd 440 8/5/10
11:17 PM Confirming Pages CHAPTER 14 Collective Bargaining and Labor Relations 441 issues that they will
have flexibility later in the process. Management may or may not present proposals of its own. Sometimes
management prefers to react to the union’s proposals. During the middle stages of the process, each side must
make a series of decisions, even though the outcome is uncertain. How important is each issue to the other side?
How likely is it that disagreement on particular issues will result in a strike? When and to what extent should
one side signal its willingness to compromise? In the final stage of negotiations, pressure for an agreement
increases. Public negotiations may be only part of the process. Negotiators from each side may hold one-on-one
meetings or small-group meetings where they escape some public relations pressures. A neutral third party may
act as a go-between or facilitator. In some cases, bargaining breaks down as the two sides find they cannot reach
a mutually acceptable agreement. The outcome depends partly on the relative bargaining power of each party.
That power, in turn, depends on each party’s ability to withstand a strike, which costs the workers their pay
during the strike and costs the employer lost production and possibly lost customers. When Bargaining Breaks
Down The intended outcome of collective bargaining is a contract with terms acceptable to both parties. If one
or both sides determine that negotiation alone will not produce such an agreement, bargaining breaks down. To
bring this impasse to an end, the union may strike, or the parties may bring in outside help to resolve their
differences. Citing the strong potential for loss of jobs, union members protest Verizon’s selling of its landline
business to Frontier Communications in West Virginia. noe30468_ch14_419-455.indd 441 8/5/10 11:17 PM
Confirming Pages 500 400 300 200 100 0 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
2009 Year Number of Strikes 442 PART 5 Meeting Other HR Goals Strikes A strike is a collective decision of
the union members not to work until certain demands or conditions are met. The union members vote, and if the
majority favors a strike, they all go on strike at that time or when union leaders believe the time is right. Strikes
are typically accompanied by picketing —the union stations members near the worksite with signs indicating
the union is on strike. During the strike, the union members do not receive pay from their employer, but the
union may be able to make up for some of the lost pay. The employer loses production unless it can hire
replacement workers, and even then, productivity may be reduced. Often, other unions support striking workers
by refusing to cross their picket line—for example, refusing to make deliveries to a company during a strike.
When the Writers Guild of America went on strike, production of television shows came to a standstill. The
strike also affected the Golden Globe Awards, as actors and other union employees in the media industry
refused to cross their picket lines. The vast majority of labor-management negotiations do not result in a strike,
and the number of strikes has plunged since the 1950s, as shown in Figure 14.6 . In every year since 2000, the
percentage of total working time lost to strikes each year has been 0.01 percent—that is, one-hundredth of 1
percent of working time—or even less. A primary reason strikes are rare is that a strike is seldom in the best
interests of either party. Not only do workers lose wages and employers lose production, but the negative
experience of a strike can make future interactions more difficult. During the Writers Guild of America strike,
screenwriters won some compensation for their Figure 14.6 Strikes Involving 1,000 or More Workers Note:
Because strikes are most likely in large bargaining units, these numbers represent most lost working time in the
United States. SOURCE: Bureau of Labor Statistics, “Work Stoppages,” http://data.bls.gov . Strike A collective
decision by union members not to work until certain demands or conditions are met. noe30468_ch14_419-
455.indd 442 8/5/10 11:17 PM Confirming Pages CHAPTER 14 Collective Bargaining and Labor Relations
443 work that is distributed over the Internet. But while television shows switched to reruns, viewers were
finding new, often free content online. That could ultimately damage network TV’s future. 40 When strikes do
occur, the conduct of each party during the strike can do lasting harm to labor-management relations. Violence
by either side or threats of job loss or actual job loss because jobs went to replacement workers can make future
relations difficult. Finally, many government employees do not have a right to strike, and their percentage
among unionized employees overall has risen in recent decades, as we discussed earlier. Alternatives to Strikes
Because strikes are so costly and risky, unions and employers generally prefer other methods for resolving
conflicts. Three common alternatives rely on a neutral third party, usually provided by the Federal Mediation
and Conciliation Service (FMCS): • Mediation is the least formal and most widely used of these procedures. A
mediator hears the views of both sides and facilitates the negotiation process. The mediator has no formal
authority to dictate a resolution, so a strike remains a possibility. In a survey studying negotiations between
unions and large businesses, mediation was used in almost 4 out of 10 negotiation efforts. 41 • A fact finder ,
most often used for negotiations with governmental bodies, typically reports on the reasons for the dispute, the
views and arguments of both sides, and (sometimes) a recommended settlement, which the parties may decline.
The public nature of these recommendations may pressure the parties to settle. Even if Mediation Conflict
resolution procedure in which a mediator hears the views of both sides and facilitates the negotiation process
but has no formal authority to dictate a resolution. Fact Finder Third party to collective bargaining who reports
the reasons for a dispute, the views and arguments of both sides, and possibly a recommended settlement, which
the parties may decline. Strikes such as this one between security officers and management of several office
buildings in San Francisco are costly. Both unions and employees generally prefer to resolve contract conflicts
in other ways. noe30468_ch14_419-455.indd 443 8/5/10 11:17 PM Confirming Pages 444 PART 5 Meeting
Other HR Goals they do not accept the fact finder’s recommended settlement, the fact finder may identify or
frame issues in a way that makes agreement easier. Sometimes merely devoting time to this process gives the
parties a chance to reach an agreement. However, there is no guarantee that a strike will be avoided. • Under
arbitration , the most formal type of outside intervention, an arbitrator or arbitration board determines a
settlement that is binding, meaning the parties have to accept it. In conventional arbitration, the arbitrator
fashions the solution. In “final-offer arbitration,” the arbitrator must choose either management’s or the union’s
final offer for each issue or for the contract as a whole. “Rights arbitration” focuses on enforcing or interpreting
contract terms. Arbitration in the writing of contracts or setting of contract terms has traditionally been reserved
for special circumstances such as negotiations between unions and government agencies, where strikes may be
illegal or especially costly. Occasionally, arbitration has been used with businesses in situations where strikes
have been extremely damaging. However, the general opinion is that union and management representatives are
in the best position to resolve conflicts themselves, because they are closer to the situation than an arbitrator can
be. Contract Administration Although the process of negotiating a labor agreement (including the occasional
strike) receives the most publicity, other union-management activities occur far more often. Bargaining over a
new contract typically occurs only about every three years, but administering labor contracts goes on day after
day, year after year. The two activities are linked, of course. Vague or inconsistent language in the contract can
make administering the contract more difficult. The difficulties can create conflict that spills over into the next
round of negotiations. 42 Events during negotiations—strikes, the use of replacement workers, or violence by
either side—also can lead to difficulties in working successfully under a conflict. Contract administration
includes carrying out the terms of the agreement and resolving conflicts over interpretation or violation of the
agreement. Under a labor contract, the process for resolving these conflicts is called a grievance procedure .
This procedure has a key influence on success in contract administration. A grievance procedure may be started
by an employee or discharged employee who believes the employer violated the contract or by a union
representative on behalf of a group of workers or union representatives. For grievances launched by an
employee, a typical grievance procedure follows the steps shown in Figure 14.7 . The grievance may be settled
during any of the four steps. In the first step, the employee talks to his or her supervisor about the problem. If
this conversation is unsatisfactory, the employee may involve the union steward in further discussion. The
union steward and employee decide whether the problem has been resolved and, if not, whether it is a contract
violation. If the problem was not resolved and does seem to be a contract violation, the union moves to step 2,
putting the grievance in writing and submitting it to a line manager. The union steward meets with a
management representative to try to resolve the problem. Management consults with the industrial relations
staff and puts its response in writing too at this second stage. If step 2 fails to resolve the problem, the union
appeals the grievance to top line management and representatives of the industrial relations staff. The union
may involve more local or international officers in discussions at this stage (see step 3 in Figure 14.7 ). The
decision resulting from the appeal is put into writing. If the LO6 Summarize the practice of contract
administration. Grievance Procedure The process for resolving unionmanagement conflicts over interpretation
or violation of a collective bargaining agreement. Arbitration Conflict resolution procedure in which an
arbitrator or arbitration board determines a binding settlement. noe30468_ch14_419-455.indd 444 8/5/10 11:18
PM Confirming Pages CHAPTER 14 Collective Bargaining and Labor Relations 445 grievance is still not
resolved, the union may decide (step 4) to appeal the grievance to an arbitrator. If the grievance involves a
discharged employee, the process may begin at step 2 or 3, however, and the time limits between steps may be
shorter. Grievances filed by the union on behalf of a group may begin at step 1 or step 2. The majority of
grievances are settled during the earlier steps of the process. This reduces delays and avoids the costs of
arbitration. If a grievance does reach arbitration, the arbitrator makes the final ruling in the matter. Based on a
series of Supreme Court decisions, courts generally avoid reviewing arbitrators’ decisions and focus only on
whether the grievance involved an issue that is subject to arbitration under the contract. 43 Employers can judge
a grievance procedure in terms of various criteria. 44 One consideration is effectiveness: how well the
procedure resolves day-to-day contract questions. A second basic consideration is efficiency: whether it
resolves issues at a reasonable cost and without major delays. The company also should consider how well the
grievance procedure adapts to changing circumstances. For example, if sales drop off and the company needs to
cut costs, how clear are the provisions related to layoffs and subcontracting of work? In the case of contracts
covering multiple business Figure 14.7 Steps in an EmployeeInitiated Grievance Procedure SOURCES:
Adapted from T. A. Kochan, Collective Bargaining and Industrial Relations (Homewood, IL: Richard D. Irwin,
1980), p. 395; and J. A. Fossum, Labor Relations (Boston: McGraw-Hill/Irwin, 2002), pp. 448–52.
noe30468_ch14_419-455.indd 445 8/5/10 11:18 PM Confirming Pages 446 PART 5 Meeting Other HR Goals
units, the procedure should allow for resolving local contract issues, such as work rules at a particular facility.
Companies also should consider whether the grievance procedure is fair—whether it treats employees equitably
and gives them a voice in the process. From the point of view of employees, the grievance procedure is an
important means of getting fair treatment in the workplace. Its success depends on whether it provides for all
the kinds of problems that are likely to arise (such as how to handle a business slowdown), whether employees
feel they can file a grievance without being punished for it, and whether employees believe their union
representatives will follow through. Under the National Labor Relations Act, the union has a duty of fair
representation, which means the union must give equal representation to all members of the bargaining unit,
whether or not they actually belong to the union. Too many grievances may indicate a problem—for example,
the union members or line supervisors do not understand how to uphold the contract or have no desire to do so.
At the same time, a very small number of grievances may also signal a problem. A very low grievance rate may
suggest a fear of filing a grievance, a belief that the system does not work, or a belief that employees are poorly
represented by their union. What types of issues most commonly reach arbitration? According to data from the
Federal Mediation and Conciliation Service, the largest share of arbitration cases involved discharge or other
disciplinary actions. 45 Other issues that often reach arbitration involve wages, benefits, layoffs, work
schedules, and management’s rights. In reaching decisions about these and other issues, arbitrators consider a
number of criteria, such as employees’ understanding of the rules, the employer’s consistency and fairness, and
the employees’ chance to present a defense and appeal a decision. 46 Labor-Management Cooperation The
traditional understanding of union-management relations is that the two parties are adversaries, meaning each
side is competing to win at the expense of the other. There have always been exceptions to this approach. And
since at least the 1980s, there seems to be wider acceptance of the view that greater cooperation can increase
employee commitment and motivation while making the workplace more flexible. 47 Also, evidence suggests
that employees who worked under traditional labor relations systems and then under the new, more cooperative
systems prefer the cooperative approach. 48 For an example of a company where employees have enjoyed this
difference, see the “Best Practices” box. Cooperation between labor and management may feature employee
involvement in decision making, self-managing employee teams, labor-management problem-solving teams,
broadly defined jobs, and sharing of financial gains and business information with employees. 49 The search for
a win-win solution requires that unions and their members understand the limits on what an employer can afford
in a competitive marketplace. Without the union’s support, efforts at employee empowerment are less likely to
survive and less likely to be effective if they do survive. 50 Unions have often resisted employee empowerment
programs, precisely because the programs try to change workplace relations and the role that unions play. Union
leaders have feared that such programs will weaken unions’ role as independent representatives of employee
interests. Indeed, the National Labor Relations Act makes it an unfair labor practice for an employer to
“dominate or interfere with the formation or administration of any labor organization or contribute financial or
other support to it.” LO7 Describe more cooperative approaches to labormanagement relations.
noe30468_ch14_419-455.indd 446 8/5/10 11:18 PM Confirming Pages 447 Although employers must be
careful to meet legal requirements, the NLRB has clearly supported employee involvement in work teams and
decision making. For example, in a 2001 ruling, the NLRB found that employee participation committees at
Crown Cork & Seal’s aluminum-can factory did not violate federal labor law. 51 Those committees make and
carry out decisions regarding a wide range of issues, including production, quality, training, safety, and certain
types of discipline. The NLRB determined that the committees were not employer dominated. Instead of
“dealing with” management, where employees make proposals for management to accept or reject, the
committees exercise authority within boundaries set by management, similar to the authority of a first-line
supervisor. In spite of the legal concerns, cooperative approaches to labor relations likely contribute to an
organization’s success. 52 Beyond avoiding any taint of misuse of employee empowerment, employers build
cooperative relationships by the way they treat employees—with respect and fairness, in the knowledge that
attracting talent and minimizing turnover are in the employer’s Best Practices Midwest Mechanical started out
as a family owned plumbing and heating contractor in Kansas City, Missouri. Under its third-generation owner,
Tom Sanders, the company launched into a phase of tremendous growth, opening affiliates in New Jersey,
Nevada, and Nebraska and tackling bigger, more complex projects. As so often happens during a period of rapid
change, management responded with strict rules and tight controls. Unfortunately, that shifted the company’s
culture. Michael Kotubey, who joined the company in 2004 and eventually became its president, says Midwest
Mechanical became a “stifling” environment where management “stopped believing in our people.”
Fortunately, though, the unionized company changed its culture after performance began to suffer. Based on
management’s belief that “people will aspire to greatness if given the opportunity,” the company began
replacing strict rules with high expectations and active communication about the company’s progress and
performance. It encourages creativity and employee suggestions through its Innovator of the Year and
Innovation of the Year awards. Recently, the winning innovators were plumbers in Midwest’s fabrication shop
who developed a series of process improvements. Tangible evidence of Midwest’s commitment to
communication is its new headquarters, designed to be energy efficient and to bring together the company’s
fabrication shop, office, and warehouse, along with a Gathering Room for meetings and celebrations. Midwest
Mechanical is committed to support for training of its employees, both in trade skills and in safety. Workers
receive their training through the unions with which the company is affiliated. Various employees serve as
trainers themselves in union-run training programs. That role provides a strong, positive connection between the
company and its “union labor partners.” Finally, employees know that they have a real stake in the company’s
success. Employees, including union employees who are eligible, own shares of Midwest stock through its
employee stock ownership plan (ESOP). Every employee who meets the eligibility requirements is
automatically enrolled. Efforts such as these are aimed at supporting the company’s core values of integrity,
teamwork, quality craftsmanship, and entrepreneurial spirit. Those qualities may sound difficult to promote in a
company where many of the workers are union members, but Midwest Mechanical is making it work. Sources:
Katie Rotella, “2009 PM’s Best Contractor to Work For: Midwest Mechanical Contractors, Kansas City, MO,”
Plumbing & Mechanical, January 2010, Business & Company Resource Center, http://galenet.galegroup.com ;
and Midwest Mechanical Contractors, corporate Web site, www.mmckc.com , accessed May 4, 2010. UNION
MEMBERS VALUED AT MIDWEST MECHANICAL focus on social responsibility noe30468_ch14_419-
455.indd 447 8/5/10 11:18 PM Confirming Pages 448 PART 5 Meeting Other HR Goals best interests. One
company that does this is General Cable’s Indianapolis Compounds plant, where teams of employees,
represented by the International Brotherhood of Electrical Workers, continually seek ideas to improve quality
and cut inefficiency. Terry Jones, a team coordinator and union representative, says these efforts reflect “a
shared attitude that’s driving the push for continuous improvement.” 53 thinking ethically IS
COMMUNICATING ENOUGH? Recently, the San Fernando Valley Business Journal named Alma Quintero
one of its Top Human Resources Professionals of the Year. A major reason she was nominated and received the
prize had to do with her handling of her employer’s relationship with its employees attempting to organize a
union. Quintero is director of human resources for the Hilton Los Angeles North–Glendale hotel. When she
arrived at the organization, she found that workers were divided between some who wanted to be represented by
the union, Unite Here Local 11, and others who were not interested in a union. Furthermore, union supporters
were bitter about what they saw as unfair practices by the hotel. The union staged demonstrations and
maintained a boycott of the hotel for almost two years. While the hotel’s management insisted that it was taking
a neutral stance during the organizing effort, some employees complained that they felt harassed for their
interest in a union. At one point, the National Labor Relations Board filed a complaint alleging intimidation,
which the hotel settled. What one employee called “anti-union letters stapled to our paychecks,” a Hilton
spokesperson called an effort to help employees “get all the facts before they make their decisions.” Throughout
that time, Quintero maintained an ongoing role in the negotiations and committed herself to communicating
with employees frequently on what occurred during negotiations, trying to help them “stay focused and do their
job.” Eventually, the sides reached a representation agreement, and the union’s boycott ended. SOURCES: Jeff
Weiss, “Alma Quintero: Hilton Los Angeles North, Glendale,” San Fernando Valley Business Journal, March
30, 2009, p. 39; “Hotel Workers Sign Contract,” San Fernando Valley Business Journal, June 23, 2008,
Business & Company Resource Center, http://galenet.galegroup.com ; and Eugene Tong, “Union, Lawmakers
Rally for Federal Labor Reforms,” Daily News (Los Angeles), February 23, 2007, Business & Company
Resource Center, http://galenet .galegroup.com . Questions 1. How does a union’s organizing drive affect the
interests of an organization’s employees, owners, and customers? From an ethical perspective, which of these
interests should the company’s HR staff try to protect? 2. In this example, Alma Quintero was applauded for
communicating with employees. What are some of the ethical requirements of communicating with employees
during a union’s organization effort? Which of these are also legal requirements? 3. In communicating with
employees, Quintero says her goal was to give full information about the negotiations. What else would
Quintero need to do to ensure that the hotel was treating workers fairly during this time—or is information all
that Quintero owed the employees? SUMMARY LO1 Define unions and labor relations and their role in
organizations. A union is an organization formed for the purpose of representing its members in resolving
conflicts with employers. Labor relations is the management specialty emphasizing skills that managers and
union leaders can use to minimize costly forms of conflict and to seek win-win solutions to disagreements.
Unions—often locals belonging to national and international organizations—engage in organizing, collective
bargaining, and contract administration with businesses and government organizations. In the United States,
union membership has been declining among businesses but has held steady with government employees.
Unionization is associated with more generous compensation noe30468_ch14_419-455.indd 448 8/5/10 11:18
PM Confirming Pages CHAPTER 14 Collective Bargaining and Labor Relations 449 and higher productivity
but lower profits. Unions may reduce a business’s flexibility and economic performance. LO2 Identify the labor
relations goals of management, labor unions, and society. Management goals are to increase the organization’s
profits. Managers generally expect that unions will make these goals harder to achieve. Labor unions have the
goal of obtaining pay and working conditions that satisfy their members. They obtain these results by gaining
power in numbers. Society’s values have included the hope that the existence of unions will replace conflict or
violence between workers and employers with fruitful negotiation. LO3 Summarize laws and regulations that
affect labor relations. The National Labor Relations Act supports the use of collective bargaining and sets out
the rights of employees, including the right to organize, join a union, and go on strike. The NLRA prohibits
unfair labor practices by employers, including interference with efforts to form a labor union and discrimination
against employees who engage in union activities. The Taft-Hartley Act and Landrum-Griffin Act establish
restrictions on union practices that restrain workers, such as their preventing employees from working during a
strike or determining who an employer may hire. The Taft-Hartley Act also permits state right-to-work laws.
LO4 Describe the union organizing process. Organizing begins when union representatives contact employees
and invite them to sign an authorization card. If over half the employees sign a card, the union may request that
the employer voluntarily recognize the union. If the employer refuses or if 30 to 50 percent of employees signed
authorization cards, the NLRB conducts a secret-ballot election. If the union wins, the NLRB certifies the
union. If the union loses but the NLRB finds that the election was not conducted fairly, it may set aside the
results and call a new election. LO5 Explain how management and unions negotiate contracts. Negotiations take
place between representatives of the union and the management bargaining unit. The majority of negotiations
involve parties that have been through the process before. The process begins with preparation, including
research into the other side’s strengths and demands. In the early stages of negotiation, many more people are
present than at later stages. The union presents its demands, and management sometimes presents demands as
well. Then the sides evaluate the demands and the likelihood of a strike. In the final stages, pressure for an
agreement increases, and a neutral third party may be called on to help reach a resolution. If bargaining breaks
down, the impasse may be broken with a strike, mediation, fact finder, or arbitration. LO6 Summarize the
practice of contract administration. Contract administration is a daily activity under the labor agreement. It
includes carrying out the terms of the agreement and resolving conflicts over interpretation or violation of the
contract. Conflicts are resolved through a grievance procedure. Typically, the grievance procedure begins with
an employee talking to his or her supervisor about the problem and possibly involving the union steward in the
discussion. If this does not resolve the conflict, the union files a written grievance with a line manager, and
union and management representatives meet to discuss the problem. If this effort fails, the union appeals the
grievance to top line management and the industrial relations staff. If the appeal fails, the union may appeal the
grievance to an arbitrator. LO7 Describe more cooperative approaches to labormanagement relations. In
contrast to the traditional view that labor and management are adversaries, some organizations and unions work
more cooperatively. Cooperation may feature employee involvement in decision making, self-managing
employee teams, labor-management problem-solving teams, broadly defined jobs, and sharing of financial gains
and business information with employees. If such cooperation is tainted by attempts of the employer to
dominate or interfere with labor organizations, however, such as by dealing with wages, grievances, or working
conditions, it may be illegal under the NLRA. In spite of such legal concerns, cooperative labor relations seem
to contribute to an organization’s success. noe30468_ch14_419-455.indd 449 8/5/10 11:18 PM Confirming
Pages 450 PART 5 Meeting Other HR Goals KEY TERMS agency shop, p. 429 American Federation of Labor
and Congress of Industrial Organizations (AFL-CIO), p. 423 arbitration, p. 444 associate union membership, p.
437 checkoff provision, p. 429 closed shop, p. 429 collective bargaining, p. 438 corporate campaigns, p. 438
craft union, p. 422 fact finder, p. 443 grievance procedure, p. 444 industrial union, p. 423 labor relations, p. 421
maintenance of membership, p. 429 mediation, p. 443 National Labor Relations Act (NLRA), p. 430 National
Labor Relations Board (NLRB), p. 433 right-to-work laws, p. 432 strike, p. 442 union shop, p. 429 union
steward, p. 423 unions, p. 421 1. Why do employees join labor unions? Did you ever belong to a labor union? If
you did, do you think union membership benefited you? If you did not, do you think a union would have
benefited you? Why or why not? 2. Why do managers at most companies prefer that unions not represent their
employees? Can unions provide benefits to an employer? Explain. 3. How has union membership in the United
States changed over the past few decades? How does union membership in the United States compare with
union membership in other countries? How might these patterns in union membership affect the HR decisions
of an international company? 4. What legal responsibilities do employers have regarding unions? What are the
legal requirements affecting unions? 5. Suppose you are the HR manager for a chain of clothing stores. You
learn that union representatives have been encouraging the stores’ employees to sign authorization cards. What
events can follow in this process of organizing? Suggest some ways that you might respond in your role as HR
manager. 6. If the parties negotiating a labor contract are unable to reach an agreement, what actions can resolve
the situation? 7. Why are strikes uncommon? Under what conditions might management choose to accept a
strike? 8. What are the usual steps in a grievance procedure? What are the advantages of resolving a grievance
in the first step? What skills would a supervisor need so grievances can be resolved in the first step? 9. The
“Best Practices” box near the end of the chapter gives an example of union-management cooperation at
Midwest Mechanical. What does the company gain from this effort? What do workers gain? 10. What are the
legal restrictions on labor-management cooperation? REVIEW AND DISCUSSION QUESTIONS U.S. Labor
Lobbies European Management The Service Employees International Union [planned to] picket the annual
meeting of French food-service group Sodexo in Paris on January 25 [2010] as U.S. unions take their
organizing efforts abroad. Sodexo, which employs 380,000 people worldwide including 110,000 in the U.S., is
“engaging in behavior around the world that would not be acceptable in their home country,” says Mitch
Ackerman, an SEIU executive vice-president who heads the Washington-based union’s property services
division. With more than 5 million Americans now employed by foreign-owned companies, U.S. labor unions
are starting to export their grievances. In industries ranging from food service to telecommunications, foreign
companies are coming under attack in their home countries from American unions, which are teaming up with
local labor groups to criticize the companies’ U.S. labor practices. The SEIU alleges that Sodexo’s U.S.
subsidiary has used “harsh” though legal anti-union tactics, such as requiring employees to attend meetings
where managers try to dissuade them from unionizing. The union also alleges that some Sodexo employees
have been punished for BUSINESSWEEK CASE noe30468_ch14_419-455.indd 450 8/5/10 11:18 PM
Confirming Pages CHAPTER 14 Collective Bargaining and Labor Relations 451 taking sick days, and that the
company’s health-insurance plan is too expensive for many workers, who hold kitchen and cleaning jobs in
schools, hospitals, military bases, and other facilities. Sodexo denies those allegations. “Sodexo respects
unequivocally the rights of our employees to unionize or not to unionize, as they may so choose,” the company
says in a statement. “We will not discriminate against any employee for engaging in union organizing activities
or otherwise supporting a union.” Sodexo provides paid sick leave for full-time employees, who account for 75
percent of its U.S. workforce, the company says. It says 60 percent of full-time U.S. employees have enrolled in
Sodexo’s health insurance plan, under which two-thirds of premiums are paid by the company. In a 2008 survey
conducted for Sodexo by employeebenefits consulting group Hewitt, “Eighty-six percent of our American
employees said our company compared favorably with our competitors,” the company says. According to
Ackerman, SEIU is hoping its complaints will cause a stir in France, which offers universal public health
insurance and guarantees the right to unionize and strike in its national constitution. “We want to tell our story
to shareholders and to a larger public audience,” he says. Besides protesting at Sodexo’s annual meeting, SEIU
representatives will hold a press conference with French union members and representatives of UNISON, a
British labor union. The British union represents hospital workers who staged a two-day strike this month
against Sodexo in North Devon that resulted in the company’s agreeing to better pay and benefits. SEIU is one
of at least three U.S. unions targeting foreign employers. The Washington-based Communications Workers of
America, which is trying to organize U.S. employees of cellular provider T-Mobile, formed a partnership last
November with German union Ver.di to exert pressure on T-Mobile’s German owner, Deutsche Telekom. In
Britain, retail chain Tesco has been targeted by the Washington-based United Food and Commercial Workers,
which is attempting to organize employees of Tesco-owned Fresh & Easy markets in the western U.S. When
foreign companies set up shop in the U.S., Ackerman says, “We want to hold them accountable in their home
countries.” SOURCE: Excerpted from Carol Matlack, “U.S. Labor Takes Its Case to European Bosses,”
BusinessWeek, January 22, 2010, www.businessweek.com . Questions 1. How does the SEIU’s plan give
Sodexo’s U.S. workers influence they might not have outside of a union? Do you think the effort described in
this case will benefit these workers? Why or why not? 2. What do the SEIU’s goals seem to be with regard to
Sodexo? What would you expect Sodexo’s goals to be in this situation? 3. Should Sodexo’s U.S. employees
receive benefits similar to benefits received by employees at the company’s headquarters in France? Why or
why not? Write a paragraph expressing your views to Sodexo’s management, and then write a paragraph
presenting these views to the SEIU. Boeing’s headquarters is in Chicago, but until recently at least, the hub of
its commercial-aircraft business was in the state of Washington. That changed when Boeing bought a South
Carolina factory that had been making sections of the fuselage for Boeing’s 787 Dreamliner, as well as a stake
in an adjoining factory making 787 subassemblies. Eventually, amid talk that the South Carolina legislature
would provide tax incentives worth $450 million, Boeing announced that it would be building a second 787
assembly line in South Carolina. It planned to start production in 2011. Boeing has not been shy about saying
the International Association of Machinists and Aerospace Workers, which represents workers at the Everett,
Washington, assembly plant, bears much of the responsibility. During the past twenty years, the union has
called several strikes. With the company way behind schedule in 2008, a strike by the Machinists set production
back another eight weeks, costing Boeing $2 billion and leading some customers to cancel their orders and buy
from rival Airbus. In addition, the union recently refused to accept concessions in negotiating a new contract.
The Machinists blame Boeing for presenting vague contract requirements, a charge the company denies.
Boeing’s Jim Proulx told reporters that strikes in Washington mattered: “Repeated labor disruptions have
affected our performance in our customers’ eyes. We have to show our customers we can be a reliable supplier
to them.” With regard to bargaining, Boeing and the Machinists had different requirements for the contract.
Among other demands, the union wanted wage increases of 3 percent per year plus cost-of-living raises, and it
wanted a guarantee that future airplane construction would occur in Washington. Boeing was willing to grant
pay raises of 2 percent per year and wouldn’t commit to where future planes would be constructed. Boeing
wanted union members to start sharing the cost of health insurance; the union said it would start to do so in
2018. The union Case: Boeing’s Prickly Relationship with Its Unions noe30468_ch14_419-455.indd 451 8/5/10
11:18 PM Confirming Pages 452 PART 5 Meeting Other HR Goals claims Boeing wasn’t clear about its
requirements during bargaining, but only after announcing the move to South Carolina. Boeing’s second-largest
union, the Society of Engineering Employees in Aerospace (SPEEA), echoes that complaint. Boeing says the
reason is that it had no complaints with the SPEEA. Even without complaining about the Machinists, Boeing
can cite economic advantages to employing workers in South Carolina. Most workers at the South Carolina
plant will make roughly $14 to $15 per hour, compared with $26 for Machinists in Washington. One reason for
the lower rate is that the South Carolina employees have less experience in the industry. Workers in Charleston
also recently voted to decertify the Machinists as their union. Because South Carolina is a right-to-work state
with one of the nation’s lowest rates of unionization, the chance for future union organizing is not great.
Together, these facts suggest that Boeing doesn’t have to worry about strikes at its South Carolina facilities. The
Machinists, for their part, say their highly skilled workers in Washington have been fixing problem after
problem introduced by the company’s suppliers, so using nonunion labor carries its own costs. In fact, Boeing
did recently take control of operations at a subcontractor in Charleston that experienced delays and quality
problems. Tom Wroblewski, president of Machinists district that represents Boeing workers, told a reporter, “If
they continually offload and go into areas of nonskilled workers, they’re just not going to have that quality
product.” Perhaps the Machinists have a point, but Boeing seems to have the last word. The company recently
announced layoffs of over a thousand workers, some of them in the Commercial Airplanes and Defense unit,
which makes the 787. Under an agreement with the Machinists, some workers are eligible to volunteer to be
laid off with benefits. SOURCES: John Gillie, “Boeing Fallout to Take Time,” News Tribune (Tacoma, WA),
November 8, 2009, Business & Company Resource Center, http://galenet.galegroup.com ; “S.C. May Benefit
from Supplier Plan,” Post and Courier (Charleston, S.C.), December 9, 2009, Business & Company Resource
Center, http://galenet.galegroup.com ; “Advantage Dixie; Aviation and the South,” The Economist, January 9,
2010, Businesss & Company Resource Center, http://galenet.galegroup.com ; Dean Foust and Justin Bachman,
“Boeing’s Flight from Union Labor,” BusinessWeek, November 6, 2009, www. businessweek.com ; and
“Boeing Announces 1,020 Layoffs,” UPI NewsTrack, February 20, 2010, Business & Company Resource
Center, http://galenet .galegroup.com . Questions 1. What are the advantages to Boeing of its nonunion South
Carolina workforce? Of its unionized Washington workforce? 2. If a Boeing human resource manager
transferred from a Washington facility to a South Carolina facility, what differences could he or she expect in
the department’s work? 3. Could Boeing and the Machinists develop a more cooperative working relationship in
Washington? Why or why not? What could Boeing do to encourage cooperation? IT’S A WRAP! 1. M. Evans,
“Health Workers Saying, ‘Union, Yes,” ’ Modern Healthcare , February 4, 2008, downloaded from General
Reference Center Gold, http://find .galegroup.com . 2. J. T. Dunlop , Industrial Relations Systems (New York:
Holt, 1958); and C. Kerr , “Industrial Conflict and Its Mediation,” American Journal of Sociology 60 (1954),
pp. 230–45 . NOTES www. mhhe.com/noefund4e is your source for R eviewing, A pplying, and P racticing the
concepts you learned about in Chapter 14. Review • Chapter learning objectives Application • Manager’s Hot
Seat segment: “Partnership: The Unbalancing Act” • Video case and quiz: “Hollywood Labor Unions” • Self-
Assessment: Labor relations • Web exercise: Understanding unions • Small-business case: Republic Gets
Serious Practice • Chapter quiz noe30468_ch14_419-455.indd 452 8/5/10 11:18 PM Confirming Pages
CHAPTER 14 Collective Bargaining and Labor Relations 453 3. T. A. Kochan , Collective Bargaining and
Industrial Relations (Homewood, IL: Richard D. Irwin , 1980), p. 25 ; and H. C. Katz and T. A. Kochan , An
Introduction to Collective Bargaining and Industrial Relations , 3rd ed. (New York: McGraw-Hill , 2004 ). 4. R.
J. Grossman , “Reorganized Labor,” HRMagazine , January 2008, downloaded from General Reference Center
Gold, http://find.galegroup.com . 5. Whether the time the union steward spends on union business is paid for by
the employer, the union, or a combination is a matter of negotiation between the employer and the union. 6.
Bureau of Labor Statistics, “Union Affiliation Data from the Current Population Survey,” http://data.bls .gov ,
accessed March 10, 2008; and J. Smerd , “Unions Reverse Decline,” Workforce Management , February 4,
2008, downloaded from General Reference Center Gold, http://find.galegroup.com . 7. Katz and Kochan, An
Introduction to Collective Bargaining , building on J. Fiorito and C. L. Maranto , “The Contemporary Decline
of Union Strength,” Contemporary Policy Issues 3 (1987), pp. 12–27 ; and G. N. Chaison and J. Rose , “The
Macrodeterminants of Union Growth and Decline,” in The State of the Unions , ed. G. Straus s et al. (Madison,
WI: Industrial Relations Research Association, 1991 ). 8. Bureau of Labor Statistics Web site, www.bls.gov ;
Steven Greenhouse, “Survey Finds Deep Shift in the Makeup of Unions,” New York Times , November 11,
2009, Business & Company Resource Center, http:// galenet.galegroup.com; and John Schmitt, The Unions of
the States ( Washington, DC : Center for Economic and Policy Research, February 2010), accessed at
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Profits, and Growth: Has the Long Run Arrived?” Journal of Labor Economics 7 (1989), pp. 72–105 ; and R. B.
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Mishel and P. Voos , Unions and Economic Competitiveness (Armonk, NY: M. E. Sharpe , 1991 ); Freeman
and Medoff, “Two Faces” ; and S. Slichter , J. Healy , and E. R. Livernash , The Impact of Collective
Bargaining on Management ( Washington, DC : Brookings Institution, 1960 ). 13. A. O. Hirschman , Exit,
Voice, and Loyalty (Cambridge, MA: Harvard University Press , 1970 ); and R. Batt , A. J. S. Colvin , and J.
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, “Unions and Firm Profits,” Industrial Relations 31, no. 3 ( 1992 ), pp. 395–415 ; B. T. Hirsch and B. A.
Morgan , “Shareholder Risks and Returns in Union and Nonunion Firms,” Industrial and Labor Relations
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“Union Adds Training to Better Partner with Industry,” Bismarck (N.D.) Tribune , January 17, 2010, Business
& Company Resource Center, http://galenet.galegroup.com ; and Jim Olsztynski, “Gone but Not Forgotten,”
Plumbing & Mechanical , January 2010, Business & Company Resource Center, http://galenet.galegroup.com .
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March 10, 2010, www.bls.gov . 18. S. B. Jarrell and T. D. Stanley , “A Meta-Analysis of the Union-Nonunion
Wage Gap,” Industrial and Labor Relations Review 44 (1990), pp. 54–67 ; L. Mishel and M. Walters , “How
Unions Help All Workers,” Economic Policy Institute Briefing Paper, August 2003, www.epinet.org ; and
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Unions, but Not the Kind It Has Now,” BusinessWeek , May 23, 1994 , p. 70 . 21. E. E. Herman , J. L. Schwatz
, and A. Kuhn , Collective Bargaining and Labor Relations (Englewood Cliffs, NJ: Prentice Hall , 1992 ). 22.
Kochan, Collective Bargaining and Industrial Relations , p. 61 . 23. National Labor Relations Board, Basic
Guide to the National Labor Relations Act ( Washington, DC : U.S. Government Printing Office , 1997 ).
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www.nlrb.gov , accessed March 12, 2008 . 25. National Labor Relations Board, Basic Guide . 26. Ibid. 27. Ibid.
28. R. B. Freeman and M. M. Kleiner , “Employer Behavior in the Face of Union Organizing Drives,”
Industrial and Labor Relations Review 43, no. 4 (April 1990 ), pp. 351–65 . 29. J. A. Fossum , Labor Relations ,
8th ed. (New York: McGraw-Hill , 2002 ), p. 149 . 30. J. Gallagher , “Driving to Organize,” Traffic World ,
March 3, 2008; and “UPS Freight Teamsters Gain Steam,” Traffic World , January 28, 2008, both downloaded
from General Reference Center Gold, http:// find.galegroup.com . 31. Herman et al., Collective Bargaining; and
P. Jarley and J. Fiorito , “Associate Membership: Unionism or Consumerism?” Industrial and Labor Relations
Review 43 (1990), pp. 209–24 . 32. Katz and Kochan, An Introduction to Collective Bargaining; and R. L. Rose
, “Unions Hit Corporate Campaign Trail,” Wall Street Journal , March 8, 1993 , p. B1 . 33. Katz and Kochan,
An Introduction to Collective Bargaining . 34. A. E. Eaton and J. Kriesky , “Union Organizing under Neutrality
and Card Check Agreements,” Industrial and Labor Relations Review 55 (2001), pp. 42–59 . 35. National Labor
Relations Board , N.L.R.B. Election Reports for 2006–2009, http://nlrb.gov , accessed May 4, 2010 . 36.
Chaison and Rose, “The Macrodeterminants of Union Growth and Decline.” 37. Fossum, Labor Relations , p.
262 . 38. R. E. Walton and R. B. McKersie , A Behavioral Theory of Negotiations (New York: McGraw-Hill ,
1965 ). 39. C. M. Steven , Strategy and Collective Bargaining Negotiations (New York: McGraw-Hill , 1963 );
and Katz and Kochan, An Introduction to Collective Bargaining . 40. “The Show Will Resume,” Global Agenda
, February 12, 2008; and “Writer’s Strike Ends, Viewers to Get Network Shows Again,” Information Week ,
February 13, 2008, both downloaded from General Reference Center Gold, http://find.galegroup.com . 41.
Kochan, Collective Bargaining and Industrial Relations , p. 272 . 42. Katz and Kochan, An Introduction to
Collective Bargaining . 43. United Steelworkers v. American Manufacturing Company , 363 U.S. 564 ( 1960 );
United Steelworkers v. Warrior Gulf and Navigation Company , 363 U.S. 574 (1960); and United Steelworkers
v. Enterprise Wheel and Car Corporation , 363 U.S. 593 ( 1960 ). 44. Kochan, Collective Bargaining and
Industrial Relations , p. 386 ; and John W. Budd and Alexander J. S. Colvin, “Improved Metrics for Workplace
Dispute Resolution Procedures: Efficiency, Equity, and Voice,” Industrial Relations 47, no. 3 (July 2008 ), p.
460 . 45. Federal Mediation and Conciliation Service, “What We Do: Arbitration; Arbitration Statistics,” www.
fmcs.gov , accessed May 3, 2010 . 46. J. R. Redecker , Employee Discipline: Policies and Practices (
Washington, DC : Bureau of National Affairs, 1989 ). 47. T. A. Kochan , H. C. Katz , and R. B. McKersie , The
Transformation of American Industrial Relations (New York: Basic Books , 1986 ), chap. 6; and E. Appelbaum
, T. Bailey , and P. Berg , Manufacturing Advantage: Why High-Performance Work Systems Pay Off (Ithaca,
NY: Cornell University Press , 2000 ). 48. L. W. Hunter , J. P. MacDuffie , and L. Doucet , “What Makes
Teams Take? Employee Reactions to Work Reforms,” Industrial and Labor Relations Review 55 (2002), pp.
448–472 . 49. J. B. Arthur , “The Link between Business Strategy and Industrial Relations Systems in American
Steel Minimills,” Industrial and Labor Relations Review 45 (1992), pp. 488–506 ; M. Schuster , “Union
Management Cooperation,” in Employee and Labor Relations , ed. J. A. Fossu m ( Washington, DC : Bureau of
National Affairs, 1990); E. Cohen-Rosenthal and C. Burton, Mutual Gains: A Guide to UnionManagement
Cooperation , 2nd ed. (Ithaca, NY: ILR Press , 1993 ); T. A. Kochan and P. Osterman , The Mutual Gains
Enterprise (Boston: Harvard Business School Press , 1994 ); and E. Applebaum and R. Batt , The New
American Workplace (Ithaca, NY: ILR Press , 1994 ). 50. A. E. Eaton , “Factors Contributing to the Survival of
Employee Participation Programs in Unionized Settings,” Industrial and Labor Relations Review 47, no. 3 (
1994 ), pp. 371–89 . 51. “NLRB 4–0 Approves Crown Cork & Seal’s Use of Seven Employee Participation
Committees,” HR News , September 3, 2001 . 52. Kochan and Osterman, The Mutual Gains Enterprise; W. N.
Cooke , “Employee Participation Programs, Group-Based Incentives, and Company Performance: A Union-
Nonunion Comparison,” Industrial and Labor Relations Review 47, no. 4 ( 1994 ), pp. 594–609 ; C.
Doucouliagos , “Worker Participation and Productivity in Labor-Managed and Participatory Capitalist Firms: A
Meta-Analysis,” Industrial and Labor Relations Review 49, no. 1 ( 1995 ), pp. 58–77 ; S. J. Deery and R. D.
Iverson , “Labor-Management Cooperation: Antecedents and Impact on Organizational Performance,”
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CHAPTER 14 Collective Bargaining and Labor Relations 455 Review 58 (2005), pp. 588–609 ; James Combs,
Yongmei Liu, Angela Hall, and David Ketchen, “How Much Do High-Performance Work Practices Matter? A
Meta-analysis of Their Effects on Organizational Performance,” Personnel Psychology 59, no. 3 ( 2006 ), pp.
501–28 ; Paul Osterman, “The Wage Effects of High Performance Work Organization in Manufacturing,”
Industrial and Labor Relations Review 59 (2006), pp. 187–204 ; and Robert D. Mohr and Cindy Zoghi, “High-
Involvement Work Design and Job Satisfaction,” Industrial and Labor Relations Review 61, no. 3 (April 2008 ),
pp. 275–96 . 53. J. Teresko , “Continuing a Winning Culture,” Industry Week , January 2008 , p. 42 .
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After studying this chapter, students should be able to understand the following:
A.
Unions
B.
Collective Bargaining
C.
The HRM Department in a Nonunion Setting
D.
Phases of Labor Relations
This chapter talks about why workers organize, outlines the basics of labor law, and reviews the procedures
of labor elections, collective bargaining, and contract administration. We will also go through the grievance
procedures.
A. Unions
Organization of workers, acting collectively, seeking to protect and promote their mutual interests through
collective bargaining is termed as union. The most significant impact of a union on the management of
human resources is its influence in shaping HRM policies. In the absence of a union, the company may
develop all HRM policies based on efficiency. But, when a union enters the picture, management must
develop HRM policies that reflect consideration for the preferences of workers who are represented by a
union. A union's strong preferences for high wages, job security, the ability to express dissatisfaction with
administrative actions, and having a voice in the development of work rules that affect their jobs get
injected into the equation along with the employer's preferences.
I. Union Objectives
Several broad objectives characterize the labor movement as a whole. These include:
(1) To secure and, if possible, improve the living standards and economic status of its members.
(2) To enhance and, if possible, guarantee individual security against threats and contingencies that might
result from market fluctuations, technological change, or management decisions. (3) To influence power
relations in the social system in ways that favor and do not threaten union gains and goals. (4) To advance
the welfare of all who work for a living, whether union members or not. (5) To create mechanisms to guard
against the use of arbitrary and capricious policies and practices in the workplace. In order to accomplish
these objectives, most unions recognize that they must strive for continued growth and power.
Growth--To maximize effectiveness, a union must strive for continual growth, but the percentage
of union members in the workforce is declining. Union leaders are concerned because much of a
union's ability to accomplish objectives comes from strength in numbers. Unions must continue to
explore new sources of potential members.
Power--We define power here as the amount of external control that an organization is able to
exert. A union's power is influenced to a large extent by the size of its membership and the
possibility of future growth. By achieving power, a union is capable of exerting its force in the
political arena.
II. Factors Leading to Employee Unionization
Three types of factors play role in origin of employee unions they are:
a. Working Environment: Inadequate staffing, Mandatory overtime, Poor working conditions
b. Compensation: Non-competitive Pay, Inadequate benefits inequitable pay raises
c. Management Style: Arbitrary Management Decision Making, Use of fear, Lack of recognition
d. Organization Treatment: Job insecurity, unfair discipline and policies, Harassment and abusive
treatments, Not responsive to complaints
III. Why Employees Join Unions
Individuals join unions for many different reasons, and these reasons tend to change over time. They may
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involve dissatisfaction with management, need for a social outlet, opportunity for leadership, forced
unionization, and peer pressure.
A union is an organization that represents employees' interests to management on issues such as wages,
hours, and working conditions. Generally, employees seek to join a union when they (1) are dissatisfied
with aspects of their job,
(2) feel a lack of power or influence with management in terms of making changes, and
(3) see unionization as a solution to their problems.
a. Dissatisfaction With Management--Unions look for problems in organizations and then
emphasize the advantages of union membership as a means of solving them. Management must
exercise restraint and use its power to foster management and labor cooperation for the benefit of all
concerned. Some reasons for employee dissatisfaction are described:
1.
Compensation: If employees are dissatisfied with their wages, they may look to a union
for assistance in improving their standard of living.
2.
Job Security: If the firm doesn't provide its employees with a sense of job security,
workers may turn to a union. Employees are more concerned than ever about job security
due to a decline in employment in such key industries as automobiles, rubber, and steel.
3. Management Attitude: Employees do not like to be subjected to arbitrary and capricious
actions by management. In some firms, management is insensitive to the needs of its
employees. When this situation occurs, employees may perceive that they have little or no
influence in job-related matters, thus becoming prime targets for unionization.
b. A Social Outlet--Many people have strong social needs. Union-sponsored recreational and social
activities, day care centers, and other services can increase the sense of solidarity.
c. Opportunity For Leadership--Employers often promote union leaders into managerial ranks as
supervisors.
d. Forced Unionization--It is generally illegal for management to require that an individual join a
union prior to employment. However, in the 29 states without right-to-work laws, it is legal for an
employer to agree with the union that a new employee must join the union after a certain period of
time (generally 30 days) or be terminated.
e. Peer Pressure--Many individuals will join a union simply because they are urged to do so by other
members of the work group.
f.
IV. The Impact of Unions on Human Resource Management
Managers are more likely to develop HRM policies based on efficiency. But, when a union is in the picture,
policies must reflect employees' preferences as well. Employees have preferences related to staffing,
employee development, compensation, and employee relations.
a. Staffing: The contract can dictate how jobs are filled and on what basis they are filled.
b. Employee Development: Performance evaluations are rarely used in unionized
organizations. However, there is often a greater amount of worker training.
c. Compensation: On average, union employees earn 10% to 20% higher wages than
comparable non-union employees. Unionized firms avoid using merit pay plans and are
likely to give across-the-board pay raises to employees based on market considerations.
d. Employee Relations: The labor contract gives employees specific rights. The employees,
through the collective bargaining process, have a voice in the development of work rules
that affect their jobs.
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B. Collective Bargaining
Under a collective bargaining system, union and management negotiate with each other to develop the work
rules.
The performance of the mutual obligation of the employer and the representative of the employees to meet
at reasonable times and confer in good faith with respect to wages, hours, and other terms and conditions
of employment, or the negotiation of an agreement, or any question arising there under, and the execution
of a written contract incorporating any agreement reached if requested by either party; such obligation does
not compel either party to agree to a proposal or require the making of a concession.
I.
Labor Management Relations and Collective Bargaining
Forms of Bargaining Structures AND Union/ Management Relationships--The bargaining
structure can affect the conduct of collective bargaining. The four major structures are one
company dealing with a single union, several companies dealing with a single union, several unions
dealing with a single company, and several companies dealing with several unions. Types of
union/management relations that may exist in an organization are conflict, armed truce, power
bargaining, accommodation, cooperation, and collusion.
The Collective Bargaining Process--Both external and internal environmental factors can
influence the process. The first step in the collective bargaining process is preparing for
negotiations. This step is often extensive and ongoing for both union and management. After the
issues to be negotiated have been determined, the two sides confer to reach a mutually acceptable
contract. Although breakdowns in negotiations can occur, both labor and management have at
their disposal tools and arguments that can be used to convince the other side to accept their views.
Eventually, however, management and the union usually reach an agreement that defines the rules
of the game for the duration of the contract. The next step is for the union membership to ratify
the agreement. There is a feedback loop from "Administration of the Agreement" to "Preparing
for Negotiation." Collective bargaining is a continuous and dynamic process, and preparing for the
next round of negotiations often begins the moment a contract is ratified.
The Psychological Aspects Of Collective Bargaining
Prior to collective bargaining, both the management team and the union team have to prepare positions and
accomplish certain tasks. Vitally important for those involved are the psychological aspects of collective
bargaining. Psychologically, the collective bargaining process is often difficult because it is an adversarial
situation and must be approached as such. It is a situation that is fundamental to law, politics, business, and
government, because out of the clash of ideas, points of view, and interests come agreement, consensus,
and justice.
a. Preparing For Negotiations
Bargaining issues can be divided into three categories: mandatory, permissive, and prohibited.
Mandatory Bargaining Issues--Fall within the definition of wages, hours, and
other terms and conditions of employment.
Permissive Bargaining Issues--May be raised, but neither side may insist that
they be bargained over.
Prohibited Bargaining Issues--Are statutorily outlawed.
b. Bargaining Issues
The document that results from the collective bargaining process is known as a labor agreement or contract.
Certain topics are included in virtually all labor agreements.
Recognition--Its purpose is to identify the union that is recognized as the bargaining
representative and to describe the bargaining unit.
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Management Rights--A section that is often, but not always, written into the labor agreement
and that spells out the rights of management. If no such section is included, management may
reason that it retains control of all topics not described as bargainable in the contract.
Union Security-- The objective of union security provisions is to ensure that the union continues
to exist and to perform its function.
1.
Closed Shop: An arrangement whereby union membership is a prerequisite to
employment.
2.
Union Shop: An arrangement that requires that all employees become members of the
union after a specified period of employment (the legal minimum is 30 days) or after a
union shop provision has been negotiated.
3.
Maintenance of Membership: Employees who are members of the union at the time the
labor agreement is signed or who later voluntarily joins must continue their memberships
until the termination of the agreement, as a condition of employment. This form of
recognition is also prohibited in most states that have right-to-work laws.
4.
Agency Shop: Does not require employees to join the union; however, the labor
agreement requires, as a condition of employment, that each nonunion member of the
bargaining unit "pay the union the equivalent of membership dues as a kind of tax, or
service charge, in return for the union acting as the bargaining agent." The agency shop is
outlawed in most states that have right-to-work laws.
5.
Exclusive Bargaining Shop: The company is bound legally to deal with the union that
has achieved recognition, but employees are not obligated to join or maintain membership
in the union or to financially contribute to it.
6.
Open Shop: Employment that has equal terms for union members and nonmembers alike.
7.
Dues Checkoff: The Company agrees to withhold union dues from members' checks and
to forward the money directly to the union.
Compensation and Benefits--This section typically constitutes a large portion of most labor
agreements. Virtually any item that can affect compensation and benefits may be included.
1.
Wage Rate Schedule: The base rates to be paid each year of the contract for each job are
included in this section. At times, unions are able to obtain a cost-of-living allowance (COLA) or
escalator clause in the contract in order to protect the purchasing power of employees' earnings.
2.
Overtime and Premium Pay: Provisions covering hours of work, overtime pay, and
premium pay, such as shift differentials, are included in this section.
3.
Jury Pay: Some firms pay an employee's entire salary when he or she is serving jury duty.
Others pay the difference between jury pay and the compensation that would have been
earned. The procedure covering jury pay is typically stated in the contract.
4.
Layoff or Severance Pay: The amount that employees in various jobs and/or seniority
levels will be paid if they are laid off or terminated is presented in this section.
5.
Holidays: The holidays to be recognized and the amount of pay that a worker will receive
if he or she has to work on a holiday are specified. In addition, the pay procedure for times
when a holiday falls on a worker's nominal day off is provided.
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6.
Vacation: This section spells out the amount of vacation that a person may take, based on
seniority. Any restrictions as to when the vacation may be taken are also stated.
7.
Family Care: This is a benefit that has been included in recent collective bargaining
agreements, with child care expected to be a hot bargaining issue in the near future.
Grievance Procedure--It contains the means by which employees can voice dissatisfaction with
specific management actions. Also included in this section are the procedures for disciplinary action
by management and the termination procedure that must be followed.
Employee Security--This section of the labor agreement establishes the procedures that cover
job security for individual employees. Seniority and grievance handling procedures are the key
topics related to employee security.
a. Negotiating The Agreement
The negotiating phase of collective bargaining begins with each side presenting its initial demands. The term
negotiating suggests a certain amount of give and take, the purpose of which is to lower the other side's
expectations. Each side does not expect to obtain all the demands presented in its first proposal. Demands
that the union does not expect to receive when they are first made are known as beachhead demands.
b. Breakdowns In Negotiations
At times negotiations break down, even though both labor and management may sincerely want to arrive at
an equitable contract settlement. Several means of removing roadblocks may be used in order to get
negotiations moving again.
Third-Party Intervention--Often a person from outside both the union and the organization can
intervene to provide assistance when an agreement cannot be reached and a breakdown occurs. At
this point there is an impasse.
1.
Mediation: A process whereby a neutral third party enters a labor dispute when a
bargaining impasse has occurred.
2.
Arbitration: A process in which a dispute is submitted to an impartial third party to make
a binding decision.
3.
Sources of Mediators and Arbitrators: The principle organization involved in mediation
efforts, other than the available state and local agencies, is the Federal Mediation and
Conciliation Service (FMCS). Either or both parties involved in negotiations can seek the
assistance of the FMCS, or the agency can offer help if it feels that the situation warrants
this.
Union Strategies for Overcoming Negotiations Breakdowns--There are times when a union
believes that it must exert extreme pressure on management to agree to its bargaining demands.
Strikes and boycotts are the primary means that the union may use to overcome breakdowns in
negotiations.
1.
Strikes: When union members refuse to work in order to exert pressure on management
in negotiations.
2.
Boycotts: An agreement by union members to refuse to use or buy the firm's products.
The practice of a union attempting to encourage third parties (suppliers and customers) to
stop doing business with the firm is a secondary boycott.
Management's Strategies For Overcoming Negotiation Breakdowns--One form of action
that is somewhat analogous to a strike is called a lockout. Management keeps employees out of the
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workplace and may run the operation with management personnel and/or temporary replacements.
The employees are unable to work and do not get paid.
a. Ratifying The Agreement
In the vast majority of collective bargaining encounters, the parties reach agreement without experiencing
severe breakdowns in negotiations or resorting to disruptive actions. Typically, this is accomplished before
the current agreement expires. After the negotiators have reached a tentative agreement on all topics
negotiated, they will prepare a written agreement complete with the effective and termination dates.
However, the approval process can be more difficult for the union. Until it has received approval by a
majority of members voting in a ratification election, the proposed agreement is not final. Union members
may reject the proposed agreement, and new negotiations must begin.
b. Administration Of The Agreement
The larger and perhaps more important part of collective bargaining is the administration of the agreement,
which is seldom viewed by the public. The agreement establishes the union-management relationship for
the duration of the contract.
.
II.
Grievance Handling Under a Collective Bargaining Agreement
If employees in an organization are represented by a union, workers who believe that they have been
disciplined or dealt with unjustly can appeal through the grievance and arbitration procedures of the
collective bargaining agreement.
a.
Grievance Procedure--A grievance can be broadly defined as an employee's
dissatisfaction or feeling of personal injustice relating to his or her
employment relationship.
b. Arbitration--The process that allows the parties to submit their dispute to an
impartial third party for resolution.
c. Proof that Disciplinary Action was Needed--Any disciplinary action
administered may ultimately be taken to arbitration, when such a remedy is
specified in the labor agreement.
d. Weaknesses Of Arbitration--The reason for the initial filing of the
grievance may actually be forgotten before it is finally settled. Another
problem is the cost of arbitration, which has been rising at an alarming rate.
III.
Grievance Handling In Union-Free Organizations
Although the step-by-step procedure for handling union grievances is common practice, the means of
resolving complaints in union-free firms varies. A well-designed union-free grievance procedure ensures
that the worker has ample opportunity to make complaints without fear of reprisal.
C. The HRM Department in a Nonunion Setting
Employers who adhere to certain union-free strategies and tactics can remain or become union free.
Effective first-line supervision: Extremely important to an organization's ability to remain union
free is the overall effectiveness of its management, particularly its first-line supervisors. These
supervisors represent the first line of defense against unionization.
Union-free policy: The fact that the organization's goal is to remain union free should be clearly
and forcefully communicated to all its members.
Effective communication: One of the most important actions an organization that wants to
remain union free can take is to establish credible and effective communication. One approach
taken to encourage open communication is the open-door policy. The open-door policy gives
employees the right to take any grievance to the person next in the chain of command if the
immediate supervisor cannot resolve the problem.
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Trust and openness: Openness and trust on the part of managers and employees alike are
important in order to remain union free. The old expression actions speak louder than words is certainly
valid for an organization that desires to remain union free.
Effective compensation programs: The financial compensation that employees receive is the
most tangible measure they have of their worth to the organization. If an individual's pay is
substantially below that provided for similar work in the area, the employee will soon become
dissatisfied.
Healthy and safe work environment: An organization that gains a reputation for failing to
maintain a safe and healthy work environment leaves itself wide open for unionization.
Effective employee and labor relations: No organization is free from employee disagreements
and dissatisfaction. Therefore, a means of resolving employee complaints, whether actual or
perceived, should be available. The grievance procedure is a formal process that permits employees to
complain about matters affecting them. Most labor-management agreements contain formal
grievance procedures, and union members regard handling grievances as one of the most important
functions of a labor union.
D. Phases of Labor Relations
Labor relations consist of the human resource management activities associated with the movement of
employees within the firm after they have become organizational members and include the actions of
promotion, transfer, demotion, resignation, discharge, layoff, and retirement. Labor relations can be divided
into following three phases:
a.
Union organizing: Organization of workers, acting collectively, seeking to protect and promote
their mutual interests through collective bargaining is termed as union. The most significant impact
of a union on the management of human resources is its influence in shaping HRM policies. In the
absence of a union, the company may develop all HRM policies based on efficiency. But, when a
union enters the picture, management must develop HRM policies that reflect consideration for the
preferences of workers who are represented by a union. A union's strong preferences for high
wages, job security, the ability to express dissatisfaction with administrative actions, and having a
voice in the development of work rules that affect their jobs get injected into the equation along
with the employer's preferences.
b. Collective bargaining: The performance of the mutual obligation of the employer and the
representative of the employees to meet at reasonable times and confer in good faith with respect
to wages, hours, and other terms and conditions of employment, or the negotiation of an
agreement, or any question arising there under, and the execution of a written contract
incorporating any agreement reached if requested by either party; such obligation does not compel
either party to agree to a proposal or require the making of a concession.
c.
Contract administration: The larger and perhaps more important part of collective bargaining is
the administration of the agreement, which is seldom viewed by the public. The agreement
establishes the union-management relationship for the duration of the contract. The agreement
established the union-management relationship for its effective length. Usually no changes in
contract language can be made until the expiration date except by mutual consent. Administering
the contract is a day-to-day activity. Ideally, the aim of both management and the union is to make
the agreement work to the mutual benefit of all concerned. This is not easy. In the daily stress of
the work environment, terms of the contract are not always uniformly interpreted and applied.
162
Human Resource Management (MGT501)
VU
KEY TERMS
Grievance procedure
A formal, systematic process that permits employees to complain about
matters affecting them and their work.
Collective bargaining
The process through which representatives of management and the union
meet to negotiate a labor agreement
Mediation
A process whereby a neutral third party enters a labor dispute when a
bargaining impasse has occurred.
Boycotts
An agreement by union members to refuse to use or buy the firm's
products.
Arbitration
The process that allows the parties to submit their dispute to an impartial
third party for resolution
What Role Does the HR Manager Play in the Collective Bargaining Process?
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 Frequently Asked Questions About Human Resources Degrees and Careers
 What Role Does the HR Manager Play in the Collective Bargaining Process?

HR managers and collective bargaining go hand-in-hand because management

professionals in the field of HR are experts in both employee relations and labor relations.
If you have always dreamed of becoming a Human Resources administrator or manager, it is important to know
some of the modern day tasks you will be responsible for.
In the past, the HR manager played a small role in the organization, but as the position becomes more strategic,
managers in HR have played an important part of different planning within the organization. This is why HR
managers are part of the labor contract negotiations process, where an agreement must be made that will benefit
both employees and the organization.
Related Infographic: State of the Unions
What is Collective Bargaining?
Before you can understand just how HR managers play a role in collective bargaining, you should have a firm
understanding of what collective bargaining is. Collective bargaining is a part of the labor contract negotiations
process and involves drafting an agreement between a labor union and the employer. The agreement itself will
lay out the terms and conditions of employment for the union with the employer for a specified period of time
that can last between 2 and 5 years.
What Are Some of the Roles of the HR Manager in Collective Bargaining Agreements?
HR Managers are involved in several different parts of the process. First, managers who are well-versed and
knowledgeable in labor law will be a part of the negotiations process. During this time, the manager will decide
which terms and conditions are fair and how long of a period is appropriate for the company. Some managers
who hold this title and do not have experience in labor law may not take part in the negotiations process.
After an agreement is made between the union and the manager, the next step will be to set the wages. The
manager will need to meet with a team of executives, including the CEO and the CFO to to discuss the amount
the company has allotted for wages. The team will then assess the financial condition of the company and
trends. If production levels are level or on the rise, a wage decrease will not be necessary. The manager will
need to negotiate a fair wage after calculating the labor costs and considering many different future scenarios.
The manager will have many different wage proposals prepared to present to the union and will typically offer a
range from the current rate to the maximum rate the company is willing to pay employees from the union.
Another important part of negotiations concerns benefits, and this is the area of negotiations that is most
contested. Wage increases directly affect benefits, and this is what parties discuss in their meetings. The
manager will prepare benefit proposals and offer the union concessions during this lengthy stage of the process.
Collective bargaining can be a long process of contract negotiations and the HR manager plays a very important
dual role. Not only does the manager need to protect the interests of their company, they must also strengthen
relationships with employees and keep them satisfied. To agree with the negotiations, HR managers must be
experienced and technically trained.
loyee & Labor Relations
The Employee and Labor Relations function of the Human Resources Department is commonly associated with
matters such as investigations, counseling and disciplinary actions, but that certainly is not its primary mission.
This critical HR component operates as a nexus between staff and management, bridging gaps that oftentimes
seem insurmountable to either party. Through various forms of intervention, including problem-solving,
mediation, training and counseling, Labor Relations offers balanced advocacy to management and individual
employees to protect their respective rights and facilitate a more harmonious work environment.
The Labor Relations Office provides assistance and advice to UCM managers and supervisors in the following
areas:
  Performance Management
 Layoff Planning
 Discipline & Dismissal
 Contract interpretation and administration (Union contracts and relevant personnel policies)
 Complaint/Grievance processing (represented and non-represented staff)
 Represents management in employee disputes/grievance proceedings
 Mediates/negotiates resolution of complaints with employee representatives
 Responds to union information requests
Important Links
 Union-Represented Employees
 Collective Bargaining FAQ
 Personnel Policies for Staff Members
 Academic Personnel Policies
 Bargaining Unit Matrix
General email: laborrelations@ucmerced.edu
EMPLOYEE AND LABOR RELATIONS STAFF
Paul Garza
Employee & Labor Relations Manager
pgarza@ucmerced.edu
+1 (209) 259-8161
Margaret Franklin
Employee & Labor Relations Consultant
mfranklin7@ucmerced.edu
+1 (209) 285-8737
Peter Ishaya
Employee & Labor Relations Consultant
bishaya@ucmerced.edu
+1 (209) 355-7215
Labor Relations And Human Resources Management: An Overview
Written by Trebilcock, Anne
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Labour or Industrial Relations
The term labour relations, also known as industrial relations, refers to the system in which employers, workers
and their representatives and, directly or indirectly, the government interact to set the ground rules for the
governance of work relationships. It also describes a field of study dedicated to examining such relationships.
The field is an outgrowth of the industrial revolution, whose excesses led to the emergence of trade unions to
represent workers and to the development of collective labour relations. A labour or industrial relations system
reflects the interaction between the main actors in it: the state, the employer (or employers or an employers’
association), trade unions and employees (who may participate or not in unions and other bodies affording
workers’ representation). The phrases “labour relations” and “industrial relations” are also used in connection
with various forms of workers’ participation; they can also encompass individual employment relationships
between an employer and a worker under a written or implied contract of employment, although these are
usually referred to as “employment relations”. There is considerable variation in the use of the terms, partly
reflecting the evolving nature of the field over time and place. There is general agreement, however, that the
field embraces collective bargaining, various forms of workers’ participation (such as works councils and joint
health and safety committees) and mechanisms for resolving collective and individual disputes. The wide
variety of labour relations systems throughout the world has meant that comparative studies and identification
of types are accompanied by caveats about the limitations of over-generalization and false analogies.
Traditionally, four distinct types of workplace governance have been described: dictatorial, paternalistic,
institutional and worker-participative; this chapter examines primarily the latter two types.
Both private and public interests are at stake in any labour relations system. The state is an actor in the system
as well, although its role varies from active to passive in different countries. The nature of the relationships
among organized labour, employers and the government with respect to health and safety are indicative of the
overall status of industrial relations in a country or an industry and the obverse is equally the case. An
underdeveloped labour relations system tends to be authoritarian, with rules dictated by an employer without
direct or indirect employee involvement except at the point of accepting employment on the terms offered.
A labour relations system incorporates both societal values (e.g., freedom of association, a sense of group
solidarity, search for maximized profits) and techniques (e.g., methods of negotiation, work organization,
consultation and dispute resolution). Traditionally, labour relations systems have been categorized along
national lines, but the validity of this is waning in the face of increasingly varied practices within countries and
the rise of a more global economy driven by international competition. Some countries have been characterized
as having cooperative labour relations models (e.g., Belgium, Germany), whereas others are known as being
conflictual (e.g., Bangladesh, Canada, United States). Different systems have also been distinguished on the
basis of having centralized collective bargaining (e.g., those in Nordic countries, although there is a move away
from this, as illustrated by Sweden), bargaining at the sectoral or industrial level (e.g., Germany), or bargaining
at the enterprise or plant level (e.g., Japan, the United States). In countries having moved from planned to free-
market economies, labour relations systems are in transition. There is also increasing analytical work being
done on the typologies of individual employment relationships as indic- ators of types of labour relations
systems.
Even the more classic portrayals of labour relations systems are not by any means static characterizations, since
any such system changes to meet new circumstances, whether economic or political. The globalization of the
market economy, the weakening of the state as an effective force and the ebbing of trade union power in many
industrialized countries pose serious challenges to traditional labour relations systems. Technological
development has brought changes in the content and organization of work that also have a crucial impact on the
extent to which collective labour relations can develop and the direction they take. Employees’ traditionally
shared work schedule and common workplace have increasingly given way to more varied working hours and
to the performance of work at varied locations, including home, with less direct employer supervision. What
have been termed “atypical” employment relationships are becoming less so, as the contingent workforce
continues to expand. This in turn places pressure on established labour relations systems.
Newer forms of employee representation and participation are adding an additional dimension to the labour
relations picture in a number of countries. A labour relations system sets the formal or informal ground rules for
determining the nature of collective industrial relations as well as the framework for individual employment
relationships between a worker and his or her employer. Complicating the scene at the management end are
additional players such as temporary employment agencies, labour contractors and job contractors who may
have responsibilities towards workers without having control over the physical environment in which the work
is carried out or the opportunity to provide safety training. In addition, public sector and private sector
employers are governed by separate legislation in most countries, with the rights and protections of employees
in these two sectors often differing significantly. Moreover, the private sector is influenced by forces of
international competition that do not directly touch public-sector labour relations.
Finally, neoliberal ideology favouring the conclusion of indi-vidualized employment contracts to the detriment
of collectively bargained arrangements poses another threat to traditional labour relations systems. Those
systems have developed as a result of the emergence of collective representation for workers, based on past
experience that an individual worker’s power is weak when compared to that of the employer. Abandoning all
collective representation would risk returning to a nineteenth century concept in which acceptance of hazardous
work was largely regarded as a matter of individual free choice. The increasingly globalized economy, the
accelerated pace of technological change and the resultant call for greater flexibility on the part of industrial
relations institutions, however, pose new challenges for their survival and prosperity. Depending upon their
existing traditions and institutions, the parties involved in a labour relations system may react quite differently
to the same pressures, just as management may choose a cost-based or a value-added strategy for confronting
increased competition (Locke, Kochan and Piore, 1995). The extent to which workers’ participation and/or
collective bargaining are regular features of a labour relations system will most certainly have an impact on how
management confronts health and safety problems.
Moreover, there is another constant: the economic dependence of an individual worker on an employer remains
the underlying fact of their relationship–one that has serious potential consequences when it comes to safety and
health. The employer is seen as having a general duty to provide a safe and healthful workplace and to train and
equip workers to do their jobs safely. The worker has a reciprocal duty to follow safety and health instructions
and to refrain from harming himself/herself or others while at work. Failure to live up to these or other duties
can lead to disputes, which depend on the labour relations system for their resolution. Dispute resolution
mechanisms include rules governing not only work stoppages (strikes, slowdowns or go-slows, work to rule,
etc.) and lockouts, but the discipline and dismissal of employees as well. Additionally, in many countries
employers are required to participate in various institutions dealing with safety and health, perform safety and
health monitoring, report on-the-job accidents and diseases and, indirectly, to compensate workers who are
found to be suffering from an occupational injury or disease.
Human Resources Management
Human resources management has been defined as “the science and the practice that deals with the nature of
the employment relationship and all of the decisions, actions and issues that relate to that relationship” (Ferris,
Rosen and Barnum 1995; see figure 1). It encapsulates employer-formulated policies and practices that see the
utilization and management of employees as a business resource in the context of a firm’s overall strategy to
enhance productivity and competitiveness. It is a term most often used to describe an employer’s approach to
personnel administration that emphasizes employee involvement, normally but not always in a union-free
setting, with the goal of motivating workers to enhance their productivity. The field was formed from a merger
of scientific management theories, welfare work and industrial psychology around the time of the First World
War and has undergone considerable evolution since. Today, it stresses work organization techniques,
recruitment and selection, performance appraisal, training, upgrading of skills and career development, along
with direct employee participation and communication. Human resources management has been put forth as an
alternative to “Fordism”, the traditional assembly-line type of production in which engineers are responsible for
work organization and workers’ assigned tasks are divided up and narrowly circumscribed. Common forms of
employee involvement include suggestion schemes, attitude surveys, job enrichment schemes, teamworking and
similar forms of empowerment schemes, quality of working-life programmes, quality circles and task forces.
Another feature of human resources management may be linking pay, individually or collectively, to
performance. It is noteworthy that one of the three objectives of occupational health has been identified by the
Joint ILO/WHO Committee on Occupational Health as “development of work organizations and working
cultures in a direction which supports health and safety at work and in doing so also promotes a positive social
climate and smooth operation and may enhance productivity of the undertakings...” (ILO 1995b). This is known
as developing a “safety culture.”
Figure 1. The role of human resources management in adding value to people and to organizations

The example of a safety performance management programme illustrates some human resource management
theories in the context of occupational safety and health. As described by Reber, Wallin and Duhon (1993), this
approach has had considerable success in reducing lost time on account of accidents. It relies on specifying safe
and unsafe behaviours, teaching employees how to recognize safe behaviour and motivating them to follow the
safety rules with goal setting and feedback. The programme relies heavily on a training technique whereby
employees are shown safe, correct methods via videotapes or live models. They then have a chance to practice
new behaviours and are provided with frequent performance feedback. In addition, some companies offer
tangible prizes and rewards for engaging in safe behaviour (rather than simply for having fewer accidents).
Employee consultation is an important feature of the programme as well.
The implications of human resources management for industrial relations practices remain a source of some
controversy. This is particularly the case for types of workers’ participation schemes that are perceived by trade
unions as a threat. In some instances human resources management strategies are pursued alongside collective
bargaining; in other cases the human resources management approach seeks to supplant or prevent the activities
of independent organizations of workers in defence of their interests. Proponents of human resources
management maintain that since the 1970s, the personnel management side of human resources management
has evolved from being a maintenance function, secondary to the industrial relations function, to being one of
critical importance to the effectiveness of an organization (Ferris, Rosen and Barnum 1995). Since human
resources management is a tool for management to employ as part of its personnel policy rather than a
relationship between an employer and workers’ chosen representatives, it is not the focus of this chapter.
The articles which follow describe the main parties in a labour relations system and the basic principles
underpinning their interaction: rights to freedom of association and representation. A natural corollary to
freedom of association is the right to engage in collective bargaining, a phenomenon which must be
distinguished from consultative and non-union worker participation arrangements. Collective bargaining takes
place as negotiations between representatives chosen by the workers and those acting on behalf of the employer;
it leads to a mutually accepted, binding agreement that can cover a wide range of subjects. Other forms of
workers’ participation, national-level consultative bodies, works councils and enterprise-level health and safety
representatives are also important features of some labour relations systems and are thus examined in this
chapter. Consultation can take various forms and occur at different levels, with national-, regional- and/or
industrial- and enterprise-level arrangements. Worker representatives in consultative bodies may or may not
have been selected by the workers and there is no obligation for the state or the employer to follow the wishes
of those representatives or to abide by the results of the consultative process. In some countries, collective
bargaining and consultative arrangements exist side by side and, to work properly, must be carefully
intermeshed. For both, rights to information about health and safety and training are crucial. Finally, this
chapter takes into account that in any labour relations system, disputes may arise, whether they are individual or
collective. Safety and health issues can lead to labour relations strife, producing work stoppages. The chapter
thus concludes with descriptions of how labour relations disputes are resolved, including by arbitration,
mediation or resort to the regular or labour courts, preceded by a discussion of the role of the labour
inspectorate in the context of labour relations.
The Actors in the Labour Relations System
Classically, three actors have been identified as parties to the labour relations system: the state, employers and
workers’ representatives. To this picture must now be added the forces that transcend these categories: regional
and other multilateral economic integration arrangements among states and multinational corporations as
employers which do not have a national identity but which also can be seen as labour market institutions. Since
the impact of these phenomena on labour relations remains unclear in many respects, however, discussion will
focus on the more classic actors despite this caveat of the limitation of such an analysis in an increasingly global
community. In addition, greater emphasis is needed on analysing the role of the individual employment
relationship in labour relations systems and on the impact of the emerging alternative forms of work.
The State
The state always has at least an indirect effect on all labour relations. As the source of legislation, the state
exerts an inevitable influence on the emergence and development of a labour relations system. Laws can hinder
or foster, directly or indirectly, the establishment of organizations representing workers and employers.
Legislation also sets a minimum level of worker protection and lays down “the rules of the game”. To take an
example, it can provide lesser or greater protection for a worker who refuses to perform work he or she
reasonably considers to be too hazardous, or for one who acts as a health and safety representative.
Through the development of its labour administration, the state also has an impact on how a labour relations
system may function. If effective enforcement of the law is afforded through a labour inspectorate, collective
bargaining can pick up where the law leaves off. If, however, the state infrastructure for having rights
vindicated or for assisting in the resolution of disputes that emerge between employers and workers is weak,
they will be left more to their own devices to develop alternative institutions or arrangements.
The extent to which the state has built up a well-functioning court or other dispute resolution system may also
have an influence on the course of labour relations. The ease with which workers, employers and their
respective organizations may enforce their legal rights can be as important as the rights themselves. Thus the
decision by a government to set up special tribunals or administrative bodies to deal with labour disputes and/or
disagreements over individual employment problems can be an expression of the priority given to such issues in
that society.
In many countries, the state has a direct role to play in labour relations. In countries that do not respect freedom
of association principles, this may involve outright control of employers’ and workers’ organizations or
interference with their activities. The state may attempt to invalidate collective bargaining agreements that it
perceives as interfering with its economic policy goals. Generally speaking, however, the role of the state in
industrialized countries has tended to promote orderly industrial relations by providing the necessary legislative
framework, including minimum levels of worker protection and offering parties information, advice and dispute
settlement services. This could take the form of mere toleration of labour relations institutions and the actors in
them; it could move beyond to actively encourage such institutions. In a few countries, the state is a more active
participant in the industrial relations system, which includes national level tripartite negotiations. For decades in
Belgium and more recently in Ireland, for instance, government representatives have been sitting down
alongside those from employer and trade union circles to hammer out a national level agreement or pact on a
wide range of labour and social issues. Tripartite machinery to fix minimum wages has long been a feature of
labour relations in Argentina and Mexico, for example. The interest of the state in doing so derives from its
desires to move the national economy in a certain direction and to maintain social peace for the duration of the
pact; such bipartite or tripartite arrangements create what has been called a “social dialogue”, as it has
developed in Australia (until 1994), Austria, Belgium, Ireland and the Netherlands, for instance. The pros and
cons of what have been termed “corporatist” or “neocorporatist” approaches to labour relations have been
extensively debated over the years. With its tripartite structure, the International Labour Organization has long
been a proponent of strong tripartite cooperation in which the “social partners” play a significant role in shaping
government policy on a wide range of issues.
In some countries, the very idea of the state becoming involved as a negotiator in private sector bargaining is
unthinkable, as in Germany or the United States. In such systems, the role of the state is, aside from its
legislative function, generally restricted to providing assistance to the parties in reaching an agreement, such as
in offering voluntary mediation services. Whether active or passive, however, the state is a constant partner in
any labour relations system. In addition, where the state is itself the employer, or an enterprise is publicly
owned, it is of course directly involved in labour relations with the employees and their representatives. In this
context, the state is motivated by its role as provider of public services and/or as an economic actor.
Finally, the impact of regional economic integration arrangements on state policy is also felt in the labour
relations field. Within the European Union, practice in member countries has changed to reflect directives
dealing with consultation of workers and their representatives, including those on health and safety matters in
particular. Multilateral trade agreements, such as the labour side agreement to the North American Free Trade
Agreement (Canada, Mexico, United States) or the agreements implementing the Mercosur Common Market
(Argentina, Brazil, Chile, Paraguay, thought soon to be joined by Bolivia and Chile) also sometimes contain
workers’ rights provisions or mechanisms that over time may have an indirect impact on labour relations
systems of the participating states.
Employers
Employers–that is, providers of work–are usually differentiated in industrial relations systems depending upon
whether they are in the private or the public sector. Historically, trade unionism and collective bargaining
developed first in the private sector, but in recent years these phenomena have spread to many public sector
settings as well. The position of state-owned enterprises—which in any event are dwindling in number around
the world—as employers, varies depending upon the country. (They still play a key role in China, India, Viet
Nam and in many African countries.) In Eastern and Central Europe, one of the major challenges of the post-
Communist era has been the establishment of independent organizations of employers.

International Employers’ Organizations

Based in Geneva, Switzerland, the International Organization of Employers (IOE) in 1996 grouped 118 central
national organizations of employers in 116 countries. The exact form of each member organization may differ
from country to country, but in order to qualify for membership in the IOE an employers’ organization must
meet certain conditions: it must be the most representative organization of employers - exclusively of employers
- in the country; it must be voluntary and independent, free from outside interference; and it must stand for and
defend the principles of free enterprise. Members include employer federations and confederations, chambers
of commerce and industry, councils and associations. Regional or sectoral organizations cannot become
members; nor can enterprises, regardless of their size or importance, affiliate themselves directly with the IOE -
a factor that has served to ensure that its voice is representative of the employer community at large, and not of
the particular interests of individual enterprises or sectors.
The IOE’s main activity, however, is to organize employers whenever they have to deal with social and labour
matters at the global level. In practice, most of this takes place in the ILO, which has responsibility for these
questions in the United Nations system. The IOE also has Category I consultative status with the Economic and
Social Council of the United Nations, where it intervenes whenever matters of interest or consequence to
employers arise.
The IOE is one of only two organizations that the employer community has set up to represent the interests of
enterprise globally. The other is the International Chamber of Commerce, with its headquarters in Paris, which
concerns itself principally with economic matters. While structurally quite different, the two organizations
complement each other. They cooperate on the basis of an agreement which defines their areas of responsibility
as well as through good personal relations between their representatives and, to a degree, on a common
membership base. Many subjects cut across their mandates, of course, but are dealt with pragmatically without
friction. On certain issues, such as multinational enterprises, the two organizations even act in unison.
by Chapter Editor (excerpted from: ILO 1994)
In the private sector, the situation has been summed up as follows:
Employers have common interests to defend and precise causes to advance. In organizing themselves, they
pursue several aims which in turn determine the character of their organizations. These can be chambers of
commerce, economic federations and employers’ organizations (for social and labour matters) ... Where issues
centre essentially on social matters and industrial relations, including collective bargaining, occupational health
and safety, human resource development, labour law and wages, the desire for co-ordinated action has led to the
creation of employers’ organizations, which are always voluntary in nature ... (ILO 1994a).
Some employers’ organizations were initially established in response to pressure from the trade unions to
negotiate, but others may be traced to medieval guilds or other groups founded to defend particular market
interests. Employers’ organizations have been described as formal groups of employers set up to defend,
represent and advise affiliated employers and to strengthen their position in society at large with respect to
labour matters as distinct from economic matters ... Unlike trade unions, which are composed of individual
persons, employers’ organizations are composed of enterprises (Oechslin 1995).
As identified by Oechslin, there tend to be three main functions (to some extent overlapping) common to all
employers’ organizations: defence and promotion of their members’ interests, representation in the political
structure and provision of services to their members. The first function is reflected largely in lobbying
government to adopt policies that are friendly to employers’ interests and in influencing public opinion, chiefly
through media campaigns. The representative function may occur in the political structure or in industrial
relations institutions. Political representation is found in systems where consultation of interested economic
groups is foreseen by law (e.g., Switzerland), where economic and social councils provide for employer
representation (e.g., France, French-speaking African countries and the Netherlands) and where there is
participation in tripartite forums such as the International Labour Conference and other aspects of ILO activity.
In addition, employers’ organizations can exercise considerable influence at the regional level (especially within
the European Union).
The way in which the representative function in the industrial relations system occurs depends very much on the
level at which collective bargaining takes place in a particular country. This factor also largely determines the
structure of an employers’ organization. If bargaining is centralized at the national level, the employers’
organization will reflect that in its internal structure and operations (central economic and statistical data bank,
creation of a mutual strike insurance system, strong sense of member discipline, etc.). Even in countries where
bargaining takes place at the enterprise level (such as Japan or the United States), the employers’ organization
can offer its members information, guidelines and advice. Bargaining that takes place at the industrial level (as
in Germany, where, however, some employers have recently broken ranks with their associations) or at multiple
levels (as in France or Italy) of course also influences the structure of employers’ organizations.
As for the third function, Oechslin notes, “it is not always easy to draw a line between activities supporting the
functions described above and those undertaken for the members in their interest” (p. 42). Research is the prime
example, since it can be used for multiple purposes. Safety and health is an area in which data and information
can be usefully shared by employers across sectors. Often, new concepts or reactions to novel developments in
the world of work have been the product of broad reflection within employers’ organizations. These groups also
provide training to members on a wide range of management issues and have undertaken social affairs action,
such as in the development of workers’ housing or support for community activities. In some countries,
employers’ organizations provide assistance to their members in labour court cases.
The structure of employers’ organizations will depend not only on the level at which bargaining is done, but
also on the country’s size, political system and sometimes religious traditions. In developing countries, the main
challenge has been the integration of a very heterogeneous membership that may include small and medium-
sized businesses, state enterprises and subsidiaries of multinational corporations. The strength of an employers’
organi-zation is reflected in the resources its members are willing to devote to it, whether in the form of dues
and contributions or in terms of their expertise and time.
The size of an enterprise is a major determinant in its approach to labour relations, with the employer of a small
workforce being more likely to rely on informal means for dealing with its workers. Small and medium-sized
enterprises, which are variously defined, sometimes fall under the threshold for legally mandated workers’
participation schemes. Where collective bargaining occurs at the enterprise level, it is much more likely to exist
in large firms; where it takes place at the industry or national level, it is more likely to have an effect in areas
where large firms have historically dominated the private sector market.
As interest organizations, employers’ organizations—like trade unions—have their own problems in the areas
of leadership, internal decision-making and member participation. Since employers tend to be individualists,
however, the challenge of marshalling discipline among the membership is even greater for employers’
organizations. As van Waarden notes (1995), “employers’ associations generally have high density ratios ...
However, employers find it a much greater sacrifice to comply with the decisions and regulations of their
associations, as these reduce their much cherished freedom of enterprise.” Trends in the structure of employers’
organizations very much reflect those of the labour market– towards or against centralization, in favour of or
opposed to regulation of competition. Van Waarden continues: “even if the pressure to become more flexible in
the ‘post-Fordist’ era continues, it does not necessarily make employers’ associations redundant or less
influential ... [They] would still play an important role, namely as a forum for the coordination of labour market
policies behind the scenes and as an advisor for firms or branch associations engaged in collective bargaining”
(ibid., p. 104). They can also perform a solidarity function; through employers’ associations, small employers
may have access to legal or advisory services they otherwise could not afford.
Public employers have come to see themselves as such only relatively recently. Initially, the government took
the position that a worker’s involvement in trade union activity was incompatible with service to the sovereign
state. They later resisted calls to engage in collective bargaining with the argument that the legislature, not the
public administration, was the paymaster and that it was thus impossible for the administration to enter into an
agreement. These arguments, however, did not prevent (often unlawful) public sector strikes in many countries
and they have fallen by the wayside. In 1978, the International Labour Conference adopted the Labour
Relations (Public Service) Convention (No. 151) and Recommendation (No. 159) on public employees’ right to
organize and on procedures for determining their terms and conditions of employment. Collective bargaining in
the public sector is now a way of life in many developed countries (e.g., Australia, France, United Kingdom) as
well as in some developing countries (e.g., many francophone African countries and many countries in Latin
America).
The level of employer representation in the public sector depends largely upon the political system of the
country. In some this is a centralized function (as in France) whereas in others it reflects the various divisions of
government (as in the United States, where bargaining can take place at the federal, state and municipal levels).
Germany presents an interesting case in which the thousands of local communities have banded together to have
a single bargaining agent deal with the unions in the public sector throughout the country.
Because public sector employers are already part of the state, they do not fall under laws requiring registration
of employers’ organizations. The designation of the bargaining agent in the public sector varies considerably by
country; it may be the Public Service Commission, the Ministry of Labour, the Ministry of Finance or another
entity altogether. The positions taken by a public employer in dealing with employees in this sector tend to
follow the political orientation of the ruling political party. This may range from taking a particular stance in
bargaining to a flat-out denial of the right of public employees to organize into trade unions. However, while as
an employer the public service is shrinking in many countries, there is an increasing readiness on its part to
engage in bargaining and consultations with employee representatives.
International Labour Federations
The international labour movement on a global, as opposed to a regional or national level, consists of
international associations of national federations of labour unions. There are currently three such
internationals, reflecting different ideological tendencies: the International Confederation of Free Trade
Unions (ICFTU), the World Federation of Trade Unions (WFTU) and the relatively small, originally Christian,
World Congress of Labour (WCL). The ICFTU is the largest, with 174 affiliated unions from 124 countries in
1995, representing 116 million trade union members. These groups lobby intergovernmental organizations on
overall economic and social policy and press for worldwide protection of basic trade union rights. They can be
thought of as the political force behind the international labour movement.
The industrial force of the international labour movement lies in the international associations of specific
labour unions, usually drawn from one trade, industry or economic sector. Known as International Trade
Secretariats (ITSs) or Trade Union Internationals (TUIs), they may be independent, affiliated to, or controlled
by the internationals. Coverage has traditionally been by sector, but also in some cases is by employee category
(such as white-collar workers), or by employer (public or private). For example, in 1995 there were 13
operative ITSs aligned with the ICFTU, distributed as follows: building and woodworking; chemical and
mining, energy; commercial, clerical, professional and technical; education; entertainment; food, agriculture,
restaurant and catering; graphic arts; journalism; metalworking; postal and telecommunications; public
service; textile, garment and leather work; transport. The ITSs concentrate mainly on industry-specific issues,
such as industrial disputes and pay rates, but also the application of health and safety provisions in a specific
sector. They provide information, education, training and other services to affiliated unions. They also help
coordinate international solidarity between unions in different countries, and represent the interests of workers
in various international and regional forums.
Such action is illustrated by the international trade union response to the incident at Bhopal, India, involving
the leak of methyl isocyanate, which claimed thousands of victims on 3 December 1984. At the request of their
Indian national trade union affiliates, the ICFTU and the International Federation of Chemical, Energy, Mine
and General Workers’ Unions (ICEM) sent a mission to Bhopal to study the causes and effects of the gas leak.
The report contained recommendations for preventing similar disasters and endorsed a list of safety principles;
this report has been used by trade unionists in both industrialized and developing countries as a basis of
programmes for improving health and safety at work.
Source: Rice 1995.

Trade Unions
The classic definition of a trade union is “a continuous association of wage earners for the purpose of
maintaining or improving the conditions of their employment” (Webb and Webb 1920). The origins of trade
unions go back as far as the first attempts to organize collective action at the beginning of the industrial
revolution. In the modern sense, however, trade unions arose in the later part of the nineteenth century, when
governments first began to concede the unions’ legal right to exist (previously, they had been seen as illegal
combinations interfering with freedom of commerce, or as outlawed political groups). Trade unions reflect the
conviction that only by banding together can workers improve their situation. Trade union rights were born out
of economic and political struggle which saw short-term individual sacrifice in the cause of longer-term
collective gain. They have often played an important role in national politics and have influenced developments
in the world of work at the regional and international levels. Having suffered membership losses, however, in
recent years in a number of countries (in North America and some parts of Europe), their role is under challenge
in many quarters (see figure 2). The pattern is mixed with areas of membership growth in the public service in
many countries around the world and with a new lease on life in places where trade unions were previously
non-existent or active only under severe restrictions (e.g., Korea, the Philippines, some countries of Central and
Eastern Europe). The flourishing of democratic institutions goes hand in hand with the exercise of trade union
freedoms, as the cases of Chile and Poland in the 1980s and 1990s best illustrate. A process of internal reform
and reorientation to attract greater and more diverse membership, particularly more women, can also be seen
within trade union circles in a number of countries. Only time will tell if these and other factors will be
sufficient to deflect the counterweighing tendencies towards the “de-collectivization”, also referred to as
“atomization”, of labour relations that has accompanied increased economic globalization and ideological
individualism.
Figure 2. Membership rates in trade unions, 1980-1990

In contemporary industrial relations systems, the functions fulfilled by trade unions are, like employers’
organizations, basically the following: defence and promotion of the members’ interests; political
representation; and provision of services to members. The flip side of trade unions’ representative function is
their control function: their legitimacy depends in part upon the ability to exert discipline over the membership,
as for example in calling or ending a strike. The trade unions’ constant challenge is to increase their density,
that is, the number of members as a percentage of the formal sector workforce. The members of trade unions are
individuals; their dues, called contributions in some systems, support the union’s activities. (Trade unions
financed by employers, called “company unions”, or by governments as in formerly Communist countries, are
not considered here, since only independent organizations of workers are true trade unions.) Affiliation is
generally a matter of an individual’s voluntary decision, although some unions that have been able to win closed
shop or union security arrangements are considered to be the representatives of all workers covered by a
particular collective bargaining agreement (i.e., in countries where trade unions are recognized as
representatives of workers in a circumscribed bargaining unit). Trade unions may be affiliated to umbrella
organizations at the industrial, national, regional and international levels.
Trade unions are structured along various lines: by craft or occupation, by branch of industry, by whether they
group white- or blue-collar workers and sometimes even by enterprise. There are also general unions, which
include workers from various occupations and industries. Even in countries where mergers of industrial unions
and general unions are the trend, the situation of agricultural or rural workers has often favoured the
development of special structures for that sector. On top of this breakdown there is often a territorial division,
with regional and sometimes local subunits, within a union. In some countries there have been splits in the
labour movement around ideological (party politics) and even religious lines which then come to be reflected in
trade union structure and membership. Public sector employees tend to be represented by unions separate from
those representing employees in the private sector, although there are exceptions to this as well.
The legal status of a trade union may be that of any other association, or it may be subject to special rules. A
great number of countries require trade unions to register and to divulge certain basic information to the
authorities (name, address, identity of officials, etc.). In some countries this goes beyond mere record-keeping
to interference; in extreme cases of disregard for freedom of association principles, trade unions will need
government authorization to operate. As representatives of workers, trade unions are empowered to enter into
engagements on their behalf. Some countries (such as the United States) require employer recognition of trade
unions as an initial prerequisite to engaging in collective bargaining.
Trade union density varies widely between and within countries. In some countries in Western Europe, for
instance, it is very high in the public sector but tends to be low in the private sector and especially in its white-
collar employment. The figures for blue-collar employment in that region are mixed, from a high in Austria and
Sweden to a low in France, where, however, trade union political power far exceeds what membership figures
would suggest. There is some positive correlation between centralization of bargaining and trade union density,
but exceptions to this also exist.
As voluntary associations, trade unions draw up their own rules, usually in the form of a constitution and by-
laws. In democratic trade union structures, members select trade union officers either by direct vote or through
delegates to a general conference. Internal union government in a small, highly decentralized union of workers
in a particular occupational group is likely to differ significantly from that found in a large, centralized general
or industrial union. There are tasks to allocate among union officers, between paid and unpaid union
representatives and coordination work to be done. The financial resources available to a union will also vary
depending upon its size and the ease with which it can collect dues. Institution of a dues check-off system
(whereby dues are deducted from a worker’s wages and paid directly to the union) alleviates this task greatly. In
most of Central and Eastern Europe, trade unions that were dominated and funded by the state are being
transformed and/or joined by new independent organizations; all are struggling to find a place and operate
successfully in the new economic structure. Extremely low wages (and thus dues) there and in developing
countries with government-supported unions make it difficult to build a strong independent union movement.
In addition to the important function of collective bargaining, one of the main activities of trade unions in many
countries is their political work. This may take the form of direct representation, with trade unions being given
reserved seats in some parliaments (e.g., Senegal) and on tripartite bodies that have a role in determining
national economic and social policy (e.g., Austria, France, the Netherlands), or on tripartite advisory bodies in
the fields of labour and social affairs (e.g., in many Latin American and some African and Asian countries). In
the European Union, trade union federations have had an important impact on the development of social policy.
More typically, trade unions have an influence through the exercise of power (backed up by a threat of
industrial action) and lobbying political decision makers at the national level. It is certainly true that trade
unions have successfully fought for greater legislative protection for all workers around the world; some believe
that this has been a bittersweet victory, in the long run undermining their own justification to exist. The
objectives and issues of union political action have often extended well beyond narrower interests; a prime
example of this was the struggle against apartheid within South Africa and the international solidarity expressed
by unions around the world in words and in deeds (e.g., organizing dockworker boycotts of imported South
African coal). Whether trade union political activity is on the offence or the defence will of course depend
largely on whether the government in power tends to be pro- or anti-labour. It will also depend upon the union’s
relationship to political parties; some unions, particularly in Africa, were part of their countries’ struggles for
independence and maintain very close ties with ruling political parties. In other countries there is a traditional
interdependence between the labour movement and a political party (e.g., Australia, United Kingdom), whereas
in others alliances may shift over time. In any event, the power of trade unions often exceeds what would be
expected from their numerical strength, particularly where they represent workers in a key economic or public
service sector, such as transport or mining.
Aside from trade unions, many other types of workers’ participation have sprung up to provide indirect or direct
representation of employees. In some instances they exist alongside trade unions; in others they are the only
type of participation available to workers. The functions and powers of workers’ representatives that exist under
such arrangements are described in the article “Forms of workers’ participation’’.
The third type of function of trade unions, providing services to members, focuses first and foremost on the
workplace. A shop steward at the enterprise level is there to ensure that workers’ rights under the collective
bargaining agreement and the law are being respected–and, if not, to take action. The union officer’s job is to
defend the interests of workers vis-à-vis management, thereby legitimizing his or her own representative role.
This may involve taking up an individual grievance over discipline or dismissal, or cooperating with
management on a joint health and safety committee. Outside the workplace, many unions provide other types of
benefit, such as preferential access to credit and participation in welfare schemes. The union hall can also serve
as a centre for cultural events or even large family ceremonies. The range of services a union can offer to its
members is vast and reflects the creativity and resources of the union itself as well as the cultural milieu in
which it operates.
As Visser observes:
The power of trade unions depends on various internal and external factors. We can distinguish between
organizational power (how many internal sources of power can unions mobilize?), institutional power (which
external sources of support can unions depend on?) and economic power (which market forces play into the
hands of unions?) (Visser in van Ruysseveldt et al. 1995).
Among the factors he identifies for a strong trade union structure are the mobilization of a large, stable, dues-
paying and well-trained membership (to this could be added a membership that reflects the composition of the
labour market), avoidance of organizational fragmentation and political or ideological rifts and development of
an organizational structure that provides a presence at the company level while having central control of funds
and decision making. Whether such a model for success, which to date has been national in character, can
evolve in the face of an increasingly internationalized economy, is the great challenge facing trade unions at this
juncture.

HR Support on the Collective Bargaining Process

Editor's Note: Union employers should remain reasonable throughout the bargaining process.
Overview: Part of the labor management process might include engaging in the
collective bargaining process. If a union is declared the exclusive representative
of a group of employees, a bargaining obligation arises, and the employer may
no longer attempt to strike deals with individual employees. The employer and
union must instead negotiate a collective bargaining agreement (CBA) in good
faith that will govern the terms and conditions of employment for the unionized
employees. Once the CBA is in place, the parties must then bargain to change
any of its terms.
The collective bargaining process requires that the parties, including those that
qualify as joint employers, negotiate in good faith. This means that both parties
must enter the bargaining process with a real intent to reach a fair written
agreement and use their best efforts to achieve this goal.
This includes:
 Meeting at reasonable times and in reasonable locations;
 Adequately responding to union requests for information relevant to its role as a bargaining
representative; and
 Conferring on mandatory bargaining subjects such as wage and hour, benefits, discipline and other terms
and conditions of employment.
Neither party can request or require the other party to agree to any terms that violate the National Labor
Relations Act (NLRA) and/or federal or state antidiscrimination laws.
Trends: Under the NLRA, union and non-union employees cannot be disciplined for engaging in "protected
concerted activity" for the purpose of collective bargaining or other mutual aid or protection. Recently, the
National Labor Relations Board (NLRB) has been going after union and non-union employers for any
workplace polices or practice that restrain employees from engaging in protected concerted activity. Employee
complaints about work, supervisors, the employer, salaries, or other co-workers on a social networking site,
may be deemed to be protected activity by the NLRB.
Author: Melissa Boyce, JD, Legal Editor
New and Updated
 NLRB Rulings Make It Harder to Organize Micro-Bargaining Units, Easier to Change Contract Terms
September 12, 2019
News
Two new NLRB rulings make it more difficult for a union to organize a micro-unit within an organization and
adopt a new standard for determining whether a unilateral change of a term or condition of employment by an
employer violates the National Labor Relations Act.
 New York Extends Labor Protections to Farm Workers
July 29, 2019
News
A new law extends collective bargaining rights, overtime and other labor protections to farm workers in New
York.
  Nevada Enacts Paid Leave, Minimum Wage Increases and More
June 13, 2019
News
Starting in 2020, employers with 50 or more employees in Nevada will be required to provide employees up to
40 hours hours of paid leave per benefit year. In addition, Nevada's minimum wage will increase by 75 cents
per year, until it reaches $12 per hour in 2020.
 The Unionization Process: Missouri
Employment Law Manual
In-depth review of the spectrum of Missouri employment law requirements HR must follow with respect to
union organization and labor relations.
 Collective Bargaining Process: Federal
Employment Law Manual
This section helps HR professionals understand how to engage in a good-faith, collective bargaining process
with a union in order to achieve a contract. In addition, this section highlights the different categories of
subjects of collective bargaining - mandatory, permissive and illegal.
 Florida Regulates Resolution of Collective Bargaining Issues at Impasse with State Employees
Legal Timetable
 How to Prepare for Collective Negotiations With a Union
How To
This How To details the steps a prudent employer should take to prepare for collective negotiations with a
union.
 Which employers must comply with the Railway Labor Act (RLA)?
FAQs
 Labor Rights and Enforcement: North Dakota
Employment Law Manual
In-depth review of the spectrum of North Dakota employment law requirements HR must follow with respect to
labor relations.
 Grievance Procedure for Collective Bargaining Agreement
Policies and Documents
An employer may use this policy to communicate the grievance procedure for a collective bargaining
agreement. If an employer has unionized employees, the grievance process will involve the employee, union
representatives and management representatives.
Why Is Collective Bargaining A Hallmark of Industrial Relations?
by Leigh C. Raper
Related Articles
 1The Difference Between a Bargaining and a Non-Bargaining Employee
 2Important Things to Know About Human Resource Labor Relations
 3Manage Human Resources & Industrial Relations
 4Labor Law & Arbitration
Collective bargaining is a keystone of industrial and labor relations. When Congress enacted the National Labor
Relations Act in 1935, one of the stated objectives in the language of the law was to “encourage” collective
bargaining and in doing so pave the way for smoother relations between management and labor. A strong
relationship between management and employees lets both groups focus on the operation of the business and
building and growing the company.
What is collective bargaining?
Collective bargaining is what takes place when management and the employees (or the employees’
representative) get together to try and reach an agreement. Contrary to what many might think, employees
acting as a group do not have to be represented by a union to bargain with their employer over the terms and
conditions of employment, but, more often than not, a union is the employee representative. Wages, hours and
working conditions are considered mandatory subjects of bargaining, meaning that employers must respond to
collective requests to meet and bargain over those topics.
Negotiations
The negotiations process part of collective bargaining can vary depending on the size or type of company
involved. For example, a small service business might hire a labor attorney or consultant to negotiate on its
behalf, whereas a larger business might have someone on staff that is knowledgeable in labor matters. On the
union side, negotiations will be very similar: either an employee from the union or the union’s lawyer will
negotiate on behalf of the union. In certain industries, such as construction and janitorial services, it is common
for employers of varied sizes to join together as a group and bargain a single master agreement with the union.
Collective Bargaining Agreement
The end result of collective bargaining negotiations is a collective bargaining agreement. This agreement is the
contract that outlines the relationship between management and the employees. The contract will contain
provisions about things like vacation policies, wages and other employee benefits. It is important for
management and HR (if the company is big enough to have a dedicated HR professional on staff) to know the
CBA inside and out. Any changes to items covered in the contract, like an overtime policy or even a holiday
bonus, would have to be negotiated. Small businesses, which often are more nimble than larger ones and make
changes more quickly and more often, would need to be aware of what is covered in the agreement.
Trends
Union membership overall has been on the decline, according to the Bureau of Labor Statistics. Even so,
collective bargaining disputes still exist and can cause significant disruption to businesses of all sizes. The
Federal Mediation and Conciliation Service, the government agency that provides no-cost mediation for parties
involved in collective bargaining, offers education and training in alternatives to traditional bargaining: interest
arbitration and alternative dispute resolution. For small businesses, many resources are available through the
FMCS and other government agencies, such as the Small Business Administration, to help employers make
informed decisions about collective bargaining issues.

III. Financial Management

 An overview of Financial Management Introduction and significance of financial markets,
Differentiation between real assets and financial assets, Types of Financial Markets, Role of capital and
money markets in economic development, Organizational goals and shareholder wealth maximization
perspective
Introduction and significance of financial markets
Overview:
Throughout his text, Mishkin stresses that the evolution of financial markets, both in the U.S. and throughout
the world, has resulted from an intricate interplay of three factors: chance, necessity, and design. In short,
history matters, and it matters a lot.
In addition, throughout his text Mishkin consistently stresses the importance of information. He argues that it is
impossible to understand the special nature of financial markets relative to markets for real goods and services
unless one understands the peculiar types of "asymmetric information problems" intrinsically associated with
financial assets. He argues that these asymmetric information problems have largely shaped the structure of
financial markets in the past, and that the recent surge of innovations in information technology (IT) -- in
particular, Internet-related IT -- is leading to a dramatic restucturing of financial markets today.
The notes, below, provide basic background information on financial markets as covered in Mishkin in
Chapters 2 and 4. For a more extensive set of notes relating to these and other Mishkin chapters, visit the home
page for Econ 353 (Money, Banking, and Financial Institutions)
 Basic Terms
 Introduction to Financial Markets and Institutions
 Additional Distinctions Among Securities Markets
 Asymmetric Information Problems Arising in Financial Markets
 The Concept of Present Value
 Measuring Interest Rates by Yield to Maturity
 Interest Rates vs. Return Rates
 Real vs. Nominal Interest Rates

Basic Terms:
An asset is anything of durable value, that is, anything that acts as a means to store value over time. Real
assets are assets in physical form (e.g., land, equipment, houses,...), including "human capital" assets embodied
in people (natural abilities, learned skills, knowledge,..). Financial assets are claims against real assets, either
directly (e.g., stock share equity claims) or indirectly (e.g., money holdings, or claims to future income streams
that originate ultimately from real assets). Securities are financial assets exchanged in auction and over-the-
counter markets (see below) whose distribution is subject to legal requirements and restrictions (e.g.,
information disclosure requirements).
Lenders are people who have available funds in excess of their desired expenditures that they are attempting to
loan out, and borrowers are people who have a shortage of funds relative to their desired expenditures who are
seeking to obtain loans. Borrowers attempt to obtain funds from lenders by selling to lenders newly issued
claims against the borrowers' real assets, i.e., by selling the lenders newly issued financial assets.
A financial market is a market in which financial assets are traded. In addition to enabling exchange of
previously issued financial assets, financial markets facilitate borrowing and lending by facilitating the sale by
newly issued financial assets. Examples of financial markets include the New York Stock Exchange (resale of
previously issued stock shares), the U.S. government bond market (resale of previously issued bonds), and the
U.S. Treasury bills auction (sales of newly issued T-bills). A financial institution is an institution whose
primary source of profits is through financial asset transactions. Examples of such financial institutions include
discount brokers (e.g., Charles Schwab and Associates), banks, insurance companies, and complex multi-
function financial institutions such as Merrill Lynch.

Introduction to Financial Markets and Institutions:

Financial markets serve six basic functions. These functions are briefly listed below:
 Borrowing and Lending: Financial markets permit the transfer of funds (purchasing power) from one
agent to another for either investment or consumption purposes.
 Price Determination: Financial markets provide vehicles by which prices are set both for newly issued
financial assets and for the existing stock of financial assets.
 Information Aggregation and Coordination: Financial markets act as collectors and aggregators of
information about financial asset values and the flow of funds from lenders to borrowers.
 Risk Sharing: Financial markets allow a transfer of risk from those who undertake investments to those
who provide funds for those investments.
 Liquidity: Financial markets provide the holders of financial assets with a chance to resell or liquidate
these assets.
 Efficiency: Financial markets reduce transaction costs and information costs.
In attempting to characterize the way financial markets operate, one must consider both the various types of
financial institutions that participate in such markets and the various ways in which these markets are
structured.
Who are the Major Players in Financial Markets?
By definition, financial institutions are institutions that participate in financial markets, i.e., in the creation
and/or exchange of financial assets. At present in the United States, financial institutions can be roughly
classified into the following four categories: "brokers;" "dealers;" "investment bankers;" and "financial
intermediaries."
Brokers:
A broker is a commissioned agent of a buyer (or seller) who facilitates trade by locating a seller (or buyer) to
complete the desired transaction. A broker does not take a position in the assets he or she trades -- that is, the
broker does not maintain inventories in these assets. The profits of brokers are determined by the commissions
they charge to the users of their services (either the buyers, the sellers, or both). Examples of brokers include
real estate brokers and stock brokers.
Diagrammatic Illustration of a Stock Broker:

Payment ----------------- Payment

------------>| |------------->
Stock | | Stock
Buyer | Stock Broker | Seller
<-------------|<----------------|<-------------
Stock | (Passed Thru) | Stock
Shares ----------------- Shares

Dealers:
Like brokers, dealers facilitate trade by matching buyers with sellers of assets; they do not engage in asset
transformation. Unlike brokers, however, a dealer can and does "take positions" (i.e., maintain inventories) in
the assets he or she trades that permit the dealer to sell out of inventory rather than always having to locate
sellers to match every offer to buy. Also, unlike brokers, dealers do not receive sales commissions. Rather,
dealers make profits by buying assets at relatively low prices and reselling them at relatively high prices (buy
low - sell high). The price at which a dealer offers to sell an asset (the "asked price") minus the price at which a
dealer offers to buy an asset (the "bid price") is called the bid-ask spread and represents the dealer's profit
margin on the asset exchange. Real-world examples of dealers include car dealers, dealers in U.S. government
bonds, and Nasdaq stock dealers.
Diagrammatic Illustration of a Bond Dealer:
Payment ----------------- Payment
------------>| |------------->
Bond | Dealer | Bond
Buyer | | Seller
<-------------| Bond Inventory |<-------------
Bonds | | Bonds
-----------------

Investment Banks:
An investment bank assists in the initial sale of newly issued securities (i.e., in IPOs = Initial Public Offerings)
by engaging in a number of different activities:
  Advice: Advising corporations on whether they should issue bonds or stock, and, for bond issues, on the
particular types of payment schedules these securities should offer;
 Underwriting: Guaranteeing corporations a price on the securities they offer, either individually or by
having several different investment banks form a syndicate to underwrite the issue jointly;
 Sales Assistance: Assisting in the sale of these securities to the public.
Some of the best-known U.S. investment banking firms are Morgan Stanley, Merrill Lynch, Salomon Brothers,
First Boston Corporation, and Goldman Sachs.
Financial Intermediaries:
Unlike brokers, dealers, and investment banks, financial intermediaries are financial institutions that engage in
financial asset transformation. That is, financial intermediaries purchase one kind of financial asset from
borrowers -- generally some kind of long-term loan contract whose terms are adapted to the specific
circumstances of the borrower (e.g., a mortgage) -- and sell a different kind of financial asset to savers,
generally some kind of relatively liquid claim against the financial intermediary (e.g., a deposit account). In
addition, unlike brokers and dealers, financial intermediaries typically hold financial assets as part of an
investment portfolio rather than as an inventory for resale. In addition to making profits on their investment
portfolios, financial intermediaries make profits by charging relatively high interest rates to borrowers and
paying relatively low interest rates to savers.
Types of financial intermediaries include: Depository Institutions (commercial banks, savings and loan
associations, mutual savings banks, credit unions); Contractual Savings Institutions (life insurance companies,
fire and casualty insurance companies, pension funds, government retirement funds); and Investment
Intermediaries (finance companies, stock and bond mutual funds, money market mutual funds).
Diagrammatic Example of a Financial Intermediary: A Commercial Bank
Lending by B Borrowing by B

deposited
------- funds ------- funds -------
| |<............. | | <............. | |
| F |.............> | B | ..............> | H |
------- loan ------- deposit -------
contracts accounts

Loan contracts Deposit accounts

issued by F to B issued by B to H
are liabilities of F are liabilities of B
and assets of B and assets of H
NOTE: F=Firms, B=Commercial Bank, and H=Households

Important Caution: These four types of financial institutions are simplified idealized classifications, and many
actual financial institutions in the fast-changing financial landscape today engage in activities that overlap two
or more of these classifications, or even to some extent fall outside these classifications. A prime example is
Merrill Lynch, which simultaneously acts as a broker, a dealer (taking positions in certain stocks and bonds it
sells), a financial intermediary (e.g., through its provision of mutual funds and CMA checkable deposit
accounts), and an investment banker.
What Types of Financial Market Structures Exist?
The costs of collecting and aggregating information determine, to a large extent, the types of financial market
structures that emerge. These structures take four basic forms:
 Auction markets conducted through brokers;
 Over-the-counter (OTC) markets conducted through dealers;
 Organized Exchanges, such as the New York Stock Exchange, which combine auction and OTC market
features. Specifically, organized exchanges permit buyers and sellers to trade with each other in a
centralized location, like an auction. However, securities are traded on the floor of the exchange with the
help of specialist traders who combine broker and dealer functions. The specialists broker trades but
also stand ready to buy and sell stocks from personal inventories if buy and sell orders do not match up.
 Intermediation financial markets conducted through financial intermediaries;
Financial markets taking the first three forms are generally referred to as securities markets. Some financial
markets combine features from more than one of these categories, so the categories constitute only rough
guidelines.
Auction Markets:
An auction market is some form of centralized facility (or clearing house) by which buyers and sellers, through
their commissioned agents (brokers), execute trades in an open and competitive bidding process. The
"centralized facility" is not necessarily a place where buyers and sellers physically meet. Rather, it is any
institution that provides buyers and sellers with a centralized access to the bidding process. All of the needed
information about offers to buy (bid prices) and offers to sell (asked prices) is centralized in one location which
is readily accessible to all would-be buyers and sellers, e.g., through a computer network. No private exchanges
between individual buyers and sellers are made outside of the centralized facility.
An auction market is typically a public market in the sense that it open to all agents who wish to participate.
Auction markets can either be call markets -- such as art auctions -- for which bid and asked prices are all
posted at one time, or continuous markets -- such as stock exchanges and real estate markets -- for which bid
and asked prices can be posted at any time the market is open and exchanges take place on a continual basis.
Experimental economists have devoted a tremendous amount of attention in recent years to auction markets.
Many auction markets trade in relatively homogeneous assets (e.g., Treasury bills, notes, and bonds) to cut
down on information costs. Alternatively, some auction markets (e.g., in second-hand jewelry, furniture,
paintings etc.) allow would-be buyers to inspect the goods to be sold prior to the opening of the actual bidding
process. This inspection can take the form of a warehouse tour, a catalog issued with pictures and descriptions
of items to be sold, or (in televised auctions) a time during which assets are simply displayed one by one to
viewers prior to bidding.
Auction markets depend on participation for any one type of asset not being too "thin." The costs of collecting
information about any one type of asset are sunk costs independent of the volume of trading in that asset.
Consequently, auction markets depend on volume to spread these costs over a wide number of participants.
Over-the-Counter Markets:
An over-the-counter market has no centralized mechanism or facility for trading. Instead, the market is a public
market consisting of a number of dealers spread across a region, a country, or indeed the world, who make the
market in some type of asset. That is, the dealers themselves post bid and asked prices for this asset and then
stand ready to buy or sell units of this asset with anyone who chooses to trade at these posted prices. The dealers
provide customers more flexibility in trading than brokers, because dealers can offset imbalances in the demand
and supply of assets by trading out of their own accounts. Many well-known common stocks are traded over-
the-counter in the United States through NASDAQ (National Association of Securies Dealers' Automated
Quotation System).
Intermediation Financial Markets:
An intermediation financial market is a financial market in which financial intermediaries help transfer funds
from savers to borrowers by issuing certain types of financial assets to savers and receiving other types of
financial assets from borrowers. The financial assets issued to savers are claims against the financial
intermediaries, hence liabilities of the financial intermediaries, whereas the financial assets received from
borrowers are claims against the borrowers, hence assets of the financial intermediaries. (See the diagrammatic
illustration of a financial intermediary presented earlier in these
notes.)

Additional Distinctions Among Securities Markets

Primary versus Secondary Markets:
Primary markets are securities markets in which newly issued securities are offered for sale to
buyers. Secondary markets are securities markets in which existing securities that have previously been issued
are resold. The initial issuer raises funds only through the primary market.
Debt Versus Equity Markets:
Debt instruments are particular types of securities that require the issuer (the borrower) to pay the holder (the
lender) certain fixed dollar amounts at regularly scheduled intervals until a specified time (the maturity date) is
reached, regardless of the success or failure of any investment projects for which the borrowed funds are used.
A debt instrument holder only participates in the management of the debt instrument issuer if the issuer goes
bankrupt. An example of a debt instrument is a 30-year mortgage.
In contrast, an equity is a security that confers on the holder an ownership interest in the issuer.
There are two general categories of equities: "preferred stock" and "common stock."
Common stock shares issued by a corporation are claims to a share of the assets of a corporation as well as to a
share of the corporation's net income -- i.e., the corporation's income after subtraction of taxes and other
expenses, including the payment of any debt obligations. This implies that the return that holders of common
stock receive depends on the economic performance of the issuing corporation.
Holders of a corporation's common stock typically participate in any upside performance of the corporation in
two ways: by receiving a share of net income in the form of dividends; and by enjoying an appreciation in the
price of their stock shares. However, the payment of dividends is not a contractual or legal requirement. Even if
net earnings are positive, a corporation is not obliged to distribute dividends to shareholders. For example, a
corporation might instead choose to keep its profits as retained earnings to be used for new capital investment
(self-financing of investment rather than debt or equity financing).
On the other hand, corporations cannot charge losses to their common stock shareholders. Consequently, these
shareholders at most risk losing the purchase price of their shares, a situation which arises if the market price of
their shares declines to zero for any reason. An example of a common stock share is a share of IBM.
In contrast, preferred stock shares are usually issued with a par value (e.g., $100) and pay a fixed dividend
expressed as a percentage of par value. Preferred stock is a claim against a corporation's cash flow that is prior
to the claims of its common stock holders but is generally subordinate to the claims of its debt holders. In
addition, like debt holders but unlike common stock holders, preferred stock holders generally do not participate
in the management of issuers through voting or other means unless the issuer is in extreme financial distress
(e.g., insolvency). Consequently, preferred stock combines some of the basic attributes of both debt and
common stock and is often referred to as a hybrid security.
Money versus Capital Markets:
The money market is the market for shorter-term securities, generally those with one year or less remaining to
maturity.
Examples: U.S. Treasury bills; negotiable bank certificates of deposit (CDs); commercial paper, Federal funds;
Eurodollars.
Remark: Although the maturity on certificates of deposit (CDs) -- i.e., on large time deposits at depository
institutions -- can run anywhere from 30 days to over 5 years, most CDs have a maturity of less than one year.
Those with a maturity of more than one year are referred to as term CDs. A CD that can be resold without
penalty in a secondary market prior to maturity is known as a negotiable CD.
The capital market is the market for longer-term securities, generally those with more than one year to maturity.
Examples: Corporate stocks; residential mortgages; U.S. government securities (marketable long-term); state
and local government bonds; bank commercial loans; consumer loans; commercial and farm mortgages.
Remark: Corporate stocks are conventionally considered to be long-term securities because they have no
maturity date.
Domestic Versus Global Financial Markets:
Eurocurrencies are currencies deposited in banks outside the country of issue. For example, eurodollars, a
major form of eurocurrency, are U.S. dollars deposited in foreign banks outside the U.S. or in foreign branches
of U.S. banks. That is, eurodollars are dollar-denominated bank deposits held in banks outside the U.S.
An international bond is a bond available for sale outside the country of its issuer.
Example of an International Bond: a bond issued by a U.S. firm that is available for sale both in the U.S. and
abroad.
A foreign bond is an international bond issued by a country that is denominated in a foreign currency and that is
for sale exclusively in the country of that foreign currency.
Example of a Foreign Bond: a bond issued by a U.S. firm that is denominated in Japanese yen and that is for
sale exclusively in Japan.
A Eurobond is an international bond denominated in a currency other than that of the country in which it is
sold. More precisely, it is issued by a borrower in one country, denominated in the borrower's currency, and
sold outside the borrower's country.
Example of a Eurobond: Bonds sold by the U.S. government to Japan that are denominated in U.S. dollars.

Asymmetric Information in Financial Markets

Asymmetric information in a market for goods, services, or assets refers to differences ("asymmetries") between
the information available to buyers and the information available to sellers. For example, in markets for
financial assets, asymmetric information may arise between lenders (buyers of financial assets) and borrowers
(sellers of financial assets).
Problems arising in markets due to asymmetric information are typically divided into two basic types: "adverse
selection;" and "moral hazard." This section explains these two types of problems, using financial markets for
concrete illustration.
1. Adverse Selection
Adverse selection is a problem that arises for a buyer of goods, services, or assets when the buyer has difficulty
assessing the quality of these items in advance of purchase.
Consequently, adverse selection is a problem that arises because of different ("asymmetric") information
between a buyer and a seller before any purchase agreement takes place.
An Illustration of Adverse Selection in Loan Markets:
In the context of a loan market, an adverse selection problem arises if the contractual terms that a lender sets in
advance in an attempt to protect himself against the consequences of inadvertently lending to high risk
borrowers have the perverse effect of encouraging high risk borrowers to self-select into the lender's loan
applicant pool while at the same time encouraging low risk borrowers to self-select out of this pool. In this case,
the lender's pool of loan applicants is adversely affected in the sense that the average quality of borrowers in the
pool decreases.

2. Moral Hazard
Moral hazard is said to exist in a market if, after the signing of a purchase agreement between the buyer and
seller of a good, service, or asset:
 the seller changes his or her behavior in such a way that the probabilites (risk calculations) used by the
buyer to determine the terms of the purchase agreement are no longer accurate;
 the buyer is only imperfectly able to monitor (observe) this change in the seller's behavior.
For example, a moral hazard problem arises if, after a lender purchases a loan contract from a borrower, the
borrower increases the risks originally associated with the loan contract by investing his borrowed funds in
more risky projects than he originally reported to the lender.
 The Concept of Present Value
Suppose someone promises to pay you $100 in some future period T. This amount of money actually has two
different values: a nominal value of $100, which is simply a measure of the number of dollars that you will
receive in period T; and a present value (sometimes referred to as a present discounted value), roughly defined
to be the minimum number of dollars that you would have to give up today in return for receiving $100 in
period T.
Stated somewhat differently, the present value of the future $100 payment is the value of this future $100
payment measured in terms of current (or present) dollars.
The concept of present value permits financial assets with different associated payment streams to be compared
with each other by calculating the value of these payment streams in terms of a single common unit: namely,
current dollars.
A specific procedure for the calculation of present value for future payments will now be developed.
Present Value of Payments One Period Into the Future:
If you save $1 today for a period of one year at an annual interest rate i, the nominal value of your savings after
one year will be

(1) V(1) = (1+i)*$1 ,

where the asterisk "*" denotes multiplication.

On the other hand, proceeding in the reverse direction from the future to the present, the present value of the
future dollar amount V(1) = (1+i)*$1 is equal to $1. That is, the amount you would have to save today in order
to receive back V(1)=(1+i)*$1 in one year's time is $1.
Notice that this calculation of $1 as the present value of V(1)=(1+i)*$1 satisfies the following formula:
V(1)
(2) Present Value = -------- .
of V(1) (1+i)
Indeed, given any fixed annual interest rate i, and any payment V(1) to be received one year from today,
the present value of V(1) is given by formula (2). In effect, then, the payment V(1) to be received one year from
now has been discounted back to the present using the annual interest rate i, so that the value of V(1) is now
expressed in current dollars.
Present Value of Payments Multiple Periods Into the Future:
If you save $1 today at a fixed annual interest rate i, what will be the value of your savings in one year's time?
In two year's time? In n year's time?
If you save $1 at a fixed annual interest rate i, the nominal value of your savings in one year's time will be
V(1)=(1+i)*$1. If you then put aside V(1) as savings for an additional year rather than spend it, the nominal
value of your savings at the end of the second year will be
(3)
V(2) = (1+i)*V(1) = (1+i)*(1+i)*$1 = (1+i)2*$1 .
And so forth for any number of years n.

(4) START --------------------------------/\/\/\-------->YEAR

| 1 2 n
|

Nominal 2 n
Value of $1 (1+i)*$1 (1+i) *$1 (1+i) * $1
Savings:

Now consider the present value of V(n) = (1+i)n*$1 for any year n. By construction, V(n) is the nominal value
obtained after n years when a single dollar is saved for n successive years at the fixed annual interest rate i.
Consequently, the present value of V(n) is simply equal to $1, regardless of the value of n.
Notice, however, that the present value of V(n) -- namely, $1 -- can be obtained from the following formula:

V(n)
(5) Present Value = ------------ .
of V(n) n
(1+i)
Indeed, given any fixed annual interest rate i, and any nominal amount V(n) to be received n years from today,
the present value of V(n) can be calculated by using formula (5).
Present Value of Any Arbitrary Payment Stream:
Now suppose you will be receiving a sequence of three payments over the next three years. The nominal value
of the first payment is $100, to be received at the end of the first year; the nominal value of the second payment
is $150, to be received at the end of the second year; and the nominal value of the third payment is $200, to be
received at the end of the third year.
Given a fixed annual interest rate i, what is the present value of the payment stream ($100,$150,$200)
consisting of the three separate payments $100, $150, and $200 to be received over the next three years?
To calculate the present value of the payment stream ($100,$150,$200), use the following two steps:
  Step 1: Use formula (5) to separately calculate the present value of each of the individual payments in
the payment stream, taking care to note how many years into the future each payment is going to be
received.
 Step 2: Sum the separate present value calculations obtained in Step 1 to obtain the present value of the
payment stream as a whole.
Carrying out Step 1, it follows from formula (5) that the present value of the $100 payment to be received at the
end of the first year is $100/(1+i). Similarly, it follows from formula (5) that the present value of the $150
payment to be received at the end of the second year is
$150
(6) ----------
2
(1+i)
Finally, it follows from formula (3) that the present value of the $200 payment to be received at the end of the
third year is
$200
----------
(7) 3
(1+i)
Consequently, adding together these three separate present value calculations in accordance with Step 2, the
present value PV(i) of the payment stream ($100,$150,$200) is given by
(8)

PV(i) = $100 + $150 + $200

(1 + i)1 (1 + i)2 (1 + i)3

More generally, given any fixed annual interest rate i, and given any payment stream (V1,V2,V3,...,VN)
consisting of individual payments to be received over the next N years, the present value of this payment stream
can be found by following the two steps outlined above.
In particular, then, given any fixed annual interest rate, and given any payment stream paid out on a yearly basis
to the owner of some financial asset, the present (current dollar) value of this payment stream can be found by
following Steps 1 and 2 outlined above. Consequently, regardless how different the payment streams associated
with different financial assets might be, one can calculate the present values for these payment streams in
current dollar terms and hence have a way to compare them.

Measuring Interest Rates by Yield to Maturity

By definition, the current annual yield to maturity for a financial asset is the particular fixed annual interest rate
i which, when used to calculate the present value of the financial asset's future stream of payments to the
financial asset's owner, yields a present value equal to the current market value of the financial asset.
Below we illustrate this calculation for coupon bonds.
Yield to Maturity for Coupon Bonds:
The basic contractual terms of a coupon bond are as follows:

Seller Purchase
Receives: Price Pb
| MATURITY
START |_______________________ /\/\/\ _____ DATE
| | |
| | |
Coupon Coupon ... Coupon
Buyer Payment C Payment C Payment C
Receives: + Face Value F

Consider a coupon bond whose purchase price is Pb=$94, whose face value is F = $100, whose annual coupon
payment is C = $10, and whose maturity is 10 years.
The payment stream to the buyer (new owner) generated by this coupon bond is given by
(9)
( $10, $10, $10, $10, $10, $10, $10, $10, $10, [$10 + $100] ).
For any given fixed annual interest rate i, the present value PV(i) of the payment stream (9) is given by the sum
of the separate present value calculations for each of the annual payments in this payment stream as determined
by formula (5). That is,
(10)
PV(i) = $10/(1+i) + $10/(1+i)2 + ... + $10/(1+i)10 + $100/(1+i)10 .
The current value of the coupon bond is its current purchase price Pb = $94. It then follows by definition that
the yield to maturity for this coupon bond is found by solving the following equation for i:
(11)
Pb = PV(i) .
The calculation of the yield to maturity i from formula (11) can be difficult, but tables have been published that
permit one to read off the yield to maturity i for a coupon bond once the purchase price, the face value, the
coupon rate, and the maturity are known.
More generally, given any coupon bond with purchase price Pb, face value F, coupon payment C, and maturity
N, the yield to maturity i is found by means of the following formula:
(12a)
Pb = PV(i) ,
where the present value PV(i) of the coupon bond is given by
(12b)
PV(i) = C/(1+i) + C/(1+i)2 + ... + C/(1+i)N + F/(1+i)N .

Interest Rates vs. Return Rates

Given any asset A held over any given time period T, the return to A over the holding period T is, by definition:
 the sum of all payments (rents, coupon payments, dividends, etc.) generated by A during period T,
assumed paid out at the end of the period,
 PLUS the capital gain (+) or loss (-) in the market value of A over period T, measured as the market
value of A at the end of period T minus the market value of A at the beginning of period T.
The return rate on asset A over the holding period T is then defined to be the return on A over period T divided
by the market value of A at the beginning of period T.
More precisely, suppose that an asset A is held over a time period that starts at some time t and ends at time t+1.
Let the market value of A at time t be denoted by P(t) and the market value of A at time t+1 be denoted by
P(t+1). Finally, let V(t,t+1) denote the sum of all payments accruing to the holder of asset A from t to t+1,
assumed to be paid out at time t+1.
Then, by definition, the return rate on asset A from t to t+1 is given by the following formula:

(13) Return Rate on V(t,t+1) + P(t+1) - P(t)

Asset A From = ---------------------------
time t to t+1 P(t)

V(t,t+1) P(t+1) - P(t)

= --------- + -------------
P(t) P(t)

= payments + Capital Gain (if +)

received as or Loss (if -) as
 percentage percentage of P(t)
of P(t)

Formula (13) holds for any asset A, whether physical or financial. The question then arises: For financial assets,
what is the connection between the return rate defined by formula (13) and the interest rate on the financial
asset defined by the yield to maturity?
The return rate on a financial asset is not necessarily equal to the yield to maturity on the financial asset.
Starting at any current time t, the return rate is calculated for some specified holding period from t to t', whether
or not this holding period coincides with the maturity of the financial asset. Moreover, the return rate takes into
account any capital gains or losses that occur during this holding period, in addition to any payments received
from the financial asset during this holding period. In contrast, starting at any current time t, the yield to
maturity takes into account the payment stream generated by the financial asset over its entire remaining
maturity, plus the overall anticipated capital gain or loss that will be incurred when the financial asset is held to
maturity.

Real vs. Nominal Interest Rates

The yield to maturity measure of an interest rate, as examined to date, has been "nominal" in the sense that it
has not been adjusted for expected changes in prices. What actually concerns a "rational" saver considering the
purchase of a financial asset is not the nominal payment stream he or she expects to earn in future periods but
rather the command over purchasing power that this nominal payment stream is expected to entail. This
purchasing power depends on the behavior of prices.
Let infe(t) denote the expected inflation rate at time t, and let i(t) denote the (nominal) yield to maturity for some
financial asset at time t. Then the real interest rate associated with i(t) is defined by the following "Fisher
equation:"
(14)
ir(t) = i(t) - infe(t) .
That is, the real interest rate is the nominal interest rate minus the expected inflation rate.
Note:The real interest rate defined by (14) is more precisely called the ex ante real interest rate because it
adjusts for expected changes in the price level. If the expected inflation rate in (14) is replaced by
the actual inflation rate, one obtains the ex post real interest rate.
Real interest rates provide a more accurate measure of the true costs of borrowing and the true gains from
lending than nominal interest rates, and hence provide a better indicator of the incentives to borrow and lend. In
particular, for any given nominal interest rate i on a debt instrument D, the incentive to borrow (issue D) will be
higher if the real interest rate associated with i is lower (i.e., the expected inflation rate is higher). This is so
since a higher expected inflation rate means the borrower (issuer of D) can expect to pay off his future nominal
debt obligations using cheaper dollars than he borrowed. For this same reason, the incentive to lend (purchase
D) will be lower if the real interest rate associated with i is lower.
A similar distinction is made between the (nominal) return rate defined by (13), which has not been adjusted for
expected changes in prices, and the "real return rate" which is subject to such adjustment. More precisely,
the real return rate on any asset A over any holding period from t to t+1 is defined to be the (nominal) return
rate (13) minus the expected inflation rate infe(t).
Financial Markets – Functions, Importance And Types
The financial market is a very broad term that primarily refers to a marketplace where buyers and sellers
participate in the trade, i.e., buying and selling of assets. Simply saying, it is a platform that facilitates traders to
buy and sell financial instruments and securities. These instruments and securities can be shares, stocks, bonds,
commercial papers, bills, debentures, cheques and more.
Financial markets are known for transparent pricing, strict regulations, costs and fees and clear guidelines. One
big characteristic of such markets is that the market forces determine the price of the assets. Also, a financial
market may or may not have a physical location, meaning investors can buy and sell assets over the Internet or
phone.
Table of Contents [show]
IMPORTANCE
Financial markets are common to each country, and they play a major role in the economic growth of the
country. Some countries have small markets, while some have big financial markets, like NASDAQ. Such
markets act as an intermediary between savers and investors, or they help savers to become investors. On the
other hand, they also help businesses to raise money to expand their business.
It won’t be wrong to say that investors and businesses access the financial markets to raise money and also to
make more money. Moreover, they also help in lowering unemployment as these markets create massive job
opportunities.
FUNCTIONS
Price Determination: Demand and supply of an asset in a financial market help to determine their price.
Investors are the supplier of the funds, while the industries are in need of the funds. Thus, the interaction
between these two participants and other market forces helps to determine the price.
Mobilization of savings: For an economy to be successful it is crucial that the money does not sit idle. Thus, a
financial market helps in connecting those with money with those who require money.
Ensures liquidity: Assets that buyers and sellers trade in the financial market have high liquidity. It means that
investors can easily sell those assets and convert them into cash whenever they want. Liquidity is an important
reason for investors to participate in trade.
Saves time and money: Financial markets serve as a platform where buyers and sellers can easily find each
other without making too much efforts or wasting time. Also, since these markets handle so many transactions it
helps them to achieve economies of scale. This results in lower transaction cost and fees for the investors.
CLASSIFICATION OF THE FINANCIAL MARKET
As we mentioned before that financial is a very broad term, so just mentioning their types will not give readers
a good idea of the financial markets. That is why we are mentioning classification and giving type under each
category.
BY NATURE OF ASSETS
Stock market: This is the market where shares of the company are listed and traded after their IPO.
Bond market: This market allows companies and the government to raise money for a project or investment.
Investors buy bonds from a company, which later returns the amount of bond with agreed interest.
Commodities market: In this market, investors buy and sell natural resources or commodities, like corn, oil,
meat, and gold.
Derivatives market: This market deals in derivatives or contracts, whose value is based on the underlying asset
being traded.

BY NATURE OF CLAIM
Equity Market: It is a market where investors deal in stocks or other equity instruments. It is basically the
market for residual claims.
Debt Market: In this market, investors buy and sell fixed claims or debt instruments, like debentures or bonds.
BY MATURITY OF CLAIM
Money Market: The markets where investors buy and sell securities that mature within a year are the money
market. Assets that investors buy and sell in this market are commercial paper, certificate of deposits, treasury
bills, and more.
Capital Market: Markets, where investors buy and sell medium and long term financial assets, is a capital
market. There are two types of capital market: Primary Market (where a company issues its shares for the first
time (IPO), or already listed company issues fresh shares) and Secondary Market or Stock Market (where
buyers and sellers trade already issued securities in the primary market).
BY TIMING OF DELIVERY
Cash Market: It is the market where transactions are settled in real time.
Futures Market: In this market, settlement and delivery take place at a future specified date.
BY ORGANIZATIONAL STRUCTURE
Exchange Traded Market: A market with centralized authority and set regulations are Exchange Traded
Market, like NYSE, NASDAQ.
Over-the-Counter Market (OTC): Markets with customized procedures and decentralized organization is an
OTC market. It is a type of secondary market. Smaller organizations prefer this market as it has fewer
regulations and is less expensive.
A financial market is a market in which people trade financial securities and derivatives at low transaction
costs. Securities include stocks and bonds, and precious metals.
The term "market" is sometimes used for what are more strictly exchanges, organizations that facilitate the trade
in financial securities, e.g., a stock exchange or commodity exchange. This may be a physical location (such as
the NYSE, LSE, JSE, BSE) or an electronic system (such as NASDAQ). Much trading of stocks takes place on
an exchange; still, corporate actions (merger, spinoff) are outside an exchange, while any two companies or
people, for whatever reason, may agree to sell stock from the one to the other without using an exchange.
Trading of currencies and bonds is largely on a bilateral basis, although some bonds trade on a stock exchange,
and people are building electronic systems for these as well, to stock exchanges.

Contents
 1Types of financial markets
 2Raising capital
o 2.1Lenders
 2.1.1Individuals and doubles
o 2.2Companies
 o 2.3Borrowers
 3Derivative products
 4Analysis of financial markets
 5Financial market slang
 6Functions of financial markets
 7Components of financial market
o 7.1Based on market levels
o 7.2Based on security types
 8See also
 9Notes
 10References
 11External links
Types of financial markets[edit]
Within the financial sector, the term "financial markets" is often used to refer just to the markets that are used to
raise finance: for long term finance, the Capital markets; for short term finance, the Money markets. Another
common use of the term is as a catchall for all the markets in the financial sector, as per examples in the
breakdown below.
 Capital markets which consist of:
o Stock markets, which provide financing through the issuance of shares or common stock, and
enable the subsequent trading thereof.
o Bond markets, which provide financing through the issuance of bonds, and enable the
subsequent trading thereof.
 Commodity markets, which facilitate the trading of commodities.
 Money markets, which provide short term debt financing and investment.
 Derivatives markets, which provide instruments for the management of financial risk.[1]
 Futures markets, which provide standardized forward contracts for trading products at some future date;
see also forward market.
 Foreign exchange markets, which facilitate the trading of foreign exchange.
 Cryptocurrency market which facilitate the trading of digital assets and financial technologies.
 Spot market
 Interbank lending market
The capital markets may also be divided into primary markets and secondary markets. Newly formed (issued)
securities are bought or sold in primary markets, such as during initial public offerings. Secondary markets
allow investors to buy and sell existing securities. The transactions in primary markets exist between issuers and
investors, while secondary market transactions exist among investors.
Liquidity is a crucial aspect of securities that are traded in secondary markets. Liquidity refers to the ease with
which a security can be sold without a loss of value. Securities with an active secondary market mean that there
are many buyers and sellers at a given point in time. Investors benefit from liquid securities because they can
sell their assets whenever they want; an illiquid security may force the seller to get rid of their asset at a large
discount.
Raising capital[edit]
Financial markets attract funds from investors and channel them to corporations—they thus allow corporations
to finance their operations and achieve growth. Money markets allow firms to borrow funds on a short term
basis, while capital markets allow corporations to gain long-term funding to support expansion (known as
maturity transformation).
Without financial markets, borrowers would have difficulty finding lenders themselves. Intermediaries such
as banks, Investment Banks, and Boutique Investment Banks can help in this process. Banks take deposits from
those who have money to save. They can then lend money from this pool of deposited money to those who seek
to borrow. Banks popularly lend money in the form of loans and mortgages.
More complex transactions than a simple bank deposit require markets where lenders and their agents can meet
borrowers and their agents, and where existing borrowing or lending commitments can be sold on to other
parties. A good example of a financial market is a stock exchange. A company can raise money by
selling shares to investors and its existing shares can be bought or sold.
The following table illustrates where financial markets fit in the relationship between lenders and borrowers:

Relationship between lenders and borrowers

Lenders Financial Intermediaries Financial Markets Borrowers

Interbank Individuals
Banks
Stock Exchange Companies
Individuals Insurance Companies
Money Market Central Government
Companies Pension Funds
Bond Market Municipalities
Mutual Funds
Foreign Exchange Public Corporations

Lenders[edit]
The lender temporarily gives money to somebody else, on the condition of getting back the principal amount
together with some interest or profit or charge.
Individuals and doubles[edit]
Many individuals are not aware that they are lenders, but almost everybody does lend money in many ways. A
person lends money when he or she:
 Puts money in a savings account at a bank
 Contributes to a pension plan
 Pays premiums to an insurance company
 Invests in government bonds
Companies[edit]
Companies tend to be lenders of capital. When companies have surplus cash that is not needed for a short period
of time, they may seek to make money from their cash surplus by lending it via short term markets
called money markets. Alternatively, such companies may decide to return the cash surplus to their shareholders
(e.g. via a share repurchase or dividend payment).
Borrowers[edit]
 Individuals borrow money via bankers' loans for short term needs or longer term mortgages to help
finance a house purchase.
 Companies borrow money to aid short term or long term cash flows. They also borrow to fund
modernization or future business expansion.
 Governments often find their spending requirements exceed their tax revenues. To make up this
difference, they need to borrow. Governments also borrow on behalf of nationalized industries,
municipalities, local authorities and other public sector bodies. In the UK, the total borrowing
requirement is often referred to as the Public sector net cash requirement (PSNCR).
Governments borrow by issuing bonds. In the UK, the government also borrows from individuals by offering
bank accounts and Premium Bonds. Government debt seems to be permanent. Indeed, the debt seemingly
expands rather than being paid off. One strategy used by governments to reduce the value of the debt is to
influence inflation.
Municipalities and local authorities may borrow in their own name as well as receiving funding from national
governments. In the UK, this would cover an authority like Hampshire County Council.
Public Corporations typically include nationalized industries. These may include the postal services, railway
companies and utility companies.
Many borrowers have difficulty raising money locally. They need to borrow internationally with the aid
of Foreign exchange markets.
Borrowers having similar needs can form into a group of borrowers. They can also take an organizational form
like Mutual Funds. They can provide mortgage on weight basis. The main advantage is that this lowers the cost
of their borrowings.
Derivative products[edit]
During the 1980s and 1990s, a major growth sector in financial markets was the trade in so called derivatives.
In the financial markets, stock prices,share prices, bond prices, currency rates, interest rates and dividends go up
and down, creating risk. Derivative products are financial products which are used to control risk or
paradoxically exploit risk.[2] It is also called financial economics.
Derivative products or instruments help the issuers to gain an unusual profit from issuing the instruments. For
using the help of these products a contract has to be made. Derivative contracts are mainly 4 types:[3]
1. Future
2. Forward
3. Option
4. Swap
Seemingly, the most obvious buyers and sellers of currency are importers and exporters of goods. While this
may have been true in the distant past,[when?] when international trade created the demand for currency markets,
importers and exporters now represent only 1/32 of foreign exchange dealing, according to the Bank for
International Settlements.[4]
The picture of foreign currency transactions today shows:
 Banks/Institutions
 Speculators
 Government spending (for example, military bases abroad)
 Importers/Exporters
 Tourists
Analysis of financial markets[edit]
See Statistical analysis of financial markets, statistical finance
Much effort has gone into the study of financial markets and how prices vary with time. Charles Dow, one of
the founders of Dow Jones & Company and The Wall Street Journal, enunciated a set of ideas on the subject
which are now called Dow theory. This is the basis of the so-called technical analysis method of attempting to
predict future changes. One of the tenets of "technical analysis" is that market trends give an indication of the
future, at least in the short term. The claims of the technical analysts are disputed by many academics, who
claim that the evidence points rather to the random walk hypothesis, which states that the next change is not
correlated to the last change. The role of human psychology in price variations also plays a significant factor.
Large amounts of volatility often indicate the presence of strong emotional factors playing into the price. Fear
can cause excessive drops in price and greed can create bubbles. In recent years the rise of algorithmic and
high-frequency program trading has seen the adoption of momentum, ultra-short term moving average and other
similar strategies which are based on technical as opposed to fundamental or theoretical concepts of market
Behaviour.
The scale of changes in price over some unit of time is called the volatility. It was discovered by Benoit
Mandelbrot that changes in prices do not follow a normal distribution, but are rather modeled better by Lévy
stable distributions. The scale of change, or volatility, depends on the length of the time unit to a power a bit
more than 1/2. Large changes up or down are more likely than what one would calculate using a normal
distribution with an estimated standard deviation.
Financial market slang[edit]
 Poison pill, when a company issues more shares to prevent being bought out by another company,
thereby increasing the number of outstanding shares to be bought by the hostile company making the bid
to establish majority.
 Bips, meaning "bps" or basis points. A basis point is a financial unit of measurement used to describe
the magnitude of percent change in a variable. One basis point is the equivalent of one hundredth of a
percent. For example, if a stock price were to rise 100bit/s, it means it would increase 1%.
 Quant, a quantitative analyst with advanced training in mathematics and statistical methods.
 Rocket scientist, a financial consultant at the zenith of mathematical and computer programming skill.
They are able to invent derivatives of high complexity and construct sophisticated pricing models. They
 generally handle the most advanced computing techniques adopted by the financial markets since the
early 1980s. Typically, they are physicists and engineers by training.
 IPO, stands for initial public offering, which is the process a new private company goes through to "go
public" or become a publicly traded company on some index.
 White Knight, a friendly party in a takeover bid. Used to describe a party that buys the shares of one
organization to help prevent against a hostile takeover of that organization by another party.
 Round-tripping
 Smurfing, a deliberate structuring of payments or transactions to conceal it from regulators or other
parties, a type of money laundering that is often illegal.
 Bid–ask spread, the difference between the highest bid and the lowest offer.
 Pip, smallest price move that a given exchange rate makes based on market convention. [5]
 Pegging, when a country wants to obtain price stability, it can use pegging to fix their exchange rate
relative to another currency. [6]
Functions of financial markets[edit]
 Intermediary functions: The intermediary functions of financial markets include the following:
o Transfer of resources: Financial markets facilitate the transfer of real economic resources from
lenders to ultimate borrowers.
o Enhancing income: Financial markets allow lenders to earn interest or dividend on their surplus
invisible funds, thus contributing to the enhancement of the individual and the national income.
o Productive usage: Financial markets allow for the productive use of the funds borrowed. The
enhancing the income and the gross national production.
o Capital formation: Financial markets provide a channel through which new savings flow to aid
capital formation of a country.
o Price determination: Financial markets allow for the determination of price of the traded
financial assets through the interaction of buyers and sellers. They provide a sign for the
allocation of funds in the economy based on the demand and to the supply through the
mechanism called price discovery process.
o Sale mechanism: Financial markets provide a mechanism for selling of a financial asset by an
investor so as to offer the benefit of marketability and liquidity of such assets.
o Information: The activities of the participants in the financial market result in the generation
and the consequent dissemination of information to the various segments of the market. So as to
reduce the cost of transaction of financial assets.
 Financial Functions
o Providing the borrower with funds so as to enable them to carry out their investment plans.
o Providing the lenders with earning assets so as to enable them to earn wealth by deploying the
assets in production debentures.
o Providing liquidity in the market so as to facilitate trading of funds.
 o Providing liquidity to commercial bank
o Facilitating credit creation
o Promoting savings
o Promoting investment
o Facilitating balanced economic growth
o Improving trading floors
Components of financial market[edit]
Based on market levels[edit]
 Primary market: Primary market is a market for new issues or new financial claims. Hence it’s also
called new issue market. The primary market deals with those securities which are issued to the public
for the first time.
 Secondary market: A market for secondary sale of securities. In other words, securities which have
already passed through the new issue market are traded in this market. Generally, such securities are
quoted in the stock exchange and it provides a continuous and regular market for buying and selling of
securities.
Simply put, primary market is the market where the newly started company issued shares to the public for the
first time through IPO (initial public offering). Secondary market is the market where the second hand securities
are sold (securitCommodity Marketies).
Based on security types[edit]
 Money market: Money market is a market for dealing with the financial assets and securities which
have a maturity period of up to one year. In other words, it’s a market for purely short-term funds.
 Capital market: A capital market is a market for financial assets which have a long or indefinite
maturity. Generally, it deals with long-term securities which have a maturity period of above one year.
The capital market may be further divided into (a) industrial securities market (b) Govt. securities
market and (c) long-term loans market.
o Equity markets: A market where ownership of securities are issued and subscribed is known as
equity market. An example of a secondary equity market for shares is the New York (NYSE)
stock exchange.
o Debt market: The market where funds are borrowed and lent is known as debt market.
Arrangements are made in such a way that the borrowers agree to pay the lender the original
amount of the loan plus some specified amount of interest.
 Derivative markets: A market where financial instruments are derived and traded based on an
underlying asset such as commodities or stocks.
 Financial service market: A market that comprises participants such as commercial banks that provide
various financial services like ATM. Credit cards. Credit rating, stock broking etc. is known as financial
service market. Individuals and firms use financial services markets, to purchase services that enhance
the workings of debt and equity markets.
  Depository markets: A depository market consists of depository institutions (such as banks) that accept
deposits from individuals and firms and uses these funds to participate in the debt market, by giving
loans or purchasing other debt instruments such as treasury bills.
 Non-depository market: Non-depository market carry out various functions in financial markets
ranging from financial intermediary to selling, insurance etc. The various constituencies in non-
depositary markets are mutual funds, insurance companies, pension funds, brokerage firms etc.
Concept of Financial Market
In an economy, money flows in circles. One very important aspect of this is turning savings into investment.
Every business needs funds to get started and to run in the long term. These funds will be made available to
them through various functions of the financial market. Let us learn about the concept of the financial market.

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Classification of business

Basics of starting a business

Financial Market
When we talk about markets we think about a place to sell and buy goods and services. However, in reality, the
term has a much wider scope. A market is basically a sum total of demand and supply of any particular
commodity or service.

So a financial market is a market, or an arrangement or an institution that facilitates the exchange of financial
instruments and securities. These instruments include shares, stocks, bonds, debentures, commercial papers,
bills, cheques etc. The price of these instruments is determined by the laws of demand and supply in the market.

Concept of Financial Market

The Concept of Financial Market

To understand the structure and the importance of financial markets, we must first understand their role in our
economy. Now every economy has two basic sectors when it comes to funds – savings and investment. Savings
is what we refer to when individual households save money. And investment is the capital that industries
require to start and run their businesses.

Now the economy must provide a link between savings and investments. One obvious way to convert savings
into investment is via banks. Alternatively, savings can be turned into investments through financial markets.
Households will use their savings to buy financial instruments and commodities such as shares, stocks,
debentures etc. This is the whole concept of the financial market.

This way a financial market serves an allocative function and mobilize idle funds to be put to more productive
use. When the allocation of funds is done well, there are some added benefits, such as

The rate of return on their savings will be higher for householders, than what a bank offers.
The resources will be invested in firms that have high productivity and show great promise in the economy.
Functions of Financial Markets
1] Mobilizing Funds
In a successful economy, money should never sit idle. Investors that have savings must be linked with industries
that require investment. So financial markets will enable this transaction, where investors can invest their
savings according to their choices and risk assessment. This will utilize idle funds and the economy will boom.

2] Price Determination
The financial commodities traded in a financial market get their prices from the rules of demand and supply.
The investors or the household are the suppliers of the funds, and the industries are the ones demanding them.
The interaction between the two and other market factors will help determine the prices.

3] Liquidity
The instruments sold in the financial market tend to have high liquidity. This means at any given time the
investors can sell their financial commodities and convert them to cash in a very short period. This is an
important factor for investors who do not want to invest long term.

4] Easy Access
Both investors and industries need each other. The financial market provides a platform where both the buyers
and sellers can find each other easily without spending too much time, money or effort.

Solved Question for You

Q: Banking and Financial markets are competing financial intermediaries. True or False?

Ans: The above statement is True. Both banks and financial markets provide households with an option on what
to do with their savings, They can deposit the money in a bank or buy financial instruments directly. Both will
ultimately lead to allocation of funds, but these two are the two major competing mechanisms through which
that happens.
An Introduction to the Financial Markets
Make Financial Markets Work for You
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•••
BY KIMBERLY AMADEO

Updated June 25, 2019

What are the financial markets? It can be confusing because they go by many terms. They
include capital markets, Wall Street, and even simply "the markets.” Whatever you call them, financial markets
are where traders buy and sell assets. These include stocks, bonds, derivatives, foreign exchange, and
commodities. The markets are where businesses go to raise cash to grow. It’s where companies reduce risks and
investors make money.
Types of Financial Markets
The Stock Market is a series of exchanges where successful corporations go to raise large amounts of cash to
expand. Stocks are shares of ownership of a public corporation that are sold to investors through broker-dealers.
The investors profit when the companies increase their earnings. This keeps the U.S. economy growing. It's
easy to buy stocks, but it takes a lot of knowledge to buy stocks in the right company.
To a lot of people, the Dow is the stock market. The Dow--the nickname for the Dow Jones Industrial Average-
-is just one way of tracking the performance of a group of stocks. There is also the Dow
Jones Transportation Average and the Dow Jones Utilities Average. Many investors ignore the Dow and
instead focus on the S&P 500 or other indices to track the progress of the stock market. The stocks that make up
these averages are traded on the world's stock exchanges, two of which include the New York Stock
Exchange and the NASDAQ.
How the stock market works depends on the actions and decisions of both buyers and sellers concerning their
perceptions on profitabilities of the companies being traded.
Mutual funds give you the ability to buy a lot of stocks at once. In a way, this makes them an easier tool to
invest in than individual stocks. By reducing stock market volatility, they have also had a calming effect on the
U.S. economy. Despite their benefits, you still need to learn how to select a good mutual fund.
The Bond Market is where organizations go to obtain very large loans. When stock prices go up, bond prices
go down. There are many different types of bonds, including Treasury Bonds, corporate bonds, and municipal
bonds. Bonds also provide some of the liquidity that keeps the U.S. economy functioning smoothly.
It's important to understand the relationship between Treasury bonds and Treasury bond yields. When Treasury
bond values go down, the yields go up to compensate. When Treasury yields rise, so do mortgage interest rates.
Even worse, when Treasury values decline, so does the value of the dollar. This makes import prices rise, which
can trigger inflation. Treasury yields can also predict the future. For example, an inverted yield curve heralds a
recession.
The Commodities Market is where companies offset their futures risks when buying or selling natural
resources. Since the prices of things like oil, corn, and gold are so volatile, companies can lock in a known price
today. Since these exchanges are public, many investors also trade in commodities for profit only. They have no
intention of purchasing large quantities of pork bellies, for example.
Oil is the most important commodity in the U.S. economy. It is used for transportation, industrial products,
plastics, heating, and electricity generation. When oil prices rise, you'll see the effect in gas prices about a week
later. If oil and gas prices stay high, you'll see the impact on food prices in about six weeks.
The commodities futures market determines the price of oil. What are futures? They are a way to pay for
something today that is delivered tomorrow. This removes some of the volatility in the U.S. economy. It allows
businesses to control future costs of the critical commodities they use every day.
Futures also increase a trader's leverage by allowing him or her to borrow the money to purchase the
commodity. This leverage can create outsize gains if traders guess right. It also magnifies the losses if traders
guess wrong. If enough traders guess wrong, it can have a huge impact on the U.S. economy, actually
increasing overall volatility. Commodities trading was responsible for record-high oil prices in 2008 and 2011,
which resulted in food riots and even the Arab Spring.
Another important commodity is gold. It's bought as a hedge against inflation. Gold prices also go up when
there is a lot of economic uncertainty in the world. In the past, every dollar could be traded in for its value in
gold. However, when the U.S. went off the gold standard, it lost this relationship to money. Still, many people
look at gold as a safer alternative to cash or currency.
Derivatives are complicated financial products that base their value on underlying assets. Sophisticated
investors and hedge funds use them to magnify their potential gains. In 2007, hedge funds increased in
popularity due to their supposed higher returns for high-end investors. Since hedge funds invest heavily in
futures, some argued they decreased the volatility of the stock market and, therefore, the U.S. economy. The
hedge fund investments in subprime mortgages and other derivatives caused the 2008 global financial crisis.
Even before this, hedge funds had demonstrated their risky nature. In 1997, the world's largest hedge fund at the
time, Long Term Capital Management, practically brought down the U.S. economy.
Forex Trading is a decentralized global market in which currencies are bought and sold. More than $5.3 trillion
are traded per day, and 87 percent involves the U.S. dollar. Almost one-fourth of the trades are done
by banks for their customers to reduce the volatility of doing business overseas. Hedge funds are responsible for
another 11 percent, and some of it is speculative. This market affects exchange rates and, thus, the value of the
dollar and other currencies. Exchange rates work on the basis of demand and supply of a nation’s currency, as
well as of that nation’s economic and financial stability.
Functions of Financial Markets
Financial markets create an open and regulated system for companies to acquire large amounts of capital. This
is done through the stock and bond markets. Markets also allow these businesses to offset risk. They do this
with commodities, foreign exchange futures contracts, and other derivatives.
Since the markets are public, they provide an open and transparent way to set prices on everything traded. They
reflect all available knowledge about everything traded. This reduces the cost of obtaining information because
it's already incorporated into the price.
The sheer size of the financial markets provides liquidity. In other words, sellers can unload assets whenever
they need to raise cash. The size also reduces the cost of doing business. Companies don't have to go far to find
a buyer or someone willing to sell.
Financial Market Definition
REVIEWED BY WILL KENTON

Updated Apr 13, 2019

What Is a Financial Market?
A financial market is a broad term describing any marketplace where trading of securities including equities,
bonds, currencies, and derivatives occur. Some financial markets are small with little activity, while some
financial markets like the New York Stock Exchange (NYSE) trade trillions of dollars of securities daily.
Volume 75%

1:42
Financial Market
Understanding the Financial Market
Financial market prices may not indicate the true intrinsic value of a stock due to macroeconomic forces like
taxes. In addition, the prices of securities are heavily reliant on informational transparency to ensure efficient
and appropriate prices are set by the market.
The stock market is a financial market that enables investors to buy and sell shares of publicly traded
companies. The primary stock market is where new issues of stocks are first offered. Any subsequent trading of
stock securities occurs in the secondary market.

Some financial markets are small with little activity, while some financial markets like the NYSE trade trillions
of dollars of securities daily.
Types of Financial Markets
Over-the-Counter Markets
The over-the-counter (OTC) market is an example of a secondary market. An OTC market handles the
exchanging of public stocks not listed on the NASDAQ, New York Stock Exchange or American Stock
Exchange. Companies with stocks trading on the OTC market are usually smaller organizations, as this
financial market requires less regulation and is less expensive to be traded on.
Financial Markets for Bonds
A bond is a security in which an investor loans money for a defined period of time at a pre-established rate of
interest. Bonds are not only issued by corporations but may also be issued by municipalities, states, and federal
governments from around the world. Also referred to as the debt, credit or fixed-income market, the bond
market sells securities such as notes and bills issued from the United States Treasury.
Money Markets
A money market is a portion of the financial market that trades highly liquid and short-term maturities. The
intention of the money market is for short-term borrowing and lending of securities with a maturity typically
less than one year. This financial market trades certificates of deposit, banker’s acceptances, certain bills, notes,
and commercial paper.
Derivatives Market
The derivatives market is a financial market that trades securities that derive its value from its underlying asset.
The value of a derivative contract is determined by the market price of the underlying item. This financial
market trades derivatives including forward contracts, futures, options, swaps, and contracts-for-difference.
Forex Market
The forex market is a financial market where currencies are traded. This financial market is the most liquid
market in the world, as cash is the most liquid of assets. The interbank market is the financial system that trades
currency between banks.
KEY TAKEAWAYS
 "Financial market" is a broad term, and there are many kinds of financial markets, including (but not
limited to) forex, money, stock, and bond markets.
 Some financial markets are small with little activity, while some financial markets like the New York
Stock Exchange (NYSE) trade trillions of dollars of securities daily.
 Financial market prices may not indicate the true intrinsic value of a stock due to macroeconomic forces
like taxes.
Related Terms
Over-The-Counter – OTC
Over-The-Counter (OTC) trades refer to securities transacted via a dealer network as opposed to on a
centralized exchange such as the New York Stock Exchange (NYSE). These securities do not meet the
requirements to have a listing on a standard market exchange.
more
A Review of Pink Sheet Stocks and How Investors Can Trade Them
Pink sheets refer to a listing service for stocks that trade over-the-counter (OTC). Pink sheet companies are not
usually listed on a major exchange. The Securities and Exchange Commission (SEC) does not regulate the pink
sheet filing requirements.
more
Stock Market | Investopedia
The stock market consists of exchanges or OTC markets in which shares and other financial securities of
publicly held companies are issued and traded.
more
Trading Session Definition
A trading session is measured from the opening bell to the closing bell during a single day of business within a
given financial market.
more
Forex Market Definition
The forex market is the market in which participants including banks, funds, and individuals can buy or sell
currencies for both hedging and speculative purposes.
more
Forward Market
A forward market is an over-the-counter marketplace that sets the price of a financial instrument or asset for
future delivery. Forward markets are used for trading a range of instruments, but the term is primarily used with
reference to the foreign exchange market.
more
LEONARDO DA VINCI Transfer of Innovation VALDONĖ DARŠKUVIENĖ Vytautas Magnus University
Financial Markets Leonardo da Vinci programme project „Development and Approbation of Applied Courses
Based on the Transfer of Teaching Innovations in Finance and Management for Further Education of
Entrepreneurs and Specialists in Latvia, Lithuania and Bulgaria” 2010 2 TABLE OF CONTENTS Table of
contents............................................................................................................... 2 Introduction
...................................................................................................................... 5 1. FINANCIAL MARKETS:
STRUCTURE AND ROLE IN THE FINANCIAL
SYSTEM.......................................................................................................................... 6 1.1. Financial system
structure and functions............................................................ 6 1.2. Financial markets and their economic
functions................................................. 7 1.3. Financial intermediaries and their
functions....................................................... 9 1.4. Financial markets structure
.............................................................................. 11 1.4.1. Financial
instruments............................................................................... 11 1.4.2. Classification of financial markets
........................................................... 13 1.5. Financial market regulation
............................................................................. 14 1.6.
Summary......................................................................................................... 15 Key
terms.................................................................................................................... 15 Further
readings.......................................................................................................... 16 Review questions and problems
.................................................................................. 16 2. INTEREST RATES DETERMINATION AND
STRUCTURE............................... 17 2.1. Interest rate determination
............................................................................... 17 2.1.1. The rate of interest
................................................................................... 17 2.1.2. Interest rate theories: loanable funds theory
............................................. 19 2.1.3. Interest rate theories: liquidity preference theory......................................
20 2.2. The structure of interest rates........................................................................... 20 2.3. Term structure of
interest rates......................................................................... 22 2.4. Theories of term structure of interest
rates....................................................... 22 2.4.1. Expectations
theory.................................................................................. 23 2.4.2. Liquidity premium theory
........................................................................ 25 2.4.3. Market segmentation
theory..................................................................... 26 2.4.4. The preferred habitat
theory..................................................................... 26 2.5. Forward interest rates and yield
curve.............................................................. 26 2.6.
Summary......................................................................................................... 29 Key
terms.................................................................................................................... 29 Further
readings.......................................................................................................... 30 Relevant
websites........................................................................................................ 30 Review questions and problems
.................................................................................. 30 3. MONEY MARKETS
.............................................................................................. 33 3.1. Money market purpose and structure
............................................................... 33 3.1.1. The role of money
markets....................................................................... 33 3.1.2. Money market segments
.......................................................................... 34 3.1.3. Money market
participants....................................................................... 36 3.2. Money market instruments
.............................................................................. 37 3.2.1. Treasury bills and other government
securities......................................... 37 3.2.2. The interbank market
loans...................................................................... 42 3.2.3. Commercial papers
.................................................................................. 43 3.2.4. Certificates of deposit
.............................................................................. 45 3.2.5. Repurchase
agreements............................................................................ 46 3.2.6. International money market
securities...................................................... 49 3.3. Money market interest rates and yields
............................................................ 51 3.4.
Summary......................................................................................................... 54 Key
terms.................................................................................................................... 54 3 Further
readings.......................................................................................................... 54 Relevant
websites........................................................................................................ 55 Review questions and problems
.................................................................................. 55 4. DEBT MARKETS
.................................................................................................. 57 4.1. Debt market instrument characteristics
............................................................ 57 4.2. Bond
market.................................................................................................... 59 4.2.1. Bond market characteristics
..................................................................... 59 4.2.2. Bond market
yields.................................................................................. 60 4.3. Bond valuation
................................................................................................ 61 4.3.1. Discounted
models................................................................................... 61 4.3.2. Bond duration and
risk............................................................................. 63 4.3.3. Bond price volatility
................................................................................ 63 4.3.4. Behavior of Macaulay’s duration
............................................................. 65 4.3.5.
Immunization........................................................................................... 65 4.3.6. Bond
convexity........................................................................................ 65 4.4. Bond analysis
.................................................................................................. 67 4.4.1. Inverse floaters and floating rate
notes..................................................... 67 4.4.2. Callable bonds
......................................................................................... 67 4.4.3. Convertible
bonds.................................................................................... 69 4.5.
Summary......................................................................................................... 70 Key
terms.................................................................................................................... 71 Further
readings.......................................................................................................... 71 Review questions and problems
.................................................................................. 71 5. EQUITY MARKET
................................................................................................ 73 5.1. Equity
instruments........................................................................................... 74 5.1.1. Common shares
....................................................................................... 74 5.1.2. Preferred shares
....................................................................................... 75 5.1.3. Private
equity........................................................................................... 77 5.1.4. Global shares and American
Depository Receipts (ADR)......................... 78 5.2. Primary equity market
..................................................................................... 80 5.2.1. Primary public
market.............................................................................. 80 5.3. Secondary equity market
................................................................................. 83 5.3.1. Organized
exchanges............................................................................... 84 5.3.2. Over-the-counter (OTC)
market............................................................... 86 5.3.3. Electronic stock
markets.......................................................................... 87 5.4. Secondary equity market structure
................................................................... 88 5.4.1. Cash vs forward
markets.......................................................................... 89 5.4.2. Continuous markets and auction markets
................................................. 89 5.4.3. Order-driven markets and quote-driven
markets....................................... 89 5.4.4. Hybrid
markets........................................................................................ 91 5.5. Equity market
transactions............................................................................... 91 5.5.1. Bid-ask spread
......................................................................................... 91 5.5.2. Placing
order............................................................................................ 93 5.5.3. Margin trading
......................................................................................... 95 5.5.4. Short
selling............................................................................................. 97 5.5.5. Stock trading
regulations.......................................................................... 98 5.6. Equity market
characteristics......................................................................... 100 5.6.1. Stock indicators
..................................................................................... 100 5.6.2. Stock market
indexes............................................................................. 100 5.6.3. Stock market
indicators.......................................................................... 103 5.6.4. Transaction execution
costs.................................................................... 104 5.7. Stock market efficiency
................................................................................. 106 4 5.8. Stock
valuation.............................................................................................. 109 5.8.1. Fundamental
analysis............................................................................. 109 5.8.2. Technical
analysis.................................................................................. 110 5.9. Processes of consolidation of stock
exchanges............................................... 114 5.10. Summary
................................................................................................... 115 Key
terms.................................................................................................................. 116 Further
readings........................................................................................................ 116 Relevant
websites...................................................................................................... 117 Review questions and problems
................................................................................ 118 6. DERIVATIVES
MARKETS................................................................................. 120 6.1. Hedging against risk
...................................................................................... 120 6.2. Description of derivatives
markets................................................................. 120 6.3. Forward and futures
contracts........................................................................ 122 6.3.1. Principles of forward and futures
contracts............................................. 122 6.3.2. Forward and futures
valuation................................................................ 124 6.3.3. Use of forwards and futures
................................................................... 127 6.3.4. Futures contracts: stock index
futures..................................................... 129 6.3.5. Contracts for difference (CFD)
.............................................................. 130 6.4.
Swaps............................................................................................................ 131 6.5.
Options.......................................................................................................... 132 6.5.1. Options definition
.................................................................................. 132 6.5.2. Components of the Option Price
............................................................ 135 6.5.3. Determinants of the Option Price
........................................................... 136 6.5.4. Option pricing
models............................................................................ 138 6.5.5. Mixed strategies in options
trading......................................................... 139 6.6.
Summary....................................................................................................... 139 Key
terms.................................................................................................................. 140 Review questions and
problems ................................................................................ 140 5 INTRODUCTION Motivation for
developing the course Research by the members of the project consortium Employers’ Confederation of Latvia
and Bulgarian Chamber of Commerce and Industry indicated the need for further education courses in the field
of finance and managerial decision making. Innovative content of the course The course has been developed to
include the following innovative content:  Key concepts of financial markets, which are explained from an
applied perspective, including with examples and problems from current financial markets practices from EU
integration and development perspective;  Analytical techniques to be applied in financial markets provide
with understanding and tools to decision makers in the firm;  Applied exercises, which cover topics such as
money market, debt market, equity market instruments, as well as decision making rules in the financial
markets;  Summaries are provided at the end of every chapter, which aid revision and control of knowledge
acquisition during self-study; Innovative teaching methods of the course The course is developed to utilise the
following innovative teaching methods:  Availability on the electronic platform with interactive learning and
interactive evaluation methods;  Active use of case studies and participant centred learning;  Availability in
modular form;  Utilising two forms of learning - self-study and tutorial consultations;  Availability in several
languages simultaneously. Target audience for the course The target audience are: entrepreneurs, finance and
management specialists from Latvia, Lithuania and Bulgaria and, in the longer term, similar groups in any other
European country. The course assumes little prior applied knowledge in the area of financial and operation
analysis. The course is intended for 32 academic hours (2 credit points). Course objective The objective of the
course is to provide entrepreneurs with the knowledge in the area of financial markets, specific financial market
instruments, behavior in order to enable them to understand the financial markets processes and their factors,
and to make successfully financial decisions on the individual as well as company level. 6 1. FINANCIAL
MARKETS: STRUCTURE AND ROLE IN THE FINANCIAL SYSTEM Mini contents  The structure of a
financial system  Functions of a financial system  The structure and key features of financial markets  The
key features of financial intermediaries  Major financial market participants 1.1. Financial system structure and
functions The financial system plays the key role in the economy by stimulating economic growth, influencing
economic performance of the actors, affecting economic welfare. This is achieved by financial infrastructure, in
which entities with funds allocate those funds to those who have potentially more productive ways to invest
those funds. A financial system makes it possible a more efficient transfer of funds. As one party of the
transaction may possess superior information than the other party, it can lead to the information asymmetry
problem and inefficient allocation of financial resources. By overcoming the information asymmetry problem
the financial system facilitates balance between those with funds to invest and those needing funds. According
to the structural approach, the financial system of an economy consists of three main components: 1) financial
markets; 2) financial intermediaries (institutions); 3) financial regulators. Each of the components plays a
specific role in the economy. According to the functional approach, financial markets facilitate the flow of
funds in order to finance investments by corporations, governments and individuals. Financial institutions are
the key players in the financial markets as they perform the function of intermediation and thus determine the
flow of funds. The financial regulators perform the role of monitoring and regulating the participants in the
financial system. Figure 1. The structure of financial system Firms Stock market Bond market Short term fixed
securities market Banking sector Governments 7 Financial markets studies, based on capital market theory,
focus on the financial system, the structure of interest rates, and the pricing of financial assets. An asset is any
resource that is expected to provide future benefits, and thus possesses economic value. Assets are divided into
two categories: tangible assets with physical properties and intangible assets. An intangible asset represents a
legal claim to some future economic benefits. The value of an intangible asset bears no relation to the form,
physical or otherwise, in which the claims are recorded. Financial assets, often called financial instruments, are
intangible assets, which are expected to provide future benefits in the form of a claim to future cash. Some
financial instruments are called securities and generally include stocks and bonds. Any transaction related to
financial instrument includes at least two parties: 1) the party that has agreed to make future cash payments and
is called the issuer; 2) the party that owns the financial instrument, and therefore the right to receive the
payments made by the issuer, is called the investor. Financial assets provide the following key economic
functions.  they allow the transfer of funds from those entities, who have surplus funds to invest to those who
need funds to invest in tangible assets;  they redistribute the unavoidable risk related to cash generation among
deficit and surplus economic units. The claims held by the final wealth holders generally differ from the
liabilities issued by those entities who demand those funds. They role is performed by the specific entities
operating in financial systems, called financial intermediaries. The latter ones transform the final liabilities into
different financial assets preferred by the public. 1.2. Financial markets and their economic functions A
financial market is a market where financial instruments are exchanged or traded. Financial markets provide the
following three major economic functions: 1) Price discovery 2) Liquidity 3) Reduction of transaction costs 1)
Price discovery function means that transactions between buyers and sellers of financial instruments in a
financial market determine the price of the traded asset. At the same time the required return from the
investment of funds is determined by the participants in a financial market. The motivation for those seeking
funds (deficit units) depends on the required return that investors demand. It is these functions of financial
markets that signal how the funds available from those who want to lend or invest funds will be allocated
among those needing funds and raise those funds by issuing financial instruments. 2) Liquidity function
provides an opportunity for investors to sell a financial instrument, since it is referred to as a measure of the
ability to sell an asset at its fair market value at any time. Without liquidity, an investor would be forced to hold
a financial instrument until conditions arise to sell it or the issuer is contractually obligated to pay it off. Debt
instrument is liquidated when it matures, and equity instrument is until the company is 8 either voluntarily or
involuntarily liquidated. All financial markets provide some form of liquidity. However, different financial
markets are characterized by the degree of liquidity. 3) The function of reduction of transaction costs is
performed, when financial market participants are charged and/or bear the costs of trading a financial
instrument. In market economies the economic rationale for the existence of institutions and instruments is
related to transaction costs, thus the surviving institutions and instruments are those that have the lowest
transaction costs. The key attributes determining transaction costs are  asset specificity,  uncertainty, 
frequency of occurrence. Asset specificity is related to the way transaction is organized and executed. It is lower
when an asset can be easily put to alternative use, can be deployed for different tasks without significant costs.
Transactions are also related to uncertainty, which has (1) external sources (when events change beyond control
of the contracting parties), and (2) depends on opportunistic behavior of the contracting parties. If changes in
external events are readily verifiable, then it is possible to make adaptations to original contracts, taking into
account problems caused by external uncertainty. In this case there is a possibility to control transaction costs.
However, when circumstances are not easily observable, opportunism creates incentives for contracting parties
to review the initial contract and creates moral hazard problems. The higher the uncertainty, the more
opportunistic behavior may be observed, and the higher transaction costs may be born. Frequency of occurrence
plays an important role in determining if a transaction should take place within the market or within the firm. A
one-time transaction may reduce costs when it is executed in the market. Conversely, frequent transactions
require detailed contracting and should take place within a firm in order to reduce the costs. When assets are
specific, transactions are frequent, and there are significant uncertainties intra-firm transactions may be the least
costly. And, vice versa, if assets are non-specific, transactions are infrequent, and there are no significant
uncertainties least costly may be market transactions. The mentioned attributes of transactions and the
underlying incentive problems are related to behavioural assumptions about the transacting parties. The
economists (Coase (1932, 1960, 1988), Williamson (1975, 1985), Akerlof (1971) and others) have contributed
to transactions costs economics by analyzing behaviour of the human beings, assumed generally self-serving
and rational in their conduct, and also behaving opportunistically. Opportunistic behaviour was understood as
involving actions with incomplete and distorted information that may intentionally mislead the other party. This
type of behavior requires efforts of ex ante screening of transaction parties, and ex post safeguards as well as
mutual restraint among the parties, which leads to specific transaction costs. Transaction costs are classified
into: 1) costs of search and information, 2) costs of contracting and monitoring, 3) costs of incentive problems
between buyers and sellers of financial assets. 1) Costs of search and information are defined in the following
way: 9  search costs fall into categories of explicit costs and implicit costs. Explicit costs include expenses that
may be needed to advertise one’s intention to sell or purchase a financial instrument. Implicit costs include the
value of time spent in locating counterparty to the transaction. The presence of an organized financial market
reduces search costs.  information costs are associated with assessing a financial instrument’s investment
attributes. In a price efficient market, prices reflect the aggregate information collected by all market
participants. 2) Costs of contracting and monitoring are related to the costs necessary to resolve information
asymmetry problems, when the two parties entering into the transaction possess limited information on each
other and seek to ensure that the transaction obligations are fulfilled. 3) Costs of incentive problems between
buyers and sellers arise, when there are conflicts of interest between the two parties, having different incentives
for the transactions involving financial assets. The functions of a market are performed by its diverse
participants. The participants in financial markets can be also classified into various groups, according to their
motive for trading:  Public investors, who ultimately own the securities and who are motivated by the returns
from holding the securities. Public investors include private individuals and institutional investors, such as
pension funds and mutual funds.  Brokers, who act as agents for public investors and who are motivated by the
remuneration received (typically in the form of commission fees) for the services they provide. Brokers thus
trade for others and not on their own account.  Dealers, who do trade on their own account but whose primary
motive is to profit from trading rather than from holding securities. Typically, dealers obtain their return from
the differences between the prices at which they buy and sell the security over short intervals of time.  Credit
rating agencies (CRAs) that assess the credit risk of borrowers. In reality three groups are not mutually
exclusive. Some public investors may occasionally act on behalf of others; brokers may act as dealers and hold
securities on their own, while dealers often hold securities in excess of the inventories needed to facilitate their
trading activities. The role of these three groups differs according to the trading mechanism adopted by a
financial market. 1.3. Financial intermediaries and their functions Financial intermediary is a special financial
entity, which performs the role of efficient allocation of funds, when there are conditions that make it difficult
for lenders or investors of funds to deal directly with borrowers of funds in financial markets. Financial
intermediaries include depository institutions, insurance companies, regulated investment companies,
investment banks, pension funds. The role of financial intermediaries is to create more favourable transaction
terms than could be realized by lenders/investors and borrowers dealing directly with each other in the financial
market. The financial intermediaries are engaged in: 10  obtaining funds from lenders or investors and 
lending or investing the funds that they borrow to those who need funds. The funds that a financial intermediary
acquires become, depending on the financial claim, either the liability of the financial intermediary or equity
participants of the financial intermediary. The funds that a financial intermediary lends or invests become the
asset of the financial intermediary. Financial intermediaries are engaged in transformation of financial assets,
which are less desirable for a large part of the investing public into other financial assets—their own
liabilities—which are more widely preferred by the public. Asset transformation provides at least one of three
economic functions:  Maturity intermediation.  Risk reduction via diversification.  Cost reduction for
contracting and information processing. Figure 2. Comparison of roles among financial institutions Source:
Madura J. (2008). Financial Institutions and Markets, Eight Edition These economic functions are performed by
financial market participants while providing the special financial services (e.g. the first and second functions
can be performed by brokers, dealers and market makers. The third function is related to the service of
underwriting of securities). Other services that can be provided by financial intermediaries include: 
Facilitating the trading of financial assets for the financial intermediary’s customers through brokering
arrangements. Surplus Units Policyholders Employers and Employees Depository Institutions (Commercial
Banks, Savings Institutions, Credit Unions) Finance Companies Mutual Funds Insurance Companies Pension
funds Deficit Units (Firms, Government, Agencies, Some Individuals) Deposits Purchase Securities Purchase
Shares Premium s Employee Contributions 11  Facilitating the trading of financial assets by using its own
capital to take a position in a financial asset the financial intermediary’s customer want to transact in. 
Assisting in the creation of financial assets for its customers and then either distributing those financial assets to
other market participants.  Providing investment advice to customers.  Manage the financial assets of
customers.  Providing a payment mechanism. 1.4. Financial markets structure 1.4.1. Financial instruments
There is a great variety of financial instrument in the financial marketplace. The use of these instruments by
major market participants depends upon their offered risk and return characteristics, as well as availability in
retail or wholesale markets. The general view on the financial instrument categories is provided in Table 1.
Table 1. Financial instrument categories Category Risk determinants Expected returns Main participants
Nontradables and nontransferables In wholesale money markets: transaction volumes In wholesale money
markets: low In wholesale money markets: banks In retail markets: low transparency, lack of standardisation,
low creditworthiness In credit markets: low In retail markets: banks and non-bank firms and households In
foreign exchange markets: high volatility, change of currency In foreign exchange markets: high In foreign
exchange markets: financial institutions, companies Securities Market volatility, individual risks and failures
Comparably high Banks and non-bank firms, individuals Derivatives Market volatility, leverage Very high
Banks and non-bank firms, individuals Source: Reszat B. (2008). European Financial Systems in the Global
Economy A financial instrument can be classified by the type of claims that the investor has on the issuer. A
financial instrument in which the issuer agrees to pay the investor interest plus repay the amount borrowed is a
debt instrument. A debt instrument also referred to as an instrument of indebtedness, can be in the form of a
note, bond, or loan. The interest payments that must be made by the issuer are fixed contractually. For example,
in the case of a debt instrument that is required to make payments in Euros, the amount can be a fixed Euro
amount or it can vary depending upon some benchmark. The investor in a debt instrument can realize no more
than the contractual amount. For this reason, debt instruments are often called fixed income instruments. 12
Fixed income instruments forma a wide and diversified fixed income market. The key characteristics of it is
provided in Table 2. Table 2.Fixed-income market Market Features Issuers Long term Bonds Long-term
obligations to make a series of fixed payments Governments, firms Convertibles Bonds that can be swapped for
equity at pre-specified conditions Firms Asset-backed securities Securitised “receivables” presenting future
streams of payments Financial institutions, firms Preferred stock, subordinated debt Debt and equity hybrids
Firms Medium term Notes Medium-term obligations Governments Floating-rate notes Medium-term
instruments with interest rates based on LIBOR or another index Firms Short term Bills Short-term obligations
Governments Commercial paper Short-term debt instruments Firms Certificates of deposit Short-term debt
instruments Banks Source: Reszat B. (2008). European Financial Systems in the Global Economy In contrast to
a debt obligation, an equity instrument specifies that the issuer pays the investor an amount based on earnings, if
any, after the obligations that the issuer is required to make to investors of the firm’s debt instruments have been
paid. Common stock is an example of equity instruments. Some financial instruments due to their
characteristics can be viewed as a mix of debt and equity. Preferred stock is a financial instrument, which has
the attribute of a debt because typically the investor is only entitled to receive a fixed contractual amount.
However, it is similar to an equity instrument because the payment is only made after payments to the investors
in the firm’s debt instruments are satisfied. Another “combination” instrument is a convertible bond, which
allows the investor to convert debt into equity under certain circumstances. Because preferred stockholders
typically are entitled to a fixed contractual amount, preferred stock is referred to as a fixed income instrument.
Hence, fixed income instruments include debt instruments and preferred stock. The features of debt and equity
instruments are contrasted in Table 3. The classification of debt and equity is especially important for two legal
reasons. First, in the case of a bankruptcy of the issuer, investor in debt instruments has a priority on the 13
claim on the issuer’s assets over equity investors. Second, the tax treatment of the payments by the issuer can
differ depending on the type of financial instrument class. Table 3. Debt versus equity Debt Equity
Characteristic Borrower-lender relation, fixed maturities Ownership, no time limit Advantages:  for the firm
Predictability, independence from shareholders’ influence Flexibility, low cost of finance, reputation  for the
investor Low risk High expected return Disadvantages:  for the firm Debt servicing obligation Shareholder
dependence, shortsightedness, market volatility influencing management decisions  for the investor Low
returns High risk Source: Reszat B. (2008). European Financial Systems in the Global Economy 1.4.2.
Classification of financial markets There different ways to classify financial markets. They are classified
according to the financial instruments they are trading, features of services they provide, trading procedures,
key market participants, as well as the origin of the markets. The generalized financial market classification is
given in Table 4. Table 4. Financial market classification Criterion Features Examples Products Tradability,
transferability, ownership, maturity, denomination, substance Equity, debt instruments, derivatives Services
Technical, advisory, information and knowledgebased, administrative IT support, research and analysis, custody
Ways of trading Physical, electronic, virtual Over the counter, exchange, internet Participants Professionals,
nonprofessionals, institutions, officials Banks, central banks, non-bank financial companies, institutional
investors, business firms, households Origin Domestic, cross-border, regional, international National markets,
regionally integrated markets, Euromarkets, domestic/foreign currency markets, onshore/offshore markets
Source: Reszat B. (2008). European Financial Systems in the Global Economy. 14 From the perspective of
country origin, its financial market can be broken down into an internal market and an external market. The
internal market, also called the national market, consists of two parts: the domestic market and the foreign
market. The domestic market is where issuers domiciled in the country issue securities and where those
securities are subsequently traded. The foreign market is where securities are sold and traded outside the
country of issuers. External market is the market where securities with the following two distinguishing features
are trading: 1) at issuance they are offered simultaneously to investors in a number of countries; and 2) they are
issued outside the jurisdiction of any single country. The external market is also referred to as the international
market, offshore market, and the Euromarket (despite the fact that this market is not limited to Europe). Money
market is the sector of the financial market that includes financial instruments that have a maturity or
redemption date that is one year or less at the time of issuance. These are mainly wholesale markets. The capital
market is the sector of the financial market where long-term financial instruments issued by corporations and
governments trade. Here “long-term” refers to a financial instrument with an original maturity greater than one
year and perpetual securities (those with no maturity). There are two types of capital market securities: those
that represent shares of ownership interest, also called equity, issued by corporations, and those that represent
indebtedness, or debt issued by corporations and by the state and local governments. Financial markets can be
classified in terms of cash market and derivative markets. The cash market, also referred to as the spot market,
is the market for the immediate purchase and sale of a financial instrument. In contrast, some financial
instruments are contracts that specify that the contract holder has either the obligation or the choice to buy or
sell another something at or by some future date. The “something” that is the subject of the contract is called the
underlying (asset). The underlying asset is a stock, a bond, a financial index, an interest rate, a currency, or a
commodity. Because the price of such contracts derive their value from the value of the underlying assets, these
contracts are called derivative instruments and the market where they are traded is called the derivatives market.
When a financial instrument is first issued, it is sold in the primary market. A secondary market is such in which
financial instruments are resold among investors. No new capital is raised by the issuer of the security. Trading
takes place among investors. Secondary markets are also classified in terms of organized stock exchanges and
over-thecounter (OTC) markets. Stock exchanges are central trading locations where financial instruments are
traded. In contrast, an OTC market is generally where unlisted financial instruments are traded. 1.5. Financial
market regulation In general, financial market regulation is aimed to ensure the fair treatment of participants.
Many regulations have been enacted in response to fraudulent practices. One of the key aims of regulation is to
ensure business disclosure of accurate information for investment decision making. When information is
disclosed only to limited set of investors, those have major advantages over other groups of investors. Thus
regulatory framework has to provide the equal access to disclosures by companies. The recent regulations were
passed 15 in response to large bankruptcies, overhauled corporate governance, in order to strengthen the role of
auditors in overseeing accounting procedures. The Sorbanes-Oxley Act of 2002 in US was designed particularly
to tighten companies’ governance after dotcom bust and Enron’s Bankruptcy. It had direct consequences
internationally, first of all through global companies. The US Wall Street Reform and Consumer Protection Act
(Dodd-Frank) of 2010 aims at imposing tighter financial regulation for the financial markets and financial
intermediaries in US, in order to ensure consumer protection. This is in tune with major financial regulation
system development in EU and other parts of the world. 1.6. Summary The financial system of an economy
consists of three components: (1) Financial markets; (2) financial intermediaries; and (3) financial regulators.
The main function of the system is to channel funds between the two groups of end users of the system: from
lenders (‘surplus units’) to borrowers (‘deficit units’). Besides, a financial system provides payments facilities, a
variety of services such as insurance, pensions and foreign exchange, together with facilities which allow
people to adjust their existing wealth portfolios. Apart from direct borrowing and lending between end-users,
borrowing and lending through intermediaries and organized markets have important advantages. These include
transforming the maturity of short-term savings into longer-term loans, reduction of risk and controlling
transaction costs. The field of financial markets and its theoretical foundations is based on the study of the
financial system, the structure of interest rates, and the pricing of risky assets. The major market players are
households, governments, nonfinancial corporations, depository institutions, insurance companies, asset
management firms, investment banks, nonprofit organizations, and foreign investors. Financial markets are
classified into internal versus external markets, capital markets versus money markets, cash versus derivative
markets, primary versus secondary markets, private placement versus public markets, exchange-traded versus
over-the-counter markets. The financial markets and intermediaries are subject to financial regulators. The
recent changes in the regulatory system are happening in response to the problems in the credit markets and
financial crisis that struck 2008. Key terms  Financial system  Financial markets  Money markets  Capital
markets  Debt markets  Derivative markets 16 Further readings 1. European Commission (2007). European
Financial Integration Report 2007, EC, Brussels. 2. Fabozzi F. J., Modigliani F., (2007). Capital Markets:
Institutions and Instruments. Prentice-Hall International. 3. Financial Stability Forum (2008). Report on
Enhancing Market and Institutional Resilience, FSF, Basel. 4. Howells P., Bain K. (2008). Financial Markets
and Institutions. Financial Times, Prentice Hall. 5. Madura J. (2008). Financial Markets and Institutions.
Prentice-Hall International. 6. Mishkin F. S., Eakins S. G. (2006). Financial Markets and Institutions. Addison-
Wesley. 7. Seifert, W.G., Schleitner, A.K., Mattern, F., Streit, C.C., Voth, H.J. (2000). European Capital
Markets, Macmillan. 8. Valdez, S. (2006). Introduction to Global Financial Markets, Palgrave Macmillan.
Review questions and problems 1. What are the functions of a financial system? 2. Distinguish the difference
between deficit and surplus units. 3. What is the difference between ‘saving’ and a ‘financial surplus’? 4.
Discuss the advantages to deficit and surplus units of using organized financial markets and financial
intermediaries. 5. How are financial intermediaries able to engage in maturity transformation? 6. Explain briefly
the difference between deposit-taking and non-deposit-taking intermediaries. 7. Why do people simultaneously
hold financial assets and liabilities? 8. Why is the average size of broker/ dealer operations in general smaller
than that of asset transformers? 17 2. INTEREST RATES DETERMINATION AND STRUCTURE Mini
contents  Interest rate determination  Loanable funds theory  Liquidity preference theory  Level of interest
rates in the economy  Understanding of the term structure of interest rates  Theories of term structure of
interest rates  Spot rates and forwards rates  Yield curves For financing and investing decision making in a
dynamic financial environment of market participants, it is crucial to understand interest rates as one of the key
aspects of the financial environment. Several economic theories explain determinants of the level of interest
rates. Another group of theories explain the variety of interest rates and their term structure, i.e. relationship
between interest rates and the maturity of debt instruments. 2.1. Interest rate determination 2.1.1. The rate of
interest Interest rate is a rate of return paid by a borrower of funds to a lender of them, or a price paid by a
borrower for a service, the right to make use of funds for a specified period. Thus it is one form of yield on
financial instruments. Two questions are being raised by market participants:  What determines the average
rate of interest in an economy?  Why do interest rates differ on different types and lengths of loans and debt
instruments? Interest rates vary depending on borrowing or lending decision. There is interest rate at which
banks are lending (the offer rate) and interest rate they are paying for deposits (the bid rate). The difference
between them is called a spread. Such a spread also exists between selling and buying rates in local and
international money and capital markets. The spread between offer and bid rates provides a cover for
administrative costs of the financial intermediaries and includes their profit. The spread is influenced by the
degree of competition among financial institutions. In the short-term international money markets the spread is
lower if there is considerable competition. Conversely, the spread between banks borrowing and lending rates to
their retail customers is larger in general due to considerably larger degree of loan default risk. Thus the lending
rate (offer or ask rate) always includes a risk premium. Concept Risk premium is an addition to the interest rate
demanded by a lender to take into account the risk that the borrower might default on the loan entirely or may
not repay on time (default risk). 18 There are several factors that determine the risk premium for a non-
Government security, as compared with the Government security of the same maturity. These are (1) the
perceived creditworthiness of the issuer, (2) provisions of securities such as conversion provision, call
provision, put provision, (3) interest taxes, and (4) expected liquidity of a security’s issue. In order to explain
the determinants of interest rates in general, the economic theory assumes there is some particular interest rate,
as a representative of all interest rates in an economy. Such an interest rate usually depends upon the topic
considered, and can represented by e.g. interest rate on government short-term or long-term debt, or the base
interest rate of the commercial banks, or a short-term money market rate (EURIBOR). In such a case it is
assumed that the interest rate structure is stable and that all interest rates in the economy are likely to move in
the same direction. Concept Interest rate structure is the relationships between the various rates of interest in an
economy on financial instruments of different lengths (terms) or of different degrees of risk. The rates of
interest quoted by financial institutions are nominal rates, and are used to calculate interest payments to
borrowers and lenders. However, the loan repayments remain the same in money terms and make up a smaller
and smaller proportion of the borrower’s income. The real cost of the interest payments declines over time.
Therefore there is a real interest rate, i.e. the rate of interest adjusted to take into account the rate of inflation.
Since the real rate of return to the lender can be also falling over time, the lender determines interest rates to
take into account the expected rate of inflation over the period of a loan. When there is uncertainty about the
real rate of return to be received by the lender, he will be inclined to lend at fixed interest rates for short-term.
The loan can be ‘rolled over’ at a newly set rate of interest to reflect changes in the expected rate of inflation.
On the other hand, lenders can set a floating interest rate, which is adjusted to the inflation rate changes.
Concept Real interest rate is the difference between the nominal rate of interest and the expected rate of
inflation. It is a measure of the anticipated opportunity cost of borrowing in terms of goods and services
forgone. The dependence between the real and nominal interest rates is expressed using the following equation:
i =(1+ r)(1+ i e ) - 1 where i is the nominal rate of interest, r is the real rate of interest and i e e is the expected
rate of inflation. Example Assume that a bank is providing a company with a loan of 1000 thous. Euro for one
year at a real rate of interest of 3 per cent. At the end of the year it expects to receive back 1030 thous. Euro of
purchasing power at current prices. However, if the bank expects a 10 per cent rate of inflation over the next
year, it will want 1133 thous. Euro back (10 per cent above 1030 thous. Euro). The interest rate required by the
bank would be 13.3 per cent i =(1+ 0,03)(1 + 0,1) - 1 = (1,03)(1,1) - 1 = 1,133 - 1=0,133 or 13,3 per cent 19
When simplified, the equation becomes: i = r + ie In the example, this would give 3 per cent plus 10 per cent
= 13 per cent. The real rate of return is thus: r = i - ie When assumption is made that r is stable over time, the
equation provides the Fisher effect. It suggests that changes in short-term interest rates occur because of
changes in the expected rate of inflation. If a further assumption is made that expectations about the rate of
inflation of market participants are correct, then the key reason for changes in interest rates is the changes in the
current rate of inflation. Borrowers and lenders think mostly in terms of real interest rates. There are two
economic theories explaining the level of real interest rates in an economy:  The loanable funds theory 
Liquidity preference theory 2.1.2. Interest rate theories: loanable funds theory In an economy, there is a supply
loanable funds (i.e., credit) in the capital market by households, business, and governments. The higher the level
of interest rates, the more such entities are willing to supply loan funds; the lower the level of interest, the less
they are willing to supply. These same entities demand loanable funds, demanding more when the level of
interest rates is low and less when interest rates are higher. The extent to which people are willing to postpone
consumption depends upon their time preference. Concept Time preference describes the extent to which a
person is willing to give up the satisfaction obtained from present consumption in return for increased
consumption in the future. The term ‘loanable funds’ simply refers to the sums of money offered for lending
and demanded by consumers and investors during a given period. The interest rate in the model is determined
by the interaction between potential borrowers and potential savers. Concept Loanable funds are funds
borrowed and lent in an economy during a specified period of time – the flow of money from surplus to deficit
units in the economy. The loanable funds theory was formulated by the Swedish economist Knut Wicksell in
the 1900s. According to him, the level of interest rates is determined by the supply and demand of loanable
funds available in an economy’s credit market (i.e., the sector of the capital markets for long-term debt
instruments). This theory suggests that investment and savings in the economy determine the level of long-term
interest rates. Short-term interest rates, however, are determined by an economy’s financial and monetary
conditions. According to the loanable funds theory for the economy as a whole: Demand for loanable funds =
net investment + net additions to liquid reserves Supply of loanable funds = net savings + increase in the money
supply Given the importance of loanable funds and that the major suppliers of loanable funds are commercial
banks, the key role of this financial intermediary in the determination of 20 interest rates is vivid. The central
bank is implementing specific monetary policy, therefore it influences the supply of loanable funds from
commercial banks and thereby changes the level of interest rates. As central bank increases (decreases) the
supply of credit available from commercial banks, it decreases (increases) the level of interest rates. 2.1.3.
Interest rate theories: liquidity preference theory Saving and investment of market participants under economic
uncertainty may be much more influenced by expectations and by exogenous shocks than by underlying real
forces. A possible response of risk-averse savers is to vary the form in which they hold their financial wealth
depending on their expectations about asset prices. Since they are concerned about the risk of loss in the value
of assets, they are likely to vary the average liquidity of their portfolios. Concept A liquid asset is the one that
can be turned into money quickly, cheaply and for a known monetary value. Liquidity preference theory is
another one aimed at explaining interest rates. J. M. Keynes has proposed (back in 1936) a simple model, which
explains how interest rates are determined based on the preferences of households to hold money balances
rather than spending or investing those funds. Money balances can be held in the form of currency or checking
accounts, however it does earn a very low interest rate or no interest at all. A key element in the theory is the
motivation for individuals to hold money balance despite the loss of interest income. Money is the most liquid
of all financial assets and, of course, can easily be utilized to consume or to invest. The quantity of money held
by individuals depends on their level of income and, consequently, for an economy the demand for money is
directly related to an economy’s income. There is a trade-off between holding money balance for purposes of
maintaining liquidity and investing or lending funds in less liquid debt instruments in order to earn a
competitive market interest rate. The difference in the interest rate that can be earned by investing in interest-
bearing debt instruments and money balances represents an opportunity cost for maintaining liquidity. The
lower the opportunity cost, the greater the demand for money balances; the higher the opportunity cost, the
lower the demand for money balance. Concept Liquidity preference is preference for holding financial wealth in
the form of short-term, highly liquid assets rather than long-term illiquid assets, based principally on the fear
that long-term assets will lose capital value over time. According to the liquidity preference theory, the level of
interest rates is determined by the supply and demand for money balances. The money supply is controlled by
the policy tools available to the country’s Central Bank. Conversely, in the loan funds theory the level of
interest rates is determined by supply and demand, however it is in the credit market. 2.2. The structure of
interest rates The variety of interest rates that exist in the economy and the structure of interest rates is subject to
considerable change due to different factors. Such changes are important to the operation of monetary policy.
Interest rates vary because of differences in the time period, 21 the degree of risk, and the transactions costs
associated with different financial instruments. Figure 3 provides an overview of the factors influencing interest
rates and Figure 3. Framework for Forecasting Interest Rates Source: Madura J. (2008). Financial Institutions
and Markets. thus the general framework for forecasting them. The greater the risk of default associated with an
asset, the higher must be the interest rate paid upon it as compensation for the risk. This explains why some
borrowers pay higher rates of interest than others. Future State of Foreign Economies and Expectations of
Exchange Rate Movements Future Level of Household Income Household Plans to Borrow Future Plans for
Expansion Future Volume of Business Future Volume of Government Revenues Future Government
Expenditures Future Level of Household income Fed’s Future Policies on Money Supply Growth Future State
of Foreign Economies and Expectations of Exchange Rate Movements Future Foreign Demand for Funds
Future Household Demand for Funds Future Business Demand for Funds Future Government Demand for
Funds Future Savings by Households and Others Future Foreign Supply of Loanable Funds Future Demand for
Loanable Funds Future Demand for Loanable Funds Forecast of Interest Rates Future State of the Economy
(Economic Growth, Unemployment, Inflation) 22 The degree of risk associated with a request for a loan may be
determined based upona company’s size, profitability or past performance; or, it may be determined more
formally by credit rating agencies. Borrowers with high credit ratings will be able to have commercial bills
accepted by banks, find willing takers for their commercial paper or borrow directly from banks at lower rates
of interest. Such borrowers are often referred to as prime borrowers. Those less favored may have to borrow
from other sources at higher rates. The same principle applies to the comparison between interest rates on sound
risk-free loans (such as government bonds) and expected yields on equities. The more risky a company is
thought to be, the lower will be its share price in relation to its expected average dividend payment – that is, the
higher will be its dividend yield and the more expensive it will be for the company to raise equity capital. 2.3.
Term structure of interest rates The relationship between the yields on comparable securities but different
maturities is called the term structure of interest rates. The primary focus here is the Treasury market. The
graphic that depicts the relationship between the yield on Treasury securities with different maturities is known
as the yield curve and, therefore, the maturity spread is also referred to as the yield curve spread. Concept Yield
curve: Shows the relationships between the interest rates payable on bonds with different lengths of time to
maturity. That is, it shows the term structure of interest rates. The focus on the Treasury yield curve functions is
due mainly because of its role as a benchmark for setting yields in many other sectors of the debt market.
However, a Treasury yield curve based on observed yields on the Treasury market is an unsatisfactory measure
of the relation between required yield and maturity. The key reason is that securities with the same maturity
may actually provide different yields. Hence, it is necessary to develop more accurate and reliable estimates of
the Treasury yield curve. It is important to estimate the theoretical interest rate that the Treasury would have to
pay assuming that the security it issued is a zero-coupon security. If the term structure is plotted at a given point
in time, based on the yield to maturity, or the spot rate, at successive maturities against maturity, one of the
three shapes of the yield curve would be observed. The type of yield curve, when the yield increases with
maturity, is referred to as an upward-sloping yield curve or a positively sloped yield curve. A distinction is
made for upward sloping yield curves based on the steepness of the yield curve. The steepness of the yield
curve is typically measured in terms of the maturity spread between the long-term and short-term yields. A
downward-sloping or inverted yield curve is the one, where yields in general decline as maturity increases. A
variant of the flat yield is the one in which the yield on short-term and long-term Treasuries are similar but the
yield on intermediate-term Treasuries are much lower than, for example, the six-month and 30-year yields. Such
a yield curve is referred to as a humped yield curve. 2.4. Theories of term structure of interest rates There are
several major economic theories that explain the observed shapes of the yield curve: 23  Expectations theory 
Liquidity premium theory  Market segmentation theory  Preferred habitat theory 2.4.1. Expectations theory
The pure expectations theory assumes that investors are indifferent between investing for a long period on the
one hand and investing for a shorter period with a view to reinvesting the principal plus interest on the other
hand. For example an investor would have no preference between making a 12-month deposit and making a 6-
month deposit with a view to reinvesting the proceeds for a further six months so long as the expected interest
receipts are the same. This is equivalent to saying that the pure expectations theory assumes that investors treat
alternative maturities as perfect substitutes for one another. The pure expectations theory assumes that investors
are risk-neutral. A risk-neutral investor is not concerned about the possibility that interest rate expectations will
prove to be incorrect, so long as potential favourable deviations from expectations are as likely as unfavourable
ones. Risk is not regarded negatively. However, most investors are risk-averse, i.e. they are prepared to forgo
some investment return in order to achieve greater certainty about return and value of their investments. As a
result of risk-aversion, investors may not be indifferent between alternative maturities. Attitudes to risk may
generate preferences for either short or long maturities. If such is the case, the term structure of interest rates
(the yield curve) would reflect risk premiums. Question How a yield curve would shift in response to sudden
expectations of rising interest rates according to pure expectations theory? If an investment is close to maturity,
there is little risk of capital loss arising from interest rate changes. A bond with a distant maturity (long
duration) would suffer considerable capital loss in the event of a large rise in interest rates. The risk of such
losses is known as capital risk. To compensate for the risk that capital loss might be realised on long-term
investments, investors may require a risk premium on such investments. A risk premium is an addition to the
interest or yield to compensate investors for accepting risk. This results in an upward slope to a yield curve.
This tendency towards an upward slope is likely to be reinforced by the preference of many borrowers to
borrow for long periods (rather than borrowing for a succession of short periods). Some investors may prefer
long maturity investments because they provide greater certainty of income flows. This uncertainty is income
risk. If investors have a preference for predictability of interest receipts, they may require a higher rate of
interest on shortterm investments to compensate for income risk. This would tend to cause the yield curve to be
inverted (downward sloping). The effects on the slope of the yield curve from factors such as capital risk and
income risk are in addition to the effect of expectations of future short-term interest rates. If money market
participants expect short-term interest rates to rise, the yield curve would tend to be upward sloping. If the effect
of capital risk were greater than the effect of income risk, the upward slope would be steeper. If market
expectations were that short-term interest rates would fall in the future, the yield curve would tend to be
downward sloping. A dominance 24 of capital-risk aversion over income-risk aversion would render the
downward slope less steep (or possibly turn a downward slope into an upward slope). Figure 4. How Interest
Rate Expectations Affect the Yield Curve Source: Madura J. (2008). Financial Institutions and Markets Yield
YC1 3 Months 10 Years E(↑i) → Supply of funds provided by investors ↑ in short-term (such as 3-month)
markets, and ↓ in longterm (such as 10-year) markets. Demand for funds by borrowers ↑ in long-term markets
and ↓ in shortterm markets. Therefore, the yield curve becomes upward sloping as shown here. Panel A: Impact
of a Sudden Expectation of Higher Interest Rates Market for 3-Month (Short term) Risk-free Debt Market for 3-
Month (Short term) Risk-free Debt Market for 3-Month (Short term) Risk-free Debt i i1 i2 S1 S2 D1 D2
Quantity of Funds i2 i1 i S2 S1 D2 D1 Quantity of Funds YC2 Term to Maturity Panel B: Impact of a Sudden
Expectation of Lower Interest Rates i2 i1 i S2 S1 D2 D1 Quantity of Funds i i1 i2 S1 S2 D1 D2 Quantity of
Funds Yield YC1 3 Months 10 Years E(↓i) → Supply of funds provided by investors ↑ in long-term (such as
10-year) markets, and ↓ in shortterm (such as 3-month) markets. Demand for funds by borrowers ↑ in short-
term markets and ↓ in longterm markets. Therefore, the yield curve becomes downward sloping as shown here.
YC2 Term to Maturity 25 The Figure 4 provides a graphical explanation, how interest rate expectations affect
the yield curve. Question Why interest rates tend to decrease during recessionary periods? Question What is the
relationship between yield and liquidity of the securities? 2.4.2. Liquidity premium theory Some investors may
prefer to own shorter rather than longer term securities because a shorter maturity represents greater liquidity. In
such case they will be willing to hold long term securities only if compensated with a premium for the lower
degree of liquidity. Though long-term securities may be liquidated prior to maturity, their prices are more
sensitive to interest rate movements. Short-term securities are usually considered to be more liquid because they
are more likely to be converted to cash without a loss in value. Thus there is a liquidity premium for less liquid
securities which changes over time. The impact of liquidity premium on interest rates is explained by liquidity
premium theory. Figure 5. Impact of liquidity premium on the yield curve under three scenarios Source: Madura
J. (2008). Financial Institutions and Markets. Figure 5 provides a graphical explanation of impact of liquidity
premium on interest rates and yield curve. Scenario 1: Market expects stable interest rates Scenario 3: Market
expects a reduction in interest Annualized Yield Annualized Yield Inclusion of Liquidity Premium Liquidity
Premium Removed Term to Maturity Scenario 2: Market expects an increase in interest rates Annualized Yield
Inclusion of Liquidity Premium Liquidity Premium Removed Term to Maturity Term to Maturity Inclusion of
Liquidity Premium Liquidity Premium Removed 26 2.4.3. Market segmentation theory According to the market
segmentation theory, interest rates for different maturities are determined independently of one another. The
interest rate for short maturities is determined by the supply of and demand for short-term funds. Long-term
interest rates are those that equate the sums that investors wish to lend long term with the amounts that
borrowers are seeking on a long-term basis. According to market segmentation theory, investors and borrowers
do not consider their short-term investments or borrowings as substitutes for long-term ones. This lack of
substitutability keeps interest rates of differing maturities independent of one another. If investors or borrowers
considered alternative maturities as substitutes, they may switch between maturities. However, if investors and
borrowers switch between maturities in response to interest rate changes, interest rates for different maturities
would no longer be independent of each other. An interest rate change for one maturity would affect demand
andsupply, and hence interest rates, for other maturities. 2.4.4. The preferred habitat theory Preferred habitat
theory is a variation on the market segmentation theory. The preferred habitat theory allows for some
substitutability between maturities. However the preferred habitat theory views that interest premiums are
needed to entice investors from their preferred maturities to other maturities. According to the market
segmentation and preferred habitat explanations, government can have a direct impact on the yield curve.
Governments borrow by selling bills and bonds of various maturities. If government borrows by selling long-
term bonds, it will push up long-term interest rates (by pushing down long-term bond prices) and cause the
yield curve to be more upward sloping (or less downward sloping). If the borrowing were at the short maturity
end, short-term interest rates would be pushed up. Question What factors influence the shape of the yield curve?
2.5. Forward interest rates and yield curve The expectations that are relevant to investment decisions are
expectations relative to market expectations. An active portfolio manager bases investment decisions on
attempts to forecast interest rates more accurately than the average participant in the money market. For this
reason the manager of an actively managed bond portfolio needs to be able to ascertain the market consensus
forecast. Such market expectations can be deduced from forward interest rates. Forward interest rates are rates
for periods commencing at points of time in the future. They are implied by current rates for differing
maturities. For example, the current 3- month interest rate and the current 6-month interest rate between them
imply a rate for a 3- month period which runs from a point in time three months from the present until a point in
time six months hence. The forward 3-month rate for a period commencing three months from the present is the
rate which, when compounded on the current 3-month rate, would yield the same return as the current 6-month
rate. For example if the 3-month rate is 9% p.a. and the 6-month rate is 10% p.a., the forward rate is shown as x
in equation: (1,0225)(1 + x) =1,05 27 The forward rate is calculated as: x=(1,05/1.0225) - 1 = 0,0269 which is
2.69% over three months and hence 10.76% p.a. The forward rate can be interpreted as the market expectation
of the future interest rate under the assumptions that: the expectations theory of the yield curve is correct and
there is no risk premium. If the expectations theory is seen as a good model, but there is a risk premium, an
adjustment is required to remove the effects of the risk premium before the result can be interpreted as the
market forecast of the future interest rate. Question What is the meaning of the forward rate in the context of the
term structure of interest rates? The yield curve based on zero coupon bonds is known as the spot yield curve. It
is regarded as more informative than a yield curve that relates redemption yields to maturities of coupon bearing
bonds. The redemption date is not the only maturity date. Example The one-year interest rate is 6,5% p.a. and
the six-month interest rate is 6% p.a. What is the forward six-month interest rate for the period between six
months and one year from now? Can this forward interest rate be taken to be the interest rate expected by
money market participants? Let x be the forward interest rate p.a. (so that the rate for six months is x/2).
(1,03)(1 +x/2) =1,065 1 +x/2 =(1,065)/(1,03) x/2 =[(1,065)/(1,03)] -1 x=2{ [(1,065)/(1,03)] -1} Therefore
x=0,068, i.e. 6,8% p.a. The forward interest rate of 6,8% p.a. can be taken to be the market expectation if the
expectations theory of the yield curve is correct and there is no risk premium. If the expectations theory is
correct but there is a risk premium, the risk premium must be removed before carrying out the calculation.
Suppose that the six-month rate contains no risk premium, but the one-year rate contains a risk premium of
0,1% p.a. The one-year interest rate, net of the risk premium, is 6,4% p.a. The new calculation would be as
follows: (1,03)(1 + x/2) = (1,064) x=2{[(1,064)/(1,03)] -1} Therefore x=0,066, i.e. 6,6% p.a. Coupon-bearing
bonds may have differing redemption yields, despite having common redemption dates, because of differences
in the coupon payments. Yield curves based on coupon-bearing bonds may not provide a single redemption
yield corresponding to a redemption (final maturity) date. 28 Example Suppose, zero coupon bonds with
maturities one, two, and three years from the present have prices of 95, 88, and 80 Euro. What are the spot one-,
two-, and three-year interest rates? Draw the yield curve. In the case of the one-year bond, an investment of 95
Euro entails a receipt of 100 Euro in one year. 100/95 =1,0526 which implies a spot one-year interest rate of
5,26%. In the case of the two-year bond, an investment of 88 Euro yields a receipt of 100 Euro after two years.
100/88 =1,13636 √1,13636 =1,0660 or a spot 2-year interest rate of 6,60% p.a. b) In the case of the three-year
bond, an investment of 80 Euro provides a receipt of 100 Euro after three years. 100/80 = 1,25 1,250.33=1,0772
or a spot three-year interest rate of 7,72% p.a. The forward yield curve relates forward interest rates to the
points of time to which they relate. For example, rates of return on five-year bonds and rates on four-year bonds
imply rates on one year instruments to be entered into four years from the present. The implied forward rate can
be calculated by means of the formula: (1 + 4r1) = (1 + 0r5) 5 / (1 +0r4) 4 where r5 is the five-year interest rate,
r4 is the four-year interest rate, and 4r1 is the one-year rate expected in four years’ time. This formula arises
from the relation: (1 +0r5) 5 =(1 + 0r4) 4 (1 + 4r1) which states that a five-year investment at the five-year
interest rate should yield the same final sum as a four-year investment at the four-year rate with the proceeds
reinvested for one year at the one-year rate expected to be available four years hence. The value of 4r1 would be
related to the point in time, of four years, on the yield curve. Carrying out such a calculation for a succession of
future periods produces a series of forward interest rates. Question Why might forward rates consistently
overestimate future interest rates? Question How liquidity premium affects the estimate of a forward interest
rate? When plotted against their respective dates, the series of forward rates produces a forward yield curve.
The forward yield curve requires the use of zero coupon bonds for the calculations. This forms also the basis for
calculation of short-term interest rate futures. Short-term interest rate futures, which frequently take the form of
three-month interest rate futures, are instruments suitable for the reduction of the risks of interest rate changes.
Three-month interest rate futures are notional commitments to borrow or deposit for a three-month period that
commences on the futures maturity date. They provide means whereby 29 borrowers or investors can (at least
approximately) predetermine interest rates for future periods. Example Assume that the three-month interest
rate is 4.5% p.a. and the six-month interest rate is 5% p.a. What is the forward interest rate for the three-month
period commencing three months from now? 5% p.a. is 2,5% over six months, and 4,5% p.a. is 1,125% over
three months. (1,025)/(1,01125) = 1,013597 1.013597 - 1 = 0.013597, i.e. 1.3597% for three months or 5.44%
p.a. (to two decimal places). The forward interest rate is 5,44% p.a. 2.6. Summary Level of interest rates in an
economy is explained by two key economic theories: the loanable funds theory and the liquidity preference
theory. The loanable funds theory states that the level of interest rates is determined by the supply of and
demand for loanable funds. According to the liquidity preference theory, the level of interest rates is determined
by the supply of and demand for money balances. Interest rates in the economy are determined by the base rate
(rate on a Government security) plus a risk premium (or a spread). There are several factors that determine the
risk premium for a non- Government security, as compared with the Government security of the same maturity.
These are (1) the perceived creditworthiness of the issuer, (2) provisions of securities such as conversion
provision, call provision, put provision, (3) interest taxes, and (4) expected liquidity of a security’s issue. The
term structure of interest rates shows the relationship between the yield on a bond and its maturity. The yield
curve describes the relationship between the yield on bonds of the same credit quality but different maturities in
a graphical way. Apart from spot rates, forward rates provide additional information for issuers and investors.
The major theories explain the observed shapes of the yield curve are the expectations theory, liquidity
premium, market segmentation theory and preferred habit theory. Key terms  Interest rates  Loanable funds 
Spot rate  Forward rate  Term structure of interest rates  Yield curve  Expectations  Biased expectations 
Liquidity  Segmented markets 30  Preferred habitat Further readings 1. Culbertson J.M. (1957). The Term
Structure of Interest Rates, Quarterly Journal of Economics, November, p. 489-504. 2. Estrella A., Mishkin F.
S. (1996). The yield curve as a predictor of U.S. recessions. Federal Reserve Bank of New York Current Issues
in Economics and Finance. 3. Favero C. A., Kaminska I., Söderström U. (2005). The predictie power of the
yield spread: Further evidence and a structural interpretatio,. CEPR Discussion Paper, No. 4910. 4. Kane E.J.
(1970). The term structure of interest rates: An attempt to reconcile teaching with practice, Journal of Finance,
Vol.25, May, p. 361-374. 5. Ron U. (2002). A practical guide to swap curve construction. Chapter 6 in F. J.
Fabozzi (ed.) Interest Rate, Term Structure, and Valuation Modeling. New York, John Wiley & Sons. Relevant
websites  http://www.bloomberg.com  http://www.federalreserve.gov  http://www.ft.com 
http://www.ecb.int/stats/money/yc/html/index.en.html  http://www.treas.gov/offices/domestic-finance/debt-
management/interestrate/yield.shtml  http://www.newyorkfed.org/research/capital_markets/ycfaq.html 
http://demonstrations.wolfram.com/PriceYieldCurve/ Review questions and problems  How would you expect
an increase in the propensity to save to affect the general level of interest rates in an economy? 6. Explain how
an increase in the rate of inflation might affect (a) real interest rates and (b) nominal interest rates. 7. Why are
some lenders capital risk averse and others income risk averse? What slope will the yield curve have when the
market is dominated by capital risk aversion? 8. Why might interest rates payable on long-term, ‘risk-free’
government bonds include a term premium? 9. Look at the most recent interest rate change by European Central
bank, US FED, Bank of England, Central Bank of Lithuanian, Central Bank of Latvia and Central Bank of
Estonia. Compare them. What conclusions can be drawn? 10.What conclusion might you draw about possible
future interest rates if a positive term premium were to increase? 11.Why might interest rate movements of
various developed countries be more highly correlated in recent years than in earlier years? 31 12.Consider the
prevailing conditions for inflation (including oil prices), the economy, and the budget deficit, the central bank of
your country and EU central bank monetary policy that could affect interest rates. Based on the prevailing
conditions, do you think interest rates will likely increase during the following half a year? Provide arguments
for your answer. Which factor do you think will have the largest impact on interest rates? 13.Assume that a)
investors and borrowers expect that the economy will weaken and that inflation will decline; b) investors
require a low liquidity premium; c) markets are partially segmented and the Government prefers to borrow in
the short-term markets. Explain how each of the three factors would affect the term structure of interest rates,
holding all other factors constant. Then explain the overall effect on the term structure. 14.Assume that the yield
curves in the US, Germany and Japan are flat. If the yield curve in the US suddenly becomes positively sloped,
do you think the yield curves in Germany and Japan would be affected? If yes, how? 15.A company X has
funded its operations by bank loans extensively. The interest rate on the loans is tied to the market interest rates
and is adjusted every six months. Thus the cost of funds is sensitive to interest rate movements. Because of
expectations that EU economy would strengthen during the next year, the company plans further growth
through investments. The company expects that it will need substantial long-term financing to finance its
growth and plans to borrow additional funds in the debt market. a) What can be the company’s expectations
about the change in interest rates in the future? Why? b) How would these expectations affect the company’s
cost of borrowing on its existing loans and on future debt? c) How these expectations would affect the
company’s decision when to borrow funds and whether to issue floating-rate or fixed rate debt? 16. Assume that
the interest rate for one year securities is expected to be 4 percent today, 5 percent one year from now and 7
percent two years from now. Using only the pure expectations theory find what are the current (spot) interest
rates on two and three year securities. 17. Assume that the spot (annualized) interest rate on a three year security
is 8 percent, while the spot (annualized) interest rate on a two year security is 5 percent. Use only this
information to estimate the one year forward rate two years from now. 18.Assume that the spot (annualized)
interest rate on a two year security is 7 percent, while the spot (annualized) interest rate on a one year security is
6 percent. a) Using only this information estimate the one year forward rate. b) Assume that the liquidity
premium on a two year security is 0,4 percent. Use this information to re-estimate the one year forward rate
19.Assess the shape of the yield curve using the website http://www.ecb.int/stats/ money/yc/html/index.en.html.
Based on various theories attempting to explain the shape of the yield curve, provide your explanations of the
difference between the 1 year and the 30 year government securities. Which theory according to your opinion is
the most reasonable? Why? 32 20.Consider how quickly other interest rates in the economy changed thereafter.
Why does the MPC change interest rates each time it acts by only 1/4 or, at most, 1/2 a per cent? 21.Could the
MPC of the Bank of England raise interest rates when everyone was expecting them to fall? Look at the
financial press and find the current interest spread between five-year and ten-year government bonds. Is there a
positive term premium? 22.What conclusion might you draw about possible future interest rates if a positive
term premium were to increase? How is money actually transferred from an account in one country to an
account in another? 23.Has the growth of the Euromarkets been, on balance, a positive development for the
world economy? 24.How many reasons can you think up for preferring fixed to floating rate loans and vice
versa? 25.Find out as much as you can about: a) the activities of the international credit rating agencies; b) the
role of the international banks in the international debt crisis of the developing countries. 26.What is: a)
EURIBOR? b) a euroeuro? c) a swaption? d) a plain vanilla swap? 27.Look in the financial press and find
examples of variations on plain vanilla swaps that re not mentioned in the text. 28.If you swapped a floating rate
payment for a fixed rate payment, would you gain or lose if interest rates unexpectedly rose? Why? 33 3.
MONEY MARKETS Mini contents  The purpose of money markets  Money markets segments and
participants  Money market instruments  Money market rates and yields 3.1. Money market purpose and
structure 3.1.1. The role of money markets The purpose of money markets is facilitate the transfer of short-term
funds from agents with excess funds (corporations, financial institutions, individuals, government) to those
market participants who lack funds for short-term needs. They play central role in the country’s financial
system, by influencing it through the country’s monetary authority. For financial institutions and to some extent
to other non-financial companies money markets allow for executing such functions as:  Fund raising;  Cash
management;  Risk management;  Speculation or position financing;  Signalling;  Providing access to
information on prices. Money markets are wholesale markets with very large amounts of transactions, e.g. with
transactions from 500 million Euro to 1 billion Euro or even larger ones. This is the most active financial
market in terms of volumes of trading. From the start of emergence the traditional money markets performed
the role of monetary policy. In order to influence the supply side, governments have employed methods of
direct regulation and control of the savings and investment behaviour of individuals and companies. However
due to fast technological advances, internationalization and liberalization of financial markets, possibilities to
carry out policy objectives through such measures have diminished. Current policy through marketoriented
measures is aimed primarily at demand side. Thus money markets serve the interface between execution of
monetary policy and the national economies Another role of domestic money markets is to serve public policy
objectives, i.e. financing public sector deficits and managing the accumulated government deficits. Government
public debt policy is an important determinant of the money markets operations, since government debt
typically forms a key part of the country’s money markets (as well as debt markets). The scope and measures of
monetary policy are also linked to the government’s budget and fiscal policies. Thus the country’s money
market 34 shifts are dependant upon the goals of national public policy and tools used to reach these goals.
Changes in the role and structure of money markets were also influenced by financial deregulation, which
evolved as a result of recognition that excessive controls are not compatible with efficient resource allocation,
with solid and balanced growth of economies. Money markets went through passive adaptation as well as
through active influence from the side of governments and monetary authorities. Finally, money markets were
influenced by such international dimensions as increasing capital mobility, changing exchange rate
arrangements, diminishing monetary policy autonomy. The shifts in European domestic money markets were
made by the European integration process, emergence and development of European monetary union. 3.1.2.
Money market segments In a broad sense, money market consists of the market for short-term funds, usually
with maturity up to one year. It can be divided into several major segments: Interbank market, where banks and
non-deposit financial institutions settle contracts with each other and with central bank, involving temporary
liquidity surpluses and deficits. Primary market, which is absorbing the issues and enabling borrowers to raise
new funds. Secondary market for different short-term securities, which redistributes the ownership, ensures
liquidity, and as a result, increases the supply of lending and reduces its price. Derivatives market – market for
financial contracts whose values are derived from the underlying money market instruments. Interbank market
is defined mainly in terms of participants, while other markets are defined in terms of instruments issued and
traded. Therefore there is a considerable overlap between these segments. Interbank market is referred mainly
as the market for very short deposits and loans, e.g. overnight or up to two weeks. Nearly all types of money
market instruments can be traded in interbank market. Key money market segments by instruments are provided
in Figure 6 Figure 6. Key money market instruments The money-market instruments are often grouped in the
following way:  Treasury bills and other short-term government securities (up to one year); 35  Interbank
loans, deposits and other bank liabilities;  Repurchase agreements and similar collateralized short-term loans; 
Commercial papers, issued by non-deposit entities (non-finance companies, finance companies, local
government, etc. ;  Certificates of deposit;  Eurocurrency instruments;  Interest rate and currency derivative
instruments. All these instruments have slightly different characteristics, fulfilling the demand of investors and
borrowers for diversification in terms of risk, rate of return, maturity and liquidity, and also diversification in
terms of sources of financing and means of payment. Many investors regard individual money market
instruments as close substitutes, thus changes in all money market interest rates are highly correlated. Major
characteristics of money market instruments are:  short-term nature;  low risk;  high liquidity (in general); 
close to money. Money markets consist of tradable instruments as well as non-tradable instruments. Traditional
money markets instruments, which included mostly dealing of market participants with central bank, have
decreased their importance during the recent period, followed by an increasing trend to finance short-term needs
by issuing new types of securities such as REPOs, commercial papers or certificates of deposit. The arguments
behind the trend are the following: 1. An observed steady shift to off-balance sheet instruments, as a reaction to
introduction of capital risk management rules for internationally operating banks in the recommendations of
Basel II Accord and EU Directives on banking. 2. Advantages provided to high-rated market participants,
allowing to diversify borrowing sources, to cut the costs, to reduce the borrowers’ dependence on banking
sector lending and its limitations. In terms of risk two specific money-market segments are:  unsecured debt
instruments markets (e.g. deposits with various maturities, ranging from overnight to one year);  secured debt
instruments markets (e.g. REPOs) with maturities also ranging from overnight to one year. Differences in
amount of risk are characteristic to the secured and the unsecured segments of the money markets. Credit risk is
minimized by limiting access to high-quality counter-parties. When providing unsecured interbank deposits, a
bank transfers funds to another bank for a specified period of time during which it assumes full counterparty
credit risk. In the secured REPO markets, this counterparty credit risk is mitigated as the bank that provides
liquidity receives collateral (e.g., bonds) in return. Money markets structures differ across the countries,
depending upon regulatory and legislative frameworks, factors that have supported or limited the development
of such 36 national markets. The influence of business culture and traditions, industrial structures have played
an important role also. Economic significance of money markets is predetermined by its size, level of
development of infrastructure, efficiency. Growth of government securities issues, their costs considerations,
favourable taxation policies have become additional factors boosting some of the country’s money markets.
3.1.3. Money market participants Money market participants include mainly credit institutions and other
financial intermediaries, governments, as well as individuals (households). Ultimate lenders in the money
markets are households and companies with a financial surplus which they want to lend, while ultimate
borrowers are companies and government with a financial deficit which need to borrow. Ultimate lenders and
borrowers usually do not participate directly in the markets. As a rule they deal through an intermediary, who
performs functions of broker, dealer or investment banker. Important role is played by government, which issue
money market securities and use the proceeds to finance state budget deficits. The government debt is often
refinanced by issuing new securities to pay off old debt, which matures. Thus it manages to finance longterm
needs through money market securities with short-term maturities. Central bank employs money markets to
execute monetary policy. Through monetary intervention means and by fixing the terms at which banks are
provided with money, central banks ensure economy’s supply with liquidity. Credit institutions (i.e., banks)
account for the largest share of the money market. They issue money market securities to finance loans to
households and corporations, thus supporting household purchases and investments of corporations. Besides,
these institutions rely on the money market for the management of their short-term liquidity positions and for
the fulfilment of their minimum reserve requirements. Other important market participants are other financial
intermediaries, such as money market funds, investment funds other than money-market funds, insurance
companies and pension funds. Large non-financial corporations issue money market securities and use the
proceeds to support their current operations or to expand their activities through investments. In general
issuance of money market securities allow market participants to increase their expenditures and finance
economic growth. Money market securities are purchased mainly by corporations, financial intermediaries and
government that have funds available for a short-term period. . Individuals (or households) play a limited role in
the market by investing indirectly through money market funds. Apart from transactions with the central bank,
money-market participants trade with each other to take positions dependant upon their short-term interest rate
expectations, to finance their securities trading portfolios (bonds, shares, etc.), to hedge their longer-term
positions with short-term contracts, and to reduce individual liquidity imbalances 37 3.2. Money market
instruments 3.2.1. Treasury bills and other government securities Treasury bills are short-term money market
instruments issued by government and backed by it. Therefore market participant view these government
securities as having little or even no risk. The interest rates on Treasury securities serve as benchmark default-
free interest rates. A typical life to maturity of the securities is from four weeks to 12 months. As they do not
have a specified coupon, they are in effect zero-coupon instruments and are issued at a discount to their par or
nominal value, at which price they are redeemed. Any new issue with the same maturity date as an existing
issue is regarded as a new tranche of the existing security. Question What are key characteristics of Treasury
bills? Treasury bills are typically issued at only certain maturities dependant upon the government budget
deficit financing requirements. Budget deficits create a challenge for the government. Large volumes of
Treasury securities have to be sold each year to cover annual deficit, as well as the maturing Treasury securities,
that were issued in the past. The mix of Treasury offerings determines the maturity structure of the
government’s debt. Primary market. The securities are issued via a regularly scheduled auction process. Upon
the Treasury’s announcement of the size of upcoming auction, tenders or sealed bids are being solicited.
Concept A tender is a sealed bid. Bidders are submitting two types of bids: competitive and non-competitive. A
competitive bidder specifies both the amount of the security that the bidder wants to buy, as well as the price
that the bidder wants to pay. The price is set in terms of yield. The price of the securities in the auction is set
based on the prices offered in competitive bids, taking the average of all accepted competitive prices. Not all
competitive bids that are tendered are accepted. Typically the longer the maturity, the greater would be the
percentage of accepted bids. The percentage of accepted bids is determined by the size of the issue as compared
to the amount of bids tendered. Competitive bidders are the largest financial institutions that generally purchase
largest amounts of Treasury securities. In general 80- 90% Treasury securities are sold to them. A non-
competitive bidder specifies only the amount of the security that the bidder wants to buy, without providing the
price, and automatically pay the defined price. Noncompetitive bidders are retail customers, who purchase low
volumes of the issues, and are not enough sophisticated to submit a bid price. Limits on each non-competitive
bid can be set. Direct purchases of Treasury securities by individuals are limited in many countries. In such
cases they use the services of dealers. The Figure 7 illustrates the results of sealed bid (tender) auction. The
Treasury will accept the competitive bids with the highest price and lowest interest rates, and will reject other
bids. Depending upon the existing regulation in a specific country treasury security auctions can be organized
and held at the central bank or stock exchanges. There are two auction forms:  Uniform price auction, when all
bidders pay the same price; 38  Discriminatory price auction, in which each bidder pays the bid price. Figure 7.
Prices in a sealed-bid auction The procedure of the discriminatory price auction one is more sophisticated. At
first, all the non-competitive bids are totaled, and their sum is subtracted from the total issue amount. This way
all non-competitive bids are fulfilled. The price, which non-competitive bidders are going to pay, is determined
taking into account the results of the competitive part of the auction. Concept Uniform price auction is an
auction, when all bidders pay the same price. Concept Discriminatory price auction is an auction, in which each
bidder pays the bid price. Further on, all competitive tenders are ranked in order of the bid yield. In order to
minimize the governments borrowing costs, the lowest competitive bid is accepted first. As a result, the highest
bid prices are accepted until the issue is sold out fully. The lowest rejected bid yield (or the highest accepted bid
yield) is called stop yield. The corresponding price is called the stop-out price. During such a Treasury auction,
each competitive bidder pays the price for the securities, which is determined by the yield that was bid. The
average yield is the average of all accepted competitive bids, weighted by the amounts allocated at each yield.
All noncompetitive bidders pay the average yield. Price Supply curve Accepted bids Rejected bids Demand
curve Amount of bonds Price of lowest accepte d bid 39 The discriminatory auction is characterized by  a tail
– the difference between the stop yield and the average yield;  a cover – the ratio between the total amount
competitive and non-competitive bids tendered and the total issue (i.e. the total amount of accepted bids). . A
large cover indicates active market participation in an auction. Average cover can be evaluated in terms of a
difference between maximum and minimum accepted bid yields (in basis points) A small tail shows that most
competitive bidders provide similar evaluation of Treasury security issue, and thus pay nearly the same price for
it. The larger the cover and the smaller the tail, the more efficient is the Treasury auction. Concept Basis point is
a very fine measure of interest rates, equal to one hundredth of one percentage point. In a discriminatory price
auction the bidder’s price is determined by his own tender. A low bid, i.e. low yield and high offered price,
increases the bidder’s chance of his bid to be accepted. However, this can lead to the possibility of the winner’s
curse. In such a case the low bidder’s tender is accepted, but he pays a price that is higher than of others lower
priced (or higher yield) bids. Therefore competitive bidders may be reluctant to submit low bids, because this
will oblige them to pay high prices for newly issued securities. This is a problem of discriminatory price
auction. Concept Winner’s curse is the case, when the low bidder wins acceptance of the tender, but pays a
price, which is higher than that of other lower bidders. A uniform price auction (or a Dutch auction) does not
have a problem of this kind. All the procedures of the auction except for the last one are the same as in the
discriminatory price auction. Each accepted bid pays the price of the lowest accepted bid. As a result, uniform
price auction becomes more expensive to the Treasury and it receives lower revenue. Besides, the average
bidder may bid a higher price, shifting demand curve to right with the possibility offsetting the negative effect
to the Treasury (see Figure 8). Figure 8. Impact of single-price auction upon demand curve Price in singleprice
auction Lowest accepted discriminatory bid Price Supply curve Accepted bids Rejected bids Amount of bonds
Single-price demand Discriminatory demand 40 Uniform price auction is considered fairer because all
competitive bidders pay the same price. This may encourage greater participation in the auction, and finally
increase the auction’s cover indicator. Competitive bidders are not afraid to submit too low bids, because they
will not be paying the price they bid. Conversely, the lower they will bid, the higher likelihood is that their bid
will be accepted. As a result, bidders tend to reduce their bids, thereby lowering the average yield on the entire
issue. Such changes in bidder behaviour may offset the direct effect of higher issuer’s interest costs in the
uniform price auction. While evaluating the effectiveness of the Treasury auction method, there is a concern,
that competitive as well as non-competitive bidders can be neglected, while few large financial institutions may
be favoured. This can cause decline in auction participation, undermining the Treasury’s abilities to place large
amounts of securities. On the other hand, since bidders do not pay their tendered prices, the uniform price
auction may be more subject to manipulation or collusion by informed bidders. Question What is the role of
competitive and non-competitive bidders in the Treasury securities auction? Secondary market. Typically the
Treasury securities have an active and liquid secondary market. The most actively traded issues, which are
usually the ones sold through an auction most recently, are called on-the-run issues. They have narrower bid-ask
spreads than older, off-the-run issues. The role of brokers and dealers is performed by financial institutions. As
a rule, competitive bidders can submit more than one bid to each auction, with different prices and quantities on
each tender. However, in well developed markets limitations are being placed to the amount of securities in
each auction allocated to a particular single bidder. The aim of such a rule is to prevent market from influence
of a single bidder, and thus squeezing other financial institutions with their own customers. Question What is
the role of competitive and non-competitive bidders in the Treasury securities auction? The text then can follow
(starting with the style of the first paragraph). Then, we can have some readings or an example. It can be but in
the same format as the Concept/Check Question. Price of a Treasury bill is the price that an investor will pay for
a particular maturity Treasury security, depending upon the investor’s required return on it. The price is
determined as the present value of the future cash flows to be received. Since the Treasury bill does not generate
interest payments, the value of it is the present value of par value. Therefore, since the Treasury bill does not
pay interest, investors will pay a price for a one-year security that will ensure that the amount they receive one
year later will generate the desired return. Example Assume investor requires a 5 percent annualized return on a
one-year Treasury bill with a 100000Euro par value. He will be willing to pay the price P = 100000 Euro / 1,05
= 95238 Euro If investor requires a return higher than 5 percent, he will discount the par value at a higher return
rate. This will result in a lower price to be paid today. 41 In case the maturity of Treasury bill is shorter than one
year, then the annualized return will be reduced by the fraction of the year, during which the investment is
made. The simplified calculations are provided in the example below. Example Assume investor requires a 5
percent annualized return on a 6 month Treasury bill with a 100000 Euro par value. The price of the security
will be P = 100000 Euro / ( 1 + 0,05 / 2) = = 100000 Euro / ( 1 + 0,025) = 97560,9 Euro If investor requires a
return higher than 5 percent, he will discount the par value at a higher return rate. This will result in a lower
price to be paid today. The price of the Treasury bill calculated on discount rate basis is: P = PAR x (1- (d x n /
360)) where d is the yield or rate of discount, PAR is par or maturity value and n is the number of days of the
investment (holding period). Example Assume investor requires an 8 percent annualized return on a 91-day
Treasury bill with a 100000 Euro par value. The price of the security will be P = 100000 Euro x ( 1 – (0,08 x
91/ 360) = = 100000 Euro x ( 1 – 0,02 ) = 98000 Euro If investor requires a return higher than 5 percent, he will
discount the par value at a higher return rate. This will result in a lower price to be paid today. Yield of a
Treasury bill is determined taking into account the difference between the selling price and the purchase price.
Since Treasury bills do not offer coupon payments, the yield the investor will receive if he purchases the
security and holds it until maturity will be equal to the return based on difference between par value and the
purchase price. The annualized yield on Treasury bill is calculated in the following way: y = (PAR - P) / P x
(365/n) where d is the yield, PAR – par value, P - purchase price of the Treasury bill and n is the number of
days of the investment (holding period). Example Assume investor requires pays 98000 Euro for a 91-day
Treasury bill with a 100000 Euro par value. The annualized yield of the security will be y = (100000 – 98000) /
98000 ) x ( 365 / 91 ) = = 0,02 x 4,01 = 0,0802 or 8,02 %. If the Treasury bill is sold prior to maturity, the return
is calculated on the basis of difference between the price for which the bill was sold in the secondary market
and the purchase price. The annualized yield on Treasury bill is calculated in the following way: y = (SP - P) / P
x (365/n) 42 where d is the yield, SP – selling price, P - purchase price of the Treasury bill and n is the number
of days of the investment (holding period). In some countries (e.g. US) Treasury bills are quoted on a discount
rate (or referred to as Treasury bill rate) basis. The Treasury bill discount rate represents the percent discount of
the purchase price from par value of a new issue of a Treasury bill. It is determined in the following way: d =
(PAR - P) / PAR x (360/n) where d is the yield, PAR – par value, P - purchase price of the Treasury bill and n is
the number of days of the investment (holding period). In such a case the year is assumed having 360 days, and
the number of days of the investment can be actual or an assumed convention. If a newly issued Treasury bill is
held until maturity, then its yield is always greater than rate of discount. The difference is due to price or value
used in denominator, since purchase price is always lower than par value. Besides, the yield is always calculated
on 365 day during a year basis. 3.2.2. The interbank market loans Interbank market is a market through which
banks lend to each other. Commercial banks are required to keep reserves on deposits within central bank.
Banks with reserves in excess of required reserves can lend these funds to other banks. Traditionally this formed
the basis of the interbank market operations. However, currently these operations involve lending any funds in
reserve accounts at a central bank. Concept Interbank market is a market which involves bank borrowing and
lending of any funds in reserve accounts at the central bank. In US the interbank market is the federal funds
market, which involves the borrowing and lending any funds in reserve accounts at the Federal Reserve Bank
(FED). The major characteristics of the interbank markets are:  The transfer of immediately available funds; 
Short time horizons;  Unsecured transfers. Individual banks have a possibility to invest (lend) surplus funds
and have a source of borrowing when their reserves are low, thus they manage their reserve position and fund
their assets portfolio by trading at the interbank market. This is a wholesale market with deals usually in large
denominations. It is used by all types of banks, involved in loans for very short periods, from overnight to
fourteen days mostly. Then bank borrows in the interbank market, it is said to be a funds buyer. When bank
lends immediately available reserve accounts, it is said to be a seller. Most banks simultaneously buy and sell
funds all the time. By acting as dealers they make markets for funds by announcing willingness to buy or to sell
at the current competitive interbank rate. The interbank interest rates and interest rates in the traditional market
are interconnected. If banks are short of liquidity they will lend less to both markets and will cause interest rates
to rise. When Central bank provides funds to the discount market, less attractive terms are offered by banks.
Thus they may choose other markets to invest and will cause the drop in interest rates. 43 Interbank rates are
generally slightly higher and more volatile than interest rates in the traditional market. In periods of great
shortage of liquidity, the needs of banks which do not have sufficient funds to meet the central bank
requirements drive up the overnight rates significantly. To keep up the speed of the transfer and the costs of
transfer down, the interbank market transfers are unsecured, i.e. not backed by any collateral and have no
protection against default by the borrowing bank. Credit risk in the interbank market is controlled through the
interbank rate, which is truly competitive, quoted market rate. It is determined entirely by the supply and
demand of banks for funds. Since the market is a closed interbank system, the aggregate value of all buy orders
(demand for funds) should be equal to the aggregate value of all sell orders (supply of funds). If the demand for
fund purchases increases, it drives up the interbank interest rate. Question How is interbank interest rate
determined? Participants in the interbank market typically undertake two types of transactions:  reserve
management transactions;  portfolio management transactions. Bank reserve management transactions allow
complying with contemporaneous bank reserve requirements. Through portfolio management transactions
banks use interbank market to finance their assets’ portfolio. These are encouraged by the interbank market
liquidity and flexibility. With time horizons as short as overnight, the transactions can be made rapidly at low
transaction costs. Unlike other instruments ‘traded’ in the money markets, interbank deposits are not negotiable
i.e. do not have a secondary market. A lending bank which wishes to retrieve its funds simply withdraws the
deposit from the bank to which it was lent. Thus, In this case, the distinction between primary and secondary
markets is irrelevant. Question How has the interbank interest rate volatility changed over the recent years?
What is the major cause of this change? 3.2.3. Commercial papers Commercial paper (CP) is a short-term debt
instrument issued only by large, well known, creditworthy companies and is typically unsecured. The aim of its
issuance is to provide liquidity or finance company’s investments, e.g. in inventory and accounts receivable.
The major issuers of commercial papers are financial institutions, such as finance companies, bank holding
companies, insurance companies. Financial companies tend to use CPs as a regular source of finance. Non-
financial companies tend to issue CPs on an irregular basis to meet special financing needs. Thus commercial
paper is a form of short-term borrowing. Its initial maturity is usually between seven and forty-five days. In US,
the advantage of issuing CPs with maturities less than nine months is that they do not have to register with the
Securities Exchange 44 Commission (SEC) as a public offering. This reduces the costs of registration with SEC
and avoids delays related to the registration process. CPs can be sold directly by the issuer, or may be sold to
dealers who charge a placement fee (e.g. 1/8 percent). Since issues of CPs are heterogeneous in terms of issuers,
amounts, maturity dates, there is no active secondary market for commercial papers. However, dealers may
repurchase CPs for a fee. Question What is the role of financial institutions in the commercial paper market?
The price of CP is calculated in the following way: P = PAR x (1- (d x n / 360)) where d is the yield or rate of
discount, PAR is par or maturity value and n is the number of days of the investment (holding period). CP is
sold at a discount to its maturity value, thus it is the other money market instrument whose return is expressed
on a discount basis. Example A 30 day CP with 10 million Euro par value yields 4,75%. The price of this CP
currently offering is equal to P = 10,0 million Euro x (1- (0,0475 x 30 / 360)) = = 10,0 million Euro x (1- 0,003)
= 9,97 million Euro The yield on CP is calculated in the following way: d = (PAR - P) / PAR x (360/n) where d
is the yield or rate of discount, PAR – par value, P - initial price of the CP and n is the number of days of the
investment (holding period). Example Investor has purchased a 30 day CP with a par value of 1 million Euro for
a price of 990 000 Euro. What is the yield of this CP investment? d = (1 mil Euro - 990 000 Euro) / 1 mil Euro x
(360/30) = = 0,01 x 12 = 0,12 or 12 %. Commercial paper is normally unsecured against any specific assets and
firms wishing to use the commercial paper market will usually seek a credit rating from one or other of the
credit rating agencies. A high rating will mean that such paper can be issued at a smaller discount, often
amounting to the equivalent of 1 per cent. Although commercial paper is unsecured, typically it is backed by a
line of credit at a commercial bank. As a source of finance, commercial paper serves a similar purpose to
commercial bills (and is priced in the same way). Thus, in countries with a highly developed discount, or bills,
market, the market for commercial paper is relatively small (e.g. UK). However, when the commercial bill
market is less developed, the commercial paper market is very large (e.g. France and US). The main difference
between commercial papers and commercial bills lies in the manner of their creation. A firm borrows via a
commercial bill when it agrees to ‘accept’ a bill which is ‘drawn’ by a creditor. The bill originates with the
lender. A firm borrows via commercial paper when it issues the paper itself. Question What are the substitutes
for commercial paper? 45 3.2.4. Certificates of deposit Certificate of deposit (CD) states that a deposit has been
made with a bank for a fixed period of time, at the end of which it will be repaid with interest. Thus it is, in
effect, a receipt for a time deposit and explains why CDs appear in definitions of the money supply such as M4.
It is not the certificate as such that is included, but the underlying deposit, which is a time deposit like other
time deposits. An institution is said to ‘issue’ a CD when it accepts a deposit and to ‘hold’ a CD when it itself
makes a deposit or buys a certificate in the secondary market. From an institution’s point of view, therefore,
issued CDs are liabilities; held CDs are assets. The advantage to the depositor is that the certificate can be
tradable. Thus though the deposit is made for a fixed period, he depositor can use funds earlier by selling the
certificate to a third party at a price which will reflect the period to maturity and the current level of interest
rates. The advantage to the bank is that it has the use of a deposit for a fixed period but, because of the
flexibility given to the lender, at a slightly lower price than it would have had to pay for a normal time deposit.
The minimum denomination can be 100 000USD, although the issue can be as large as 1 million USD. The
maturities of CDs usually range from two weeks to one year. Non-financial corporations usually purchase
negotiable CDs. Though negotiable CD denominations are typically too large for individual investors, they are
sometimes purchased by money market funds that have pooled individual investors’ funds. Thus money market
funds allow individuals to be indirect investors in negotiable CDs. This way the negotiable CD market can be
more active. There is also a secondary market for these securities, however its liquidity is very low. Concept
Negotiable certificates of deposit are certificates that are issued by large commercial banks and other depository
institutions as a short-term source of funds. The negotiable CDs must be priced offering a premium above
government securities (e.g. Treasury bills) to compensate for less liquidity and safety. The premiums are
generally higher during the recessionary periods. The premiums reflect also the money market participants’
understanding about the safety of the financial system. Question What factors lead to rise / decline in
certificates of deposit market? Negotiable CDs are priced on a yield basis. Institution issue negotiable CDs at a
par value. Thus the yield of the security is calculated: y = ( PAR – P )/ P x (360 / n) Example A three-month CD
for 100 000 Euro at 6 per cent matures in 73 days. It is currently trading at 99 000 Euro. Rate of return of this
CD current offering is y = (100 000 – 99 000 )/ 99 000 x (360 / 73) = = 0,01 x 4,93 = 0,0493 or 4,93% 46 The
market price of the CD is found by discounting the par or maturity value by the rate of interest currently
available on similar assets, adjusted for the residual maturity. The price of CDs is determined using the
following equation: P = PAR / (1 – (i x n / 360)) Question Find the price of a three-month 150,000 Euro CD,
paying 4 per cent, if it has 36 days to maturity and short-term interest rates are 4 per cent. What will be the price
of this same CD if short-term interest rates fall to 2 percent? The annualized yield they pay is the annualized
interest rate on negotiable CDs. If investors purchase and holds negotiable CDs until maturity, their annualized
yield is the interest rate. However, if investors purchase or negotiable CDs in the secondary market instead of
holding them from issuance to maturity, then annualized yield can differ from the annualized interest rate. y =
(Selling Price – Purchase Price + Interest) / Purchase Price Example An investor purchased a negotiable CD a
year ago in a secondary market. He redeems it today upon maturity and receives 1 million Euro. He also
receives 40000 Euro of interest. What is investor’s annualized yield on this investment? The interest rate paid
on CDs is often linked to interbank rate. If LIBOR is 4,75 per cent, for example, the CD described above might
be paying 5 percent because it is quoted as paying LIBOR plus 25 basis points. Certificates of deposit are an
alternative of short-term, wholesale lending and borrowing. Three- and six-month maturities are common. Some
CDs are issued for one year and even for two years but the market for these is comparatively thin. This has led
to the practice of banks issuing ‘roll-over’ CDs, i.e. six-month CDs with a guarantee of further renewal on
specified terms. CDs are issued by a wide variety of banks. It is quite common for a bank both to have issued
and to hold CDs, though normally of differing maturities. It will issue CDs with a maturity expected to coincide
with a liquidity surplus and hold CDs expected to mature at a time of shortage. 3.2.5. Repurchase agreements A
repurchase agreement (REPO) is an agreement to buy any securities from a seller with the agreement that they
will be repurchased at some specified date and price in the future. Concept Repurchase agreement (REPO) is a
fully collateralize loan in wich the collateral consists of marketable securities. In essence the REPO transaction
represents a loan backed by securities. If the borrower defaults on the loan, the lender has a claim on the
securities. Most REPO transactions use government securities, though some can involve such short-term
securities as commercial papers and negotiable Certificates of Deposit. 47 Since the length of any repurchase
agreement is short-term, a matter of months at most, it is usually assumed as a form of short-term finance and
therefore, logically, an alternative to other money market transactions. Concept Open REPO is a REPO
agreement with no set maturity date, but renewed each day upon agreement of both counterparties. Concept
Term REPO is a REPO with a maturity of more than one day. A reverse REPO transaction is a purchase of
securities by one party from another with the agreement to sell them. Thus a REPO and a reverse REPO can
refer to the same transaction but from different perspectives and is used to borrow securities and to lend cash.
The participants of REPO transactions are banks, money market funds, non-financial institutions. The
transactions can amount 10 million in USD terms with the maturity from one to 15 days and for one, three, six
months. There is no secondary market for REPOs Since the effect of the REPO transactions influence money
market prices and yields, it is normal to regard such REPOs as money market deals. In a REPO, the seller is the
equivalent of the borrower and the buyer is the lender. The repurchase price is higher than the initial sale price,
and the difference in price constitutes the return to the lender. The amount of REPO loan is determined in the
following way: REPO principal = Securities market value x ( 1 – Haircut ) Securities market value = PAR x ( 1
– (d x n / 360 )) where the securities market value is determined as the current market value of these securities,
d is the rate of discount of the securities, n is term of the securities, PAR is the par value of the securities. In the
REPO transaction securities market value is equal to the value of collateral, against which the borrowing takes
place. Since the value of the securities may be fluctuating during the term of , the amount of the loan (the
principal) is less than the current market value of the securities. The deduction from current market value of the
securities collateral required to do the REPO transaction is made, which is call a haircut or a margin. The
haircut is a margin stated in terms of basis points. A standard haircut can be, e.g. 25 basis points (or 0,0025%).
Thus a REPO loan is overcollateralized loan meaning that the amount of the collateral exceeds the loan
principal and the haircut. Repurchase of the securities is made by repaying REPO loan and interest: REPO
principal + Interest = REPO principal ( 1 + (y x t / 360 )) where y is the yield or rate of the REPO transaction, t
is the term of the REPO transaction. REPO principal = Securities market value x (1 – Haircut) Securities market
value is defined as present value of the par value of the securities involved in the transaction. Concept Haircut –
the function of a broker/ dealer’s securities portfolio, that cannot be traded, but instead must be held as capital
to act as a cushion against loss. 48 The haircut or margin offers some protection to the lender in case the
borrower goes bankrupt or defaults for some other reason. The size of the risk, and thus this haircut / margin,
depends in large part upon the status of the borrower, but it also depends upon the precise nature of the contract.
Some REPO deals are genuine sales. In these circumstances, the lender owns the securities and can sell them in
the case of default. In some REPO contracts, however, what is created is more strictly a collateralized loan with
securities acting as collateral while remaining in the legal ownership of the borrower. In the case of default, the
lender has only a general claim on the lender and so the haircut / margin is likely to be greater. Example
Consider a 90 day REPO transaction, with a REPO rate of 4,75%. 180 days government securities with a rate of
discount of 5% and a par value of 10 million Euro are used as collateral. Assume that the haircut is equal to 25
basis points. What is the amount of REPO loan? What is the amount of REPO loan repayment in the
transaction? REPO deals are quoted on a yield basis. The rate is quoted as a simple interest yield on a 360 days
basis set upon initiation of the transaction and fixed for the term of REPO. The REPO rate or yield is calculated:
y = ( PAR – P ) / P x (360 / t ) where P is the purchase price, PAR is the agreed repurchase price and t is the
period of the transaction. Example Investor has purchased securities at a price of 9 980 000 Euro, with an
agreement to sell them back at 10 million Euro. At the end of 15 days period. What is the yield of the
transaction? REPO transactions have two legs: 1) when cash is borrowed against collateral; 2) when REPO
transaction takes place, i.e. securities are repurchased by repaying REPO loan plus interest. The repurchase of
the securities (REPO payment) is completely independent from the market value of the securities on the
maturity date of the REPO. This reinforces the economic reality that REPO transaction is a collateralized loan.
In a reverse REPO transaction the reverse payment is calculated: Reverse principal + Interest = Reverse
principal x ( 1 + (y x t / 360)) where y is the yield or REPO rate, t is maturity of the reverse REPO. Example
Assume a financial institution utilizes a reverse REPO to borrow securities and to lend cash. The securities
collateral is 1 million of par value government securities paying 6% p.a. semi annually with 5 years to maturity.
A REPO rate is 4,5%, 181 day of maturity, with a 50 basis points of haircut. What is the amount of reverse
REPO repayment of the transaction? REPO and reverse REPO markets as well as number of their participants
have grown up tremendously, especially due to increased sensitivity to interest rate risk and the opportunity cost
of holding idle cash. 49 Question What determines the size of the REPO principal? What determines the size of
the REPO repayment? REPO transactions are negotiated through a telecommunications network. Dealers and
REPO brokers perform the role of financial intermediaries to create REPO transactions fro the companies with
funds deficit or excess funds, and receive a commission for such services. However, direct REPO transaction is
executed, when there is a possibility to find counterparty for it. Market participants include central banks,
financial institutions, non-financial corporations. Central banks conduct short-term REPO transactions on bonds
of any residual maturity as a means of influencing money market interest rates. ‘ Non-financial companies,
private financial institutions are more likely to utilize reverse REPOs to earn interest on their cash balances
during the periods of high interest rates. Speculative REPO and reverse REPO transactions are attractive to
financial institutions with the increased volatility of interest rates. Money market funds often take the other side
of REPO transactions and hold reverses in their assets portfolios as flexible short-term investment vehicles.
Individuals, owning shares in these funds, earn interest on the reverses. The fund managers may speculate on
interest rate fluctuations using REPOs and reverse REPOs without being subject to the limitations on
speculative derivative transactions. Important participants of the REPO market are security dealers. They make
markets by carrying inventories of marketable securities, and can use these securities as collateral on REPO
loans. Thus they can reduce the cost of financing, utile REPOs to take positions on interest rates, finance their
securities portfolios. Interest yields for REPOs of different terms reflect a term structure of interest rates which
is a market consensus on forecasted interest rates. The REPO rate is significantly lower than other money
market rates, however higher than the rate of government securities. It is maintained by possibility to substitute
different money market instruments. There is no REPO secondary market. 3.2.6. International money market
securities Apart from variety of money market instruments which enable short-term lending and borrowing to
take place in the domestic currency, in recent years some of the fastest growing markets have been the so-called
eurocurrency markets. These are markets in which the borrowing and lending denominated in a currency of
some other country takes place. In general, eurocurrency market instruments are the same as other money
market instruments. When such instruments are denominated in some other currency, they are identified as
‘euro-’, though it can be any currency (e.g. US dollars, or Japanese yen). The trading can also take place
anywhere (in European countries or in New York or Tokyo or Hong Kong). Concept Eurocurrency instrument
is any instrument denominated in a currency which differs from that of the country in which it is traded. The
factor contributing to the long-term development of eurocurrency business was the ability of eurobanks to offer
their services at more competitive rates than domestic institutions. ‘Eurobanks’ are banks which specialize in
eurocurrency business. They channel funds between surplus and deficit units and, and thus create assets and
liabilities 50 which are more attractive to end-users than if they dealt directly with each other, also they help to
use funds which might otherwise lay idle. In the Eurodollar market banks channel the deposited funds to other
companies which need to receive Eurodollar loans. The deposit and loan transactions are of large
denominations, e.g. exceeding 1 million USD. Therefore only governments and largest corporations can
participate in the market. The market growth was influenced greatly by Eurocurrency liabilities of financial
institutions are the following:  Euro Certificates of deposits  Interbank placements  Time deposits  Call
money Euro certificates of deposits (Euro CDs) are negotiable deposits with a fixed time to maturity. Time
deposits are non negotiable deposits with a fixed time to maturity. Due to illiquidity their yields tend to be
higher than the yields on equivalent maturity of negotiable Euro certificates of deposits. Interbank placements
are short-term, often overnight, interbank loans of Eurocurrency time deposits. Call money are non negotiable
deposits with a fixed maturity that can be withdrawn at any time. Eurocurrency assets of financial institutions
are the following:  Euro Commercial Papers (Euro CPs)  Syndicated Euroloans  Euronotes Euro Commercial
Papers (Euro CPs) are securitized short-term bearer notes issued by a large well-known corporation. They are
issued only by private corporations in short maturities with the aim to provide short-term investments with a
broad currency choice for international investors. Most issues are pure discount zero coupon debt securities with
maturities from 7 to 365 days. Issuance may be conducted through an appointed panel of dealers.It can be resold
in a highly liquid secondary market. The issuers should be highly rated as Euro CPs are unsecured. Syndicated
Euroloans are related to bank lending of Eurocurrency deposits to nonfinancial companies with the need for
funds. Since they are non-negotiable, banks used to hold the syndicated loans in their portfolios until they
mature. Due to their illiquidity, the loans are often made jointly by a group of lending banks, which is called a
syndicate. The role of syndication is to share loan risks among the banks that members of the syndicate.
Euronotes are unsecuritized debt instruments, substitutes for non-negotiable Euroloans. They are short –term,
most often up to one year. Floating rate notes (FRNs) offer a variable interest rate that is reset periodically,
usually seminannually or quarterly, according to some predetermined market interest rate (e.g. LIBOR). For a
high rated issuer the interest rate can be set lower than LIBOR. 51 3.3. Money market interest rates and yields
Short-term money market instruments have different interest rate and yield quoting conventions. The yield on
short-term money market instruments is often calculated using simple interest as opposed to compound interest,
and as a result is not directly comparable with the yields to maturity. Short-term government securities
(Treasury bills), commercial papers are often quoted and traded on a ‘discount’ basis, while interbank loan
rates, REPO rates are quoted on an “addon” basis. Besides, it is a convention in the US Treasury bills market to
assume that a year has 360 days, while if it is denominated in sterling it has 365 days, even in a leap year. Short-
term money market instruments frequently do not have a specified coupon and as a result investors in them
obtain a return by buying them at a discount to their par or maturity value. Below is provide the comparison of
different money market rates and yields. 1) Rate on a discount basis d = ( PAR – P ) / PAR x (360 / t ) where d
is the yield on the basis of rate of discount, PAR – par value, P – the purchase price of the security and t is the
number of days until maturity. Discount is calculated in this case as a percent from par value. It also assumes a
360 days year. Example A 90 day US dollar Treasury bill is issued at 99% of its par value. It will be redeemed
at its par value (100 %) 90 days after issue. It is traded on a discount basis. The discount of this issue is: d =
(100 − 99) / 100 × 360 / 90 = 4% Note that in the US dollar money market a year is assumed to have 360 days.
The discount is often converted into a yield so as to make it comparable with other money market instruments.
This yield is often called a ‘money market yield’. Using the above example, the money market yield is just 4 ×
100/99 = 4.0404 %. 2) Add-on rate y = ( PAR – P ) / P x (360 / t ) where y is the yield on the basis of add-on
rate, PAR – par value, P - the purchase price of the security and t is the number of days until maturity. Example
Assume 990 000 Euro is lent for a 90 day period at the addon rate. The par value is 1000 000 Euro. The
annualized yield of the security at an add-on basis will be y = (1000000 – 990000) / 990000 ) x ( 360 / 90 ) = =
0,0404 or 4,04 %. 52 3) Bond-equivalent yield y = ( PAR – P ) / P x (365 / t ) where y is the yield, PAR – par
value, P - the purchase price of the security and t is the number of days until maturity. Example Assume the
same 90 day US dollar Treasury bill issued at 99% of its par value. It will be redeemed at its par value (100 %)
90 days after issue. The bond equivalent yield this issue is: y = (100 − 99) / 99 × 365 / 90 = 4, 097% The bond
equivalent yield is used to compare Treasury bill yields with the yields to maturity of coupon bearing Treasury
notes and bonds. The bond equivalent yield is is an approximation of the yield to maturity of a bond. The bond
equivalent yield is higher than the discount rate. The difference is larger for longer maturities and for higher
levels of discount rate d. Therefore an error of yield using discount rate d increases for longer maturities and for
higher rates. 4) Annual yield to maturity y = ( PAR / P ) (365 / t ) – 1 where y is the yield, PAR – par or
maturity value, P - the purchase price of the security and t is the number of days until maturity. Example
Assume the same 90 day US dollar Treasury bill issued at 99% of its par value. It will be redeemed at its par
value (100 %) 90 days after issue. Annual yield to maturity of this money market instrument is: y = ( 100 / 99)
(365 / 90) - 1 = 4, 097% 5) Semiannual yield to maturity y = 2 x ( PAR / P ) (365 /2 t ) – 2 where y is the yield
on the basis of add-on rate, PAR – par or maturity value, P - the purchase price of the security and t is the
number of days until maturity. Example Assume the same 90 day US dollar Treasury bill issued at 99% of its
par value. It will be redeemed at its par value (100 %) 90 days after issue. The semiannual yield to maturity of
this money market instrument is: y = 2 x ( 100 / 99) (365 /2x 90) - 2 = 4, 097% Comparison of all the money
markets rates and yields are provided in Figure 9. It shows that the largest is always the annual yield, which is
then followed by semiannual yield, bond equivalent yield, the yield on the basis of add-on rate and the yield on
discount basis. The difference between bond equivalent yield and the semiannual yield are smaller for longer
maturities and approach as the maturity approaches half a year. The longer the maturity, the smaller is the
difference between bond equivalent yield and the annual yield. 53 Finally, the longer the maturity, the larger are
the differences between the money market discount rate and other rates. Figure 9. Money market rates and
yields Several specific money market interest rates are used in Europe. The key European Central Bank (ECB)
interest rate is the minimum bid rate, which represents the price floor, which ensures central bank liquidity in
the open-market operations. The two other key interest rates, on the marginal lending facility and the deposit
facility, define the corridor within which the overnight interest rate can fluctuate. The Governing Council of the
ECB sets the level of the minimum bid rate in the Eurosystem’s weekly main refinancing operations (MROs).
Through the MROs, the ECB aims to supply the liquidity necessary for the banking system to operate smoothly.
This way very short-term money market interest rates are aligned with the monetary policy of the ECB.
Through the money-market yield curve, monetary policy is transmitted to financial instruments and credit
conditions more generally, which in turn will influence saving and investment decisions and thus will affect
price developments in the euro area. When money market is affected by crisis in the financial markets, the ECB
needs to provide additional liquidity in order to support market confidence. Apart from the ECB interest rates,
there are other main market interest rates for the money market:  EONIA (euro overnight index average). The
EONIA is the effective overnight reference rate for the euro. It is computed daily as a volume-weighted average
of unsecured euro overnight lending transactions in the interbank market, as reported by a representative panel
of large banks.  EURIBOR (euro interbank offered rate). The EURIBOR is the benchmark rate of the large
unsecured euro money market for maturities longer than overnight (one week to one year) that has emerged
since 1999. It is based on information provided by the same panel of banks. 90 180 Days Discount rate Add-on
rate Annual Semiannual Bond equivalent yield Rate 54  EUREPO (the REPO market reference rate for the
euro) for different maturities. The EUREPO is the benchmark rate of the euro REPO market and has been
released since March 2002. It is the rate at which one prime bank offers funds in euros to another prime bank
when the funds are secured by a REPO transaction using general collateral.  The rate of interest paid on
interbank loans in London (UK) is known as London InterBank Offer Rate or LIBOR. It is an important
reference to banks of the cost of raising immediate marginal funds. Numerous bank interest rates are therefore
tied to LIBOR, particularly to the rate for three-month deposits. The spreads among the key ECB interest rates
and short-term market interest rates are low. E.g., EONIA is mostly slightly above, but very close to, the
minimum bid rate. The small spread (about 6 to 7 basis points) reflects that the EONIA is an unsecured
interbank rate. It includes a small premium for credit risk and transaction costs. Larger spreads normally occur
at the end of the reserve maintenance period when there is a need for the banks to fulfil the reserve requirement.
The yields of money market securities are closely monitored by money market participants. Since money
market securities are seen as close substitutes, investors may exchange them to achieve more attractive yields.
This causes yields among the securities to come closer. If there is a difference between yields, investors will
avoid lower yielding instruments and will favour the ones with high-yield. During the periods of larger
uncertainty about the economy, investors tend to shift from more risky money market securities to Treasury
bills and other government securities. 3.4. Summary Money market securities short-term instruments, which
have maturities shorter than one year. Trading with these securities in interbank, primary and secondary markets
are very active. The volume of transactions in national markets as well as international markets is large. A
variety of money market securities allow to meet special needs of borrowers and lenders. Key terms  Money
market  Commercial paper  Certificate of deposit  REPO  Treasury bills  Interbank market Further
readings 1. Bernanke B., Blinder A. (1992). The FF rate and the channels of monetary transmission, Journal of
Banking and Finance, No. 16, p. 585-623. 2. European Central Bank (2007). Euro Money Market Survey, ECB,
Frankfurt am Main. 55 3. European Central Bank (2008). The Analysis of the Euro Money Market from a
Monetary Policy Perspective, ECB Monthly Bulletin, February. 4. Hartmann P., Manna M., Manzanares A.
(2001). The Microstructure of the Euro Money Market, ECB Working Paper 80. 5. International Capital Market
Association (2007). European REPO Market Survey, Number 12, conducted December 2006, Zürich, ICMA. 6.
Wolswijk G., de Haan J. (2005). Government Debt Management in the Euro Area: Recent Theoretical
Developments and Changes in Practices, ECB Occasional Paper 25. Relevant websites 
http://news.ft.com/home/uk  http://www.bankofengland.co.uk  http://www.ecb.int/pub 
http://www.bis.org/publ Review questions and problems 1. How do money markets differ from capital markets?
2. Who are the main participants of money markets? 3. What is the difference between money market
instruments quoted ‘on a discount basis’ and ‘on a yield basis’? 4. How are government securities (e.g. Treasury
- bills) priced? 5. How are commercial papers priced? 6. How are certificates of deposit priced? 7. How are
REPO agreements priced? 8. Assume that one-month government security and one-month CDs are both quoted
as having a yield of 5 per cent. Which gives the higher yield to an investor? 9. Suppose that long-term interest
rates are expected to fall in future. How is this to influence the supply of commercial paper and why? 10.
Assume that the government makes a major sale of bonds to the private sector. Explain the likely effect on a)
liquidity of the banking system; b) demand for money market instruments. 11. Imagine that the central bank is
concerned about the rate of growth of credit in the economy. Explain how it might use its position in the REPO
market to address this problem. 12. How can the central bank of a country use REPOs on government bonds to
raise interest rates from 4,5 percent to 5 percent? 56 13. A money market security with the par value of 100000
Euro is selling for 881600 Euro. What is required return of investor, if the security has two years until maturity?
14. Government is selling its 91 days securities with the face value of 1 000 000 Euro for 880 000 Euro. a)
What is the yield on the investment, if the bank invests and holds the securities until maturity? b) How can the
annualized yield be affected if the purchase price is lower? c) How can the annualized yield be affected if the
selling price is lower? Explain the logic of the relationship. d) How would the annualized yield be affected if the
number of holding days is shorter, but the purchase price and the selling price is constant? Explain the
relationship. 15. A company has received a substantial loan from commercial banks. The interest rate on the
loans is tied to market interest rates and is adjusted every six months. The company has obtained a credit line to
satisfy temporary funds needs. Besides, in order to solve unexpected liquidity problems, it can sell shortterm
government securities, which it has bought half a year ago. The economic forecasts are rather optimistic, thus in
order to satisfy the rising demand, the company may be in need to increase its production capacity by about 40
percent over the next two years. However, the company is concerned about potential slow down in the economy
due to possible actions of European central bank aimed at sustaining the inflation rate low. The company needs
funding to cover payments to suppliers. It is also considering other possibilities of financing in the money
market. The interest rate that the company is paying for its line of credit is less than the prevailing commercial
paper interest rate of highly rated companies. a) Should the company issue commercial paper on this prevailing
interest rate? b) Should the company sell its holding of government securities to cover the payments to
suppliers? c) Should the company use its credit line? d) Which alternative has the lowest cost for the company?
Provide the reasoning. 57 4. DEBT MARKETS Mini contents  The characteristics of debt markets  The
characteristics of debt instruments  Valuation of bonds  Bond duration and convexity  Callable bonds and
other bond instruments 4.1. Debt market instrument characteristics Debt markets are used by both firms and
governments to raise funds for long-term purposes, though most investment by firms is financed by retained
profits. Bonds are longterm borrowing instruments for the issuer. Major issuers of bonds are governments
(Treasury bonds in US, gilts in the UK, Bunds in Germany) and firms, which issue corporate bonds Corporate
as well as government bonds vary very considerably in terms of their risk. Some corporate bonds are secured
against assets of the company that issued them, whereas other bonds are unsecured. Bonds secured on the assets
of the issuing company are known as debentures. Bonds that are not secured are referred to as loan stock. Banks
are major issuers of loan stock. The fact that unsecured bonds do not provide their holders with a claim on the
assets of the issuing firm in the event of default is normally compensated for by means of a higher rate of
coupon payment. Important characteristics of bonds involve: The conventional or straight bond has the
following characteristics: Residual maturity (or redemption date). As time passes, the residual maturity of any
bond shortens. Bonds are classified into ‘short-term’ (with lives up to five years); ‘medium-term’(from five to
fifteen years) ; ‘long-term’(over fifteen years). Bonds pay a fixed rate of interest, called coupon. It is normally
made in two installments, at six-monthly intervals, each equal to half the rate specified in the bond’s coupon.
The coupon divided by the par value of the bond (100 Euro) gives the coupon rate on the bond. The par or
redemption value of bonds is commonly 100 Euro (or other currency). This is also the price at which bonds are
first issued. However, since the preparations for issue take time, market conditions may change in such a way as
to make the bonds unattractive at their existing coupon at the time they are offered for sale. They will then have
to be sold at a discount to 100 Euro, in order to make the coupon rate approximate the market rate of interest. If,
vise versa, the market interest rates fall, the coupon may make the bond attractive at a price above 100 Euro. In
these cases the issuers are making a last-minute adjustment to the price which they hope will make the bonds
acceptable to the market. Bond prices fluctuate inversely with market interest rates. If market rates rise, people
prefer to hold the new, higher-yielding issues than existing bonds. Existing 58 bonds will be sold and their price
will fall. Eventually, existing bonds with various coupons will be willingly held, but only when their price has
fallen to the point where the coupon expressed as a percentage of the current price approximates the new market
rate. The yield on bonds are expressed commonly in two forms:  redemption yield;  interest yield or running
yield. Concept Interest yield (or running yield) - the return on a bond taking account only of the coupon
payments. Concept Yield to maturity or redemption yield: The return on a bond taking account of the coupon
cash flows and the capital gain or loss at redemption. The types of bonds include: Callable and putable bonds.
Callable bonds can be redeemed at the issuer’s discretion prior to the specified maturity (redemption) date.
Putable bonds can be sold back to the issuer on specified dates, prior to the redemption date. Convertible bonds.
These are usually corporate bonds, issued with the option for holders to convert into some other asset on
specified terms at a future date. Conversion is usually into equities in the firm, though it may sometimes be into
floating rate notes. Eurobonds. Eurobonds are bonds issued in a country other than that of the currency of
denomination. Thus bonds issued in US dollars in London are eurobonds, as are yen bonds issued in New York.
The bonds themselves may be straights, that is fixed-interest, fixed redemption bonds like the sterling ones
described above, or they may come in any of the variations listed here. Eurobonds are issued by governments
but more usually by corporations. Euro bonds. These are bonds denominated in euros and issued in the euro
currency area. If bonds denominated in euros would be issued outside the euro currency area, they would be
euro eurobonds. Floating rate notes (FRNs). These are corporate bonds where the coupon can be adjusted at
pre-determined intervals. The adjustment will be made by reference to some benchmark rate, specified when the
bond is first issued. An FRN might specify, for example, that its coupon should be fifty basis points above six-
month treasury bill rate, or six-month LIBOR, adjusted every six months. FRNs are, in part, a response to high
and variable inflation rates. Foreign bonds. These are corporate bonds, issued in the country of denomination,
by a firm based outside that country. Thus, a US firm might issue a sterling bond in London. Index-linked
bonds. These are corporate bonds where the coupon can be adjusted to high and variable rates of inflation.
While other bonds have a maturity (redemption) value fixed in nominal terms and therefore suffer a decline in
real value as a result of inflation, both the value and the coupon of an index-linked bond are uprated each year
in line with lagged changes in a specified price index. Junk bonds. Junk bonds are corporate bonds whose
issuers are regarded by bond credit rating agencies as being of high risk. They will carry a rate of interest at
least 200 basis points above that for the corresponding bonds issued by high-quality borrowers. 59 Strips.
Stripping refers to the breaking up of a bond into its component coupon payments and its maturity (redemption)
value. Thus a ten-year bond, paying semi-annual coupons, would make twenty-one strips. Each strip is then sold
as a zero-coupon bond. That is, it pays no interest but is sold at a discount to the payment that will eventually be
received. In this sense, it is like a long-dated bill. The strips are created from conventional bonds. 4.2. Bond
market 4.2.1. Bond market characteristics Debt markets include: primary markets for bonds, i.e. the markets in
which newly issued instruments are bought, secondary markets , in which existing or second hand instruments
are traded. Majority of world bond markets have different institutional arrangements for the issue and trading of
government bonds and corporate bonds. The reason is that governments should be able to sell the debt, which
they use for budgetary and other purposes. Thus an active market with high rated participants should be
ensured. Therefore government bond markets are subject to high level of supervision and regulation by the
central bank. For governments bonds are the main instrument (mainly central governments, but also regional
and local government authorities, and social securities funds) to finance their budget deficits. This is true
especially for within the euro area countries. Besides, government bonds often serve as a benchmark for pricing
other assets and they are also frequently used as collateral in various financial transactions. In governments debt
securities issues form the most important market segment, followed by debt securities issued by financial
institutions (consisting of monetary financial institutions (MFIs) and non-MFI financial institutions), and those
issued by non-financial corporations. Monetary financial institutions include all financial institutions whose
business is (1) to receive deposits and/or close substitutes for deposits from entities other than MFIs and (2) to
grant for their own account credit and/or invest in securities.. The non-government bond market is dominated by
bank debt securities. This segment includes different types of bonds, including unsecured bank debt securities
and covered bonds. Concept Covered bonds are claims of the bond holders against the issuing MFI that are
secured by a pool of cover assets on the MFI’s balance sheet, such as mortgage loans or loans to the public
sector. . The introduction of the euro in 1999 had a major impact on the operations of governmentdebt managers
as the disappearance of exchange rate risks within the euro area created the conditions for a pan-European
capital market. As a result, debt managers became players in a larger European market. Investors turned their
focus more on credit risk and liquidity, while bond portfolios have become increasingly internationally
diversified, especially in the smaller euro-area countries. Consequently, competition among debt managers has
increased, stimulating a more efficient primary market and a deeper, more liquid secondary market.
Governments have put great effort into making their outstanding debt and new issues more attractive to
international bond investors. In addition to local systems, the European electronic platform for government
securities, EuroMTS, was introduced in 1999, enabling quotation and trading of some European benchmark
bonds 60 4.2.2. Bond market yields Bond yields are influenced by interest-rate expectations, the term premium,
credit risk and liquidity. Risk-averse investors demand a risk premium (term premium) for investments in
longterm bonds to compensate them for the risk of losses due to interest rate hikes; those losses increase with
bond duration. The term premium leads to a positive term spread, i.e., the spread of yields for bonds with longer
maturity over yields for bonds with shorter maturity, even when markets expect increasing and decreasing
interest rates to be equally likely. Liquidity is one of the key characteristics of the bond market. Liquidity is the
ease with which an investor can sell or buy a bond immediately at a price close to the mid-quote (i.e., the
average of the bid–ask spread). A liquid market allows market participants to trade at low trading costs. Kyle
(1985) identifies three dimensions of liquidity:  tightness: the cost of turning around a position during a short
period. Tightness in essence refers to a low bid–ask spread;  depth: a market is deep if only large buy or sell
orders can have an impact on prices;  resiliency: a market is resilient if market prices reflect ‘fundamental’
values and, in particular, quickly return to ‘fundamental’ values after shocks. The spread between the yield of a
bond with liquidity and a similar bond with less liquidity is referred to as the liquidity premium Credit risk is
the risk of loss because of the failure of a counterparty to perform according to a contractual arrangement, for
instance due to a default by a borrower. The spread between the yield of a particular bond and the yield of a
bond with similar characteristics but without credit risk is the credit-risk premium. Rating agencies – like
Moody’s, Standard & Poor’s, and Fitch – indicate issuers’ credit risk by assigning them a rating. .Credit risk
and liquidity premia of euro-denominated bonds are typically calculated as the spread of the bond yields over
those of German government bonds. There are two reasons for this. First, German government bonds have
consistently received the highest ranking from the three main rating agencies, indicating that German
government bonds are associated with zero or very low credit risk. Second, German government bonds are very
actively traded, ensuring that they are very liquid. Yield differentials vary considerably across countries, while
for each country the yield differential varies considerably over time. Pagano and Von Thadden (2008) discuss
studies that try to explain these yield differentials, arguing that they may arise from (1) intrinsic differences in
country-specific default risk or different sensitivities of bonds’ future payoffs to common shocks, or (2) market
frictions, like trading costs, clearing and settlement fees, and taxes. They state that credit risk explains a
considerable portion of cross-country yield differences but explains very little of their variation over time. 61
4.3. Bond valuation 4.3.1. Discounted models The fair value or fair price of a bond is based on the present value
of expected future cash flows. The general formula for estimating the fair price of a bond is: P = C/(1+r)
+C/(1+r)2 + C/(1+r)3 +. . .+ C/(1 + r)n + B/(1+r)n where P is the fair price of the bond (its dirty price, which
includes accrued interest), C is the regular coupon payment each period, B is the money value to be paid to the
bondholder at maturity (redemption), r is the rate of discount per period, and n is the number of periods to
maturity (redemption). Example A bond pays a coupon of 4 Euro every six months, and 100 Euro will be repaid
at maturity. There are two years to maturity and the next coupon is due in six months. The redemption yield on
similar bonds is 6% p.a. Estimate the fair price of the bond. An interest rate of 6% p.a. indicates a rate of 3% per
sixmonth period. P = 4/(1,03) + 4/(1,03)2 + 4/(1,03)3 +4/(1,03)4 + 100/(1,03)4 P = 3,88 + 3,77 + 3,.66 + 3,55 +
88.85 = 103,71 Euro Typically a single rate, the redemption yield or redemption yield, is applied to discounting
all future cash flows. The redemption yield of a bond could be viewed as an average of discount rates applicable
to the various future cash flows. The redemption yield indicates the average annual return to be received by an
investor holding a bond to maturity. The rate of discount is the required rate of return from a bond. The required
rate of return can be regarded as the sum of the yield on bonds that are free of default risk (government bonds)
and a risk premium to reflect the default risk of the bond being valued. High default risk entails a high required
rate of return and hence a high discount rate. Therefore, for any particular stream of future cash flows, high risk
bonds would have higher rates of discount and hence lower fair prices than low risk bonds. Thus, bond prices
have an inverse relationship to interest rates, and second, that they have an inverse relationship to the risk of
default. High interest rates and high risk are associated with low prices. An important distinction when
considering bond prices is between the clean and dirty prices. When a bond is purchased, the buyer must
include in the purchase price a sum corresponding to the seller’s share of the next coupon. If the coupon is paid
six-monthly, and the bond is sold three months after the last coupon payment date, the seller would require the
price to include half the next coupon so that holding the bond for the previous three months provides an interest
yield. The rights to the coupon accumulated by the seller are referred to as accrued interest. The clean price of a
bond excludes accrued interest whereas the dirty price includes it. Concept Clean price - the price of a bond
ignoring any interest which may have accrued since the last coupon payment. Concept Dirty price - the price of
a bond, including any accrued interest. 62 Quoted prices are usually clean prices whereas the price to be paid is
the dirty price. Example Assume it is 22 November 2010.Treasury 10% 2012 matures on 21 November 2012.
Calculate the fair price of this bond when the redemption yield is 10% p.a. and 5% p.a. Assume it is 22
November 2010.Treasury 5% 2012 matures on 21 November 2012. Calculate the fair price of this bond when
the redemption yield is 10% p.a. and 5% p.a. Assume it is 22 November 2010. A zero-coupon bond matures on
21 November 2012. Calculate the fair price of this bond when the redemption yield is 10% p.a. and 5% p.a.
Treasury 10% pays 10 Euro per year, i.e. 5 Euro every six months. 5/(1,05) + 5/(1.05)2 + 5/(1.05)3 +
105/(1,05)4 = 4,76 + 4,54 + 4.32 + 86,38 = 100 Euro (Note that 105/(1,.05)4 is the same as 5/(1,05)4 +
100/(1,05)4 ) 5/(1,025) + 5/(1,025)2 + 5/(1,025)3 + 105/(1,025)4 = 4,88 + 4,76 + 4,64 + +95,12 = 109,40 Euro
Treasury 5% pays 5 Euro per year, i.e. 2.50 Euro every six months. 2,5/(1,05) + 2,5/(1,05)2 + 2,5/(1,05)3 +
102,5/(1,05)4 = 2,38 + 2,27 + 2,16 + 84,33 = 91,14 Euro 2,5/(1,025) + 2,5/(1,025)2 + 2,5/(1,025)3 +
102,5/(1,.025)4 = 2,44 + 2,38 + 2,32 + 92,86 =100 Euro A zero coupon bond pays no coupons. The only cash
flow receipt is the 100 Euro at redemption. 100/(1,1)2 = 82,64 or 100/(1,05)4 = 82,27 Euro 100/(1,05)2 = 90,70
Euro or 100/(1,025)4 = 90,60 Euro Bond prices are inversely related to interest rates, but the relationship is not
symmetrical. The proportionate fall in the bond price resulting from a rise in interest rates is less than the
proportionate rise in the bond price caused by a fall when the percentage point change in interest rates is the
same in the two cases. This can be illustrated by reference to the case of a bond with no maturity date. The price
of such a bond is: P = C/r where P represents the fair price of the bond, C the coupon, and r is the interest rate
(required rate of return). Consider the case of a 5 Euro annual coupon and an initial interest rate of 10% p.a. The
fair price of the bond would be estimated as: 5 / 0,1 = 50 Euro If the interest rate falls by 2 percentage points to
8% p.a., the price of the bond is expected to rise to: 5 / 0,08 = 62.50 Euro 63 If the interest rate rises by 2
percentage points to 12% p.a., the fair price of the bond falls to: 5 / 0,12 = 41,67 Euro Whereas the interest rate
fall results in a 25% price rise, the equivalent interest rate increase causes a 16,67% price decline. This
asymmetry of price response is referred to as convexity. Future cash flows from a bond, together with the
required rate of return, can be used to estimate the fair price of the bond. The process could be reversed in order
to find the redemption yield of the bond knowing its current price and the future cash flows. The redemption
yield (y) can be obtained by solving equation for y. P =C/(1+y)1 +C/(1+y)2 +C/(1+y)3 +C/(1+y)4 +B/(1+y)4
where P is the current market price of the bond, C is the annual coupon, B is the redemption value of the bond,
and y is the redemption yield (yield to maturity). The effective annual yield takes account of the compounding.
The effective annual yield is given by: (1+y) 2 -1 . Realized compound yield is the average compound rate of
return actually obtained from an investment. Realized compound yield is affected by yield on reinvested
coupons. The calculations of redemption yield assume that coupons are reinvested at the redemption yield. The
realized compound yield equals the redemption yield if coupons are reinvested at the redemption yield and the
bond is held to redemption. If the reinvestment rate for the coupons exceeds the redemption yield, the realized
compound yield will exceed the redemption yield. If the reinvestment rate for the coupons is less than the
redemption yield, the realised compound yield will be less than the redemption yield. Bond duration and risk
There are two types of risk encountered by investors in bonds. There is price (or capital) risk, and reinvestment
(or income) risk. Price risk is the risk that bond prices can change. For example a general rise in interest rates,
or a fall in the credit rating of a particular bond, would reduce the price of a bond. A capital loss would result.
Reinvestment risk refers to the uncertainty of the interest rate at which coupons and redemption sums can be
invested. This causes uncertainty as to the final sum that will be available at the end of an investment horizon.
4.3.2. Bond price volatility Bond price volatility is measured by duration. The duration measures include
Macaulay’s duration, modified duration, and money duration. Macaulay’s duration is the average period of time
to the receipt of cash flows. Each time period (to the receipt of a cash flow) is weighted by the proportionate
contribution of that cash flow to the fair price of the bond. Macaulay’s duration is transformed into modified
duration by means of dividing it by (1+r/n), where r is the redemption yield (which approximates an interest
rate) and n is the number of coupon payments per year. Macaulay’s duration has another meaning, it is the
proportionate change in the bond price (fair price of the bond) arising from a unit proportional change in (1 +
redemption yield). Macaulay’s duration = (ΔP/P) / (Δ(1+r)/(1+r)) 64 Where Δ is the change in, and P is the
bond price.) The corresponding interpretation of modified duration is: Modified duration = (ΔP/P) / Δ r Δ (1+r)
= Δ r. Equations assume annual coupon payments. When coupons are paid more frequently, r is replaced by r/n
(the annual redemption yield divided by the number of coupon payments per year). The calculation of duration
can be demonstrated by an example. Suppose that a bond has just paid a coupon, matures in two years, and pays
a coupon of 6 Euro six-monthly. The interest rate is 10% p.a. for all maturities. The fair price of the bond is: P =
6/(1,05)+6/(1,05)2 +6/(1,05)3 +106/(1,05)4 = 5,71 + 5,44 + 5,18 + 87,21 = 103,54 An interest rate of 10% p.a.
is 5% per six-month period. Macaulay’s duration is calculated as the weighted average of the periods to the
receipt of cash flows. The weighting is based on the contribution of the period’s cash flow to the fair price of
the bond. The periods are 0,5, 1, 1,5, and 2 years. Macaulay’s
duration=(5,71/103,54)0,5+(5,44/103,54)1,0+(5,18/103,54)1,5 +(87,21/103,54)2,0 =0,028 + 0,053 + 0,075 +
1,685 = 1,841 years. Conversion of Macaulay’s duration to modified duration is made through division by
(1+r/n). Modified duration =1,841/(1 +0,1/2) =1,841/(1,.05) =1,753 Example A corporate bond pays an annual
coupon of £10 and has four years to maturity. It has just paid a coupon. As a result of a downgrading of its
credit rating, its required rate of return rises from 8% p.a. to 12% p.a. What are the effects of this change on (a)
the price, and (b) the Macaulay’s duration, of the bond? (c) Discuss your results. Example Treasury 10% 2012,
which pays coupons six-monthly, will reach maturity on 10 June 2012. It is now 11 June 2010. Interest rates for
0,5, 1, 1,5, and 2 years are all 7% p.a. Estimate the fair price, Macaulay’s duration, and modified duration of the
bond. Example An investor has two bonds. Bond A pays a 5 Euro annual coupon and matures in five years.
Bond B pays a 4 Euro coupon semi-annually and matures in three years. The investor needs to sell one bond
immediately and hold the other for two years. The current rate of interest, for all maturities up to five years, is
6% p.a. Which bond would the investor sell if that investor expected interest rates to: (a) increase, (b) decrease?
65 4.3.3. Behavior of Macaulay’s duration Macaulay’s duration of a bond behavior can be summarized by a set
of rules. Rule 1: The duration of a zero coupon bond equals its time to maturity. Since a zero coupon bond
generates only one cash flow, the payment of principal at maturity, the average time to the receipt of cash flows
equals the time to that payment. Rule 2: Holding time to maturity and redemption yield constant, duration is
inversely related to the coupon. Rule 3: Holding the coupon rate constant, duration generally increases with
time to maturity. Rule 4: Holding coupon and maturity constant, duration is inversely related to redemption
yield. Rule 5: The duration of an irredeemable bond is given by (1 + r)/r, where r is the redemption yield. If a
bond pays the same coupon each period forever without the principal ever being repaid, the duration equals (1 +
r)/r. Example A fund manager holds a 100-million Euro bond portfolio comprising three bonds: A, B, and C.
Bond A has duration of four years and accounts for 25 Euro million of the portfolio. Bond B has a duration of
seven years and accounts for 25 Euro million. Bond C, of which 50 Euro million is held, has duration of ten
years. What is duration of the portfolio? 4.3.4. Immunization Bonds are used in institutional investment
portfolios not only as means of accumulating wealth but also as means of funding annuity payments. Since it is
possible to obtain reasonably reliable estimates of the duration of prospective annuity payment streams as well
as the duration of bond portfolios, it is possible to match the duration of the bond portfolio with the duration of
the annuity payments. Such duration matching, or immunisation, is very useful for annuity and pension
providers since it provides a high degree of protection against interest rate risk. Duration is also important for
the structuring of bond index tracker funds. If such a fund were to be constructed using stratified sampling
based on a cell structure, one of the characteristics of a cell would be duration. Other characteristics might be
redemption yield and credit rating. There would be a cell for each combination of characteristics (e.g. high
duration, low redemption yield, high credit rating), and the portfolio would contain an appropriately weighted
combination of cells. If an annuity fund, index tracker fund, or other bond fund exhibits a duration that differs
from the optimum it is possible to use bond futures to adjust the portfolio duration to the desired value. 4.3.5.
Bond convexity Duration provides just an approximation to the relationship between yield changes and bond
price movements. The analysis of the price/yield relationship for a bond together with a straight line
representing duration (i.e. price value of a basis point, PVBP), shows that for small changes in yield it is
sufficient. 66 Concept Convexity is a measure of the change in duration with respect to changes in interest rates.
However, the actual price change is expressed by the curved price/yield relationship. Thus for large yield
changes, the duration line provides a poor estimate of the actual price change. Duration underestimates price
rises and overestimates falls. In both cases the new bond price is underestimated. The inaccuracies arise because
money duration fails to take account of the convexity (curvature) of the actual price/yield relationship of a bond.
While constructing bond portfolios a bond portfolio manager should be concerned with not only duration, but
also convexity. Convexity has value in that it leads to higher bond prices following interest rate movements,
when compared with an investment with zero convexity. High convexity bonds provide this benefit to a greater
extent than low convexity bonds. The benefits of convexity are greater when interest rate changes are relatively
large. This implies that the portfolio manager needs to consider the prospective size of interest rate movement
as well as the direction. Figure 10. Duration and convexity If instead of duration a Taylor expansion is used,
expressing the percentage change in bond price in terms of the first, second and higher derivatives, the
approximation is more accurate. The second derivative incorporates what has been called convexity: Convexity
= ( d2 P / dy2 ) x ( 1/P ) x (1 / 2 ) to y2, Figure 10 shows, that for increases of interest rates to y2 the duration
plus convexity approximation gives a high estimate of bond price. For decreases in interest rates to y3 , the
duration and convexity approximation give a low estimate of bond price. Example A bond has just paid a six-
monthly coupon of 4 Euro. There are four more coupons to be paid by maturity. How accurate is modified
duration for the purpose of estimating the effect y3 y1 y2 Initial interest rate First & second derivatives First
derivative Interest rate Price e Price 67 of a (a) 0.2% p.a., and (b) 1% p.a., decrease in the redemption yield on
the bond price, when redemption yields are initially 2% p.a. Comment on the results of the calculations. A bond
with high convexity will tend to have a relatively low redemption yield. The advantage from high convexity
would be offset by a lower yield. If interest rate movements are small, the gains from convexity would not
compensate for the low yield. So if a portfolio manager expects a small interest rate change, bonds with low
convexity should be chosen. If the expectation is that there will be a substantial interest rate movement, high
convexity bonds should be chosen. Convexity is greatest for low coupon, long maturity, and low-redemption-
yield bonds (i.e. high duration bonds).Convexity can be calculated and combined with measures of duration
when evaluating the potential effects of interest rate changes on bond prices. Since measures of duration are
accurate only for very small changes in interest rates, a convexity correction is required in the case of large
interest rate movements. To estimate the effects of relatively large interest rate changes on bond prices, it is
necessary to combine an estimate of convexity with an estimate of duration. 4.4. Bond analysis 4.4.1. Inverse
floaters and floating rate notes Financial engineering can create derivatives from a non-derivative investment,
e.g. the division of a conventional bond into an inverse floater and a floating rate note. Inverse floater is a bond
whose interest rate is inversely related to a market rate. For example an inverse floater might pay a coupon rate
of 10% p.a. minus LIBOR (LIBOR is a commonly used benchmark interest rate that reflects market rates). The
price of an inverse floater is extremely sensitive to interest rate movements. Not only does the coupon rate fall
when interest rates rise, but the rate at which the coupons and principal value are discounted also rises. There
are two effects of interest rate rises that act to reduce the bond price. Conversely interest rate falls have two
positive effects on the bond price; the higher coupons are accompanied by a lower discount rate. So inverse
floaters are very sensitive to interest rate changes, in other words they have very long durations. Inverse floaters
are structured by dividing a conventional bond into an inverse floater and a floating rate note. Floating rate note
is a bond whose coupon rate moves in line with market rates. For example the coupon rate on a floating rate
note might be 2% p.a. plus EURIBOR. Since the coupon rate moves in the same direction as the rate of
discount, effects of interest rate changes tend to offset each other with the effect that there is little net effect on
the bond price. Floating rate notes exhibit low price volatility and hence short durations. The high duration of
inverse floaters renders them useful for hedging long-term liabilities. Falling interest rates increase the value of
the liabilities, but that would be offset by the increase in the value of the inverse floaters. Inverse floaters might
be attractive to institutions with long-term liabilities such as pension funds, annuity providers, and life
assurance companies. Conversely floating rate notes could be attractive to institutions with short-term liabilities,
such as banks and building societies. 4.4.2. Callable bonds Some corporate bonds are callable. This means that
the issuer has the right to repurchase the bonds at a predetermined price (the issuer has a call option on the
bonds). To 68 compensate for the risk of future calls, the bondholders require a higher coupon (on a callable as
opposed to noncallable bond), a call premium, and typically a period of call protection during which the original
coupon is locked in (see Figure 11). A rise in the bond price that makes the repurchase desirable would be
brought about by a fall in market interest rates or an improvement in the credit rating of the bonds. Under these
circumstances the issuer could repurchase the bonds and issue new bonds at a lower coupon rate. The issuer
would choose to repurchase since that would allow for a reduction in financing costs. Bonds with a relatively
high coupon could be repurchased with money raised from the sale of bonds with a lower coupon. The issuer
thereby reduces coupon payments. The predetermined price at which the issuer has the right to repurchase puts
an upper limit on the value of the bonds. No one would pay a higher price knowing that that they could be
forced to sell at the predetermined price. The price/yield relationship for a callable bond has an upper limit to
the price. Figure 11. Callable bond An implication of the upper limit to the price is that the convexity turns into
concavity. Another implication is that the coupon rate on a callable bond will be higher than the coupon rate on
a bond without the call feature. If investors face a ceiling on their prospective capital gains, they would require
an enhanced coupon yield in compensation. Effectively investors are providing the issuer with a call option. The
investors would require payment for the call option. The payment to the investors takes the form of increased
coupons. Figure 12clarifies the relationship between the values of the call option, the noncallable bond and the
callable bond. On the horizontal axis the figure shows the value of a noncallable bond. As interest rates get
lower, the value of the noncallable bond increases. The left vertical axis shows the value of a call option for a
callable bond with the same coupon, par value, and maturity as the noncallable bond. The origin for the left axis
is the point where the thick black lines cross. As interest rates go down, the market value of a noncallable bond
increases, and the value of the call option also increases. Par Issue date Maturity Noncallable but redeemable
Freely callable Time Call price 69 Figure 12. Values of callable bonds, noncallable bonds, and the call option
The right vertical axis shows the price of noncallable and callable bonds with the same coupons, maturity, and
call price. The origin of the right axis is the right corner of the figure. The value of the callable bond is equal to
the value of the non callable bond minus the call option value. As the interest rates fall, the value of the callable
bond approaches the call price. 4.4.3. Convertible bonds Some corporate bonds may be convertible into
common stock of the company at the option of the bond holder. The bonds are usually callable at par plus a call
premium. A convertible bond is in the money if the stock value of the bond exceeds the call price. The call
feature is included to allow the company to force conversion into common stock. Conversion can be forced only
if the bond is in the money. Call of an out-of-the money convertible induces the bondholders to turn in their
bonds at the call price. Sometimes voluntary conversion occurs if the convertible is in-the-money and the
dividend yield on the stock exceeds the current yield on the convertible. Call option Origin for left axis 0 EV
EV EV EV Intrinsic value Noncallable bond Bond price Option value EV = Excess value Call price Par Origin
for right axis Value of noncallable Par Call bbbbbprice Callable bond Lower interest rates 0 70 Figure 13shows
the relationship between the stock value, the straight bond value and the price of the convertible. The stock
value is initially below the par value and the stock value is assumed to grow over time. The straight bond value
gradually approaches the par value as the bond gets closer to maturity. The call price declines over time to the
par value. As the stock value rises above the call price, the premium of the convertible over the bond value
declines and the market price of the convertible approaches the stock value. The market price of the convertible
must be higher than the higher of the straight bond value or the stock value. Otherwise arbitrage occurs. When
convertible bonds are issued, the stock price tends to decline. This evidence is consistent with the view, that
issuing convertibles is a negative signal to the market. The evidence supports the view that convertibles are
issued when the management has negative information. Figure 13. Convertible bonds 4.5. Summary Bonds are
debts of the governments, companies, and organizations that issue them. One of the ways in which bonds differ
from shares is in the relative certainty of future cash flows. In the absence of default by the issuer, the future
cash flows from a bond are typically known with certainty. This is in contrast to shares since shares typically
have dividend payments, which are variable and uncertain. The relative certainty of bond cash flows influences
the pricing and analysis of bonds. The fair price of a bond is estimated using a discount model. The relative
certainty of bond cash flows means that other characteristics, such as duration and convexity, can also be
reliably estimated. Other important bond characteristics are future bond yields and of bond price volatility
(risk). The debt markets are used by both firms and governments to raise funds for long-term purposes, though
most investment by firms is financed by retained profits. Firms and Stock value Convertible bbbprice Call price
Straight bond value Issue date Maturity time Par $ 71 governments can issue corporate bonds of various types
of shares. Bonds usually pay a fixed rate of interest at pre-determined intervals. Bonds are traded on a stock
exchange and their price fluctuates in response to supply and demand. In the short run the supply of both is
fixed and price fluctuations are therefore the result of changes in demand. Key terms  Callable bond 
Convertible bond  Redemption yield  Duration  Convexity Further readings 1. Dunne P., Moore M., Portes
R. (2006). European Government Bond Markets: Transparency, Liquidity, Efficiency, CEPR, London. 2.
Edwards A. K., Harris L. E., Piwowar M. S. (2007). Corporate Bond Market Transaction Costs and
Transparency, Journal of Finance, No. 62(3), p. 1421– 1454. 3. Goldstein M. A., Hotchkiss E., Sirri E. (2007).
Transparency and Liquidity: A Controlled Experiment on Corporate Bonds, Review of Financial Studies, No.
20(2), p. 235–273. 4. Pagano M., Von Thadden E. (2008). The European Bond Markets under EMU, in X.
Freixas, P. Hartmann, and C. Mayer (eds.), Handbook of European Financial Markets and Institutions, Oxford
University Press, Oxford, p. 488– 518. 5. Wolswijk G., de Haan J. (2005). Government Debt Management in
the Euro Area: Recent Theoretical Developments and Changes in Practices, ECB Occasional Paper No. 25.
Review questions and problems 1. Why does the calculation of a ‘present value’ of a bond involve discounting?
 Which of the following would be likely to show the greatest short-run price volatility: a short-term bond, a
long-term bond? Explain.  When market interest rates are 10 percent, what relationship would you expect
between the price and redemption yields of two 8 percent bonds, one maturing in three years, the other maturing
in ten years?  Give two reasons why institutions like banks prefer to hold short-term rather than long-term
bonds.  Explain the terms: dirty price, clean price, interest yield, redemption yield.  Are high yield bonds
good investments? Why or why not? 72  Assume a redemption yield of 8%. Compute the duration for the
following bonds each 100 Euro par value. For the 12% coupon bond compute duration. a) 10 years, zero
coupon; b) 10 years, 8 percent; c) 10 years, 12 percent coupon.  In problem 7 assume that yields change from 8
to 9 %. Work out the exact change in price and compare it with the change in price predicted by duration.
Explain the difference. Assume 100 Euro par value.  Compute the duration of a portfolio composed of equal
proportions of a ten year, zero coupon bond and a ten year 8 % coupon bond, assuming 89% yields to maturity.
 A firm has decided immediately to refund existing callable bond issue. Under what circumstances is there an
immediate benefit to refunding? What does that benefit depend upon?  How can callable bonds be substitutes
for short-term bonds?  A firm has a perpetual callable bond outstanding with a par value of 100 Euro and an
annual coupon of 14 Euro. The firm can refund this with a new noncallable perpetual bond having an 8 percent
coupon. The call price on the old bond issue is 114 Euro. Flotation costs for a new issue are 2 percent of par
value. What is the myopic benefit of refunding? 73 5. EQUITY MARKET Mini contents  Equity instruments 
The purpose and functions of stock exchanges.  The distinction between primary and secondary markets. 
Types of stock exchange.  Stock market trading systems.  Bid-offer spreads.  Types of purchase and sale
order.  Processes by which shares are issued. Equity market is one of the key sectors of financial markets
where long-term financial instruments are traded. The purpose of equity instruments issued by corporations is to
raise funds for the firms. The provider of the funds is granted a residual claim on the company’s income, and
becomes one of the owners of the firm. For market participants equity securities mean holding wealth as well as
a source of new finance, and are of great significance for savings and investment process in a market economy.
The purpose of equity is the following:  A new issue of equity shares is an important source of external
corporate financing;  Equity shares perform a financing role from internally generated funds (retained
earnings);  Equity shares perform an institutional role as a means of ownership. Within the savings-investment
process magnitude of retained earnings exceeds that of the news stock issues and constitutes the main source of
funds for the firms. Equity instruments can be traded publicly and privately. External financing through equity
instruments is determined by the following financial factors:  The degree of availability of internal financing
within total financing needs of the firm;  The cost of available alternative financing sources;  Current market
price of the firm’s equity shares, which determines the return of equity investments. Internal equity financing of
companies is provided through retained earnings. When internally generated financing is scarce due to low
levels of profitability and retained earnings, and also due to low depreciation, but the need for long-term
investments is high, companies turn to look for external financing sources. Firms may raise funds by issuing
equity that grants the investor a residual claim on the company’s income. Low interest rates provide incentives
for use of debt instruments, thus lowering demand for new equity issues. High equity issuance costs force
companies to look for other sources 74 of financing as well. However, during the period of stock market growth
high market prices of equity shares encourage companies to issue new equity, providing with the possibility to
attract larger magnitude of funds from the market players. Check Question What is the purpose of equity?
Equity markets are markets which organize trading nationally and internationally in such instruments, as
common equity, preferred shares, as well as derivatives on equity instruments. Concept Bourse – a French term
often used to refer to stock market. 5.1. Equity instruments 5.1.1. Common shares Common (ordinary) shares
represent partial ownership of the company and provide their holders claims to future streams of income, paid
out of company profits and commonly referred to as dividends. Common shareholders are residual claimants,
i.e. they are entitled to a share only in those profits which remain after bondholders and preference shareholders
have been paid. If the company is liquidated, shareholders have a claim on any remaining assets only after prior
claimants have been paid. Therefore common shareholders face larger risks than other stakeholders of the
company (e.g. bondholders and owners of preferred shares. On the other hand, if the value of the company
increases, the shareholders are entitled to larger potential benefits, which may well exceed the guaranteed
interest of bondholders. Concept Common or ordinary share (stock) – an equity share that does not have a fixed
dividend yield. The variability of returns to shareholders is affected by the proportion of debt to equity
financing (called the debt to equity ratio) of the company. The higher the proportion of debt financing, the
larger the fixed interest payments and the lower is the number of shares over which the net profit is to be
distributed. When earned profits exceed the level necessary to pay the interest, all the excess profit accrues to
the smaller number of shareholders. On the other hand, if profits decrease below interest payments, the whole
reduction in payments is borne by the company shareholders. The higher is the debt to equity ratio, the greater
is the variability in dividend payments to shareholders. Thus common shares in ‘highly leveraged’ companies
are usually regarded as riskier than those in ‘low leveraged’ companies. Concept Leverage: The amount of debt,
relative to equity, in a firm’s capital structure. Usually expressed as the ratio of debt to equity, D/E, or debt to
total capital D/(D E). The law requires that the company provides the owners with specified information in
the annual report and accounts and that the firm must hold an annual general meeting at which management
conduct is subject to approval by common (ordinary) shareholders, each of whom has a number of votes
matching the size of his shareholding. The decision to issue equity against debt is based on several factors: 75 
Tax incentives. In many countries interest payments are tax deductible, however dividends are taxed. Thus the
tax shield of debt forms incentives to finance company by debt.  Cost of distress. Increase of company
leverage, increases the risk of financial insolvency and may cause distress as well as lead to bankruptcy. Thus
companies tend to minimise their credit risk and increase the portion of equity in the capital structure.  Agency
conflicts. When a company is financed by debt, an inherent conflict arises between debt holders and equity
holders. Shareholders have incentives to undertake a riskier operating and investment decisions, hoping for
higher profits in case of optimistic outcomes. Their incentives are mainly based by limited liability of their
investments. In case of worst outcome debt holders may suffer more, in spite of their priority claims towards
company assets.  Signalling effect. The companies, which issue equity to finance operations, provide signals to
the market, that current share selling price is high and company is overvalued. Check Question Why does
financial distress increase agency conflicts between equity holders and debt holders? 5.1.2. Preferred shares
Preferred shares is a financial instrument, which represents an equity interest in a firm and which usually does
not allow for voting rights of its owners. Typically the investor into it is only entitled to receive a fixed
contractual amount of dividends and this make this instrument similar to debt. However, it is similar to an
equity instrument because the payment is only made after payments to the investors in the firm’s debt
instruments are satisfied. Therefore it is call a hybrid instrument. Technically preferred shareholders share
ownership of the firm with common shareholders and are compensated when company generates earnings.
Therefore, if the company does not earn sufficient net profit, from which to pay the preferred share dividends it
may not pay dividends without the risk of bankruptcy. Because preferred stockholders typically are entitled to a
fixed contractual amount, preferred stock is referred to as a fixed income instrument. Concept Preferred share –
an equity security, which carries a predetermined constant dividend payment. Preferred stock investments may
have tax advantage to institutional investors. Majority of preferred shares have cumulative dividend provision,
which entitles to preferred share dividend payments (current and from previous periods) dividend payments on
common shares. Usually owners of preferred shares do not participate in the net profit of the company in excess
to the stated fixed annual dividend. Due to the fact that preferred dividends can be omitted, the company risk is
less compared to risk in case of company debt. However in this case, company may find it difficult to raise new
capital before all preferred dividends are paid. Investors may be unwilling to make new investments before the
company is able to compensate its existing equity investors. 76 Preferred stock is an attractive source of
financing for highly leveraged companies. Equity markets offer a variety of innovations in preferred shares
issues. These varieties include:  cumulative preference shares  non-cumulative preference shares 
irredeemable  redeemable preference shares  convertible preference shares  participating preference shares 
stepped preference shares. With the exception of the first two, these characteristics are not excluding each other.
For example it is possible to issue non-cumulative, redeemable, convertible preferred shares. Non-cumulative
preferred shares do not have an obligation to pay any missed past dividends, with the effect that missed
dividends may be lost forever. A redeemable preferred share has a maturity date on which the original sum
invested is repaid, whereas most preference shares have no maturity date (the issuer may pay the dividends
forever and never repay the principal sum). Some redeemable preference shares provide the issuer with the right
to redeem at a predetermined price without the obligation to do so; in effect such preference shares provide the
issuer with a call option, which would be paid for by means of a higher dividend for the investors. Convertible
preferred shares give the holder the right to convert preference shares into ordinary shares at a predetermined
rate; the investor pays nothing to convert apart from surrendering the convertible preference shares. In some
cases the right to convert arises only in the event of a failure to pay dividends. Participating preferred shares
allow the issuing company to increase the dividends if profits are particularly high; the preference share
dividend can exceed the fixed level if the dividend on ordinary shares is greater than a specified amount.
Stepped preferred shares pay a dividend that increases in a predetermined way. Specific adjustable rate
preferred shares are attractive in increasing interest environment. If the dividend is reset each quarter according
to a pre-established formula based on Treasury bill rate, these issues can be considered as company capital.
Auction rate preferred shares (ARPS) or Single point adjustable rate shares (ARPS) reset dividend periodically
using Dutch auction method. The reset date can be as frequent as 49 days. Because of characteristics close to
money market securities, they have significantly lower yields. Concept Dutch auction - a method, which allows
all investors participating in the auction submitting a bid for the stock by specified deadline. The bid prices are
ranked and minimum price for selling of shares is determined. All bids equal or above minimum price are
accepted, and all bids bellow the minimum price are rejected. Preferred equity redemption cumulative stocks
(PERCS) are shares that pay dividends and are automatically converted into common stock at a conversion
price and date. These 77 can be callable at any date after the issuance for price above the issue price (e.g. by
40%) and gradually declines as the conversion date approaches. The cost of preferred equity financing may be
higher, compared to debt financing. Preferred dividend is not a tax deductible expense to the company. Besides,
investors are compensated more, as they assume its risk is higher due to the fact, that the company legally is not
required to pay preferred dividends. As a rule, preferred equity has no maturity, thus it may force company to
permanent preferred dividend payments. Check Question Why does financial distress increase agency conflicts
between equity holders and debt holders? 5.1.3. Private equity When companies are organized as partnerships
and private limited companies, their shares are not traded publicly. The form of equity investments, which is
made through private placements, is called private equity. In such case investors’ liability may not be limited to
the amount of contributed capital, and may be extended to total wealth of private owners. It is used mainly by
small and medium-sized companies, young or start-up business in need to raise significant funds for investment.
However, their access to bank or public stock market financing is limited. Typically banks do not finance start-
ups due to significant risks of their operations, and a limited company equity base. On the other hand, a public
offering of shares for such companies may be feasible only if it has a significant shareholder base to support an
active secondary market. Without an active secondary market such shares are illiquid, founders of the
companies find it difficult to “cash out” by selling their original equity investment, can be forced to sell shares
at a discount to the fundamental company value, fixed costs of being public company are high, and this
prohibits company from being public. Therefore such companies attempt to raise additional capital from
wealthy individual or institutional investors. This type of investments has grown significantly since late 1990s,
mainly in US and is slowly gaining ground in European countries. The most important sources of private equity
investments come from venture capital funds, private equity funds and in the form of leveraged buyouts.
Venture capital funds receive capital from wealthy individual or institutional investors, willing to maintain the
investment for a long-term period (5-10 years). Venture capital market brings together private businesses that
need equity financing and venture capitalists (business angels) that can provide funding. Venture capital fund
identifies potential of the business, negotiates the terms of investment, return from the investments, exit
strategy. The invested funds are not withdrawn before a set deadline. Common exit strategies are either through
the public sale of the equity stake in public stock offering, or through cash out if the company is acquired by
another firm. Private equity funds pool resources of their partners to fund most often new business start-ups.
They can rely heavily on debt financing, also. Thus, they perform the role of financial intermediaries. Private
equity funds usually take over the businesses, manage them and control the restructuring, charge annual fee for
managing the fund. Exit strategies are similar to the ones used by venture capital funds. Leveraged buyouts are
company equity purchases by individual or institutional investors, which are financed by a minor portion of
share capital and a major portion of debt, provided by banks or other financial intermediaries. 78 Check
Question Why does financial distress increase agency conflicts between equity holders and debt holders? 5.1.4.
Global shares and American Depository Receipts (ADR) Investors may invest into foreign shares by purchasing
shares directly, purchasing American Depository Receipts (ADRs), Global Depository Receipts (GDRs).
Alternatively, investments can be made by investing into international funds or purchasing exchange traded
funds (ETFs). Direct purchases of foreign shares can be limited due to limited access to the stock exchanged, a
limited available set of shares, high transaction costs through specialized brokerage companies. Shares in
international funds (International mutual funds (IMFs)) offer possibility of investing into a portfolio of
international securities, created and managed by various financial institutions. Thus individual investors may
get access and diversify across international stocks. IMFs can be specializing on specific country or across
several countries or regions. Exchange traded funds (ETFs) are passive funds, that track specific index. Thus
investor can invest into a specific index, representing a country’s (e.g. foreign) stock market. Although ETFs
are denominated in US dollars as a rule, the net asset value of an international ETF is determined by translating
foreign currency value of the foreign securities into dollars. While the price of each international ETF is
denominated in US dollars, the underlying securities that make up the index are denominated in non-US
currencies. Thus the return on ETF will be influenced by the movement of the country’s currency against dollar.
If the country’s currency appreciates, this will increase the value of the index as measured in dollars. On the
other hand, if the foreign currency depreciates, this will reduce the value of the index as measured in dollars.
This is also true for IMFs. Check Question What are advantages and disadvantages for investing into exchange
traded funds (ETFs) and international investment funds? American Depository Receipts (ADR) is an
arrangement under which foreign shares are deposited within a US bank, which in turn issues ADRs in the
name of foreign company. In this way the shares of a foreign company is admitted to the well developed stock
market, like US or UK. When issued in US, they are denominated in US dollars. Dividends are also paid in US
dollars, even if the underlying security’s cash flows are denominated in terms of foreign issuer’s home
currency. ADR may represent a combination of several foreign shares (e.g. lots of 100 shares). Trading takes
place in negotiable certificates representing ownership of shares of the company. Concept American Depository
Receipts (ADR) – a certificate of ownership issued by a US bank to promote local trading on a foreign stock.
US bank holds foreign shares and issues ADRs against them. An ADR program, which is created without
company’s involvement, is called an unsponsored ADR. 79 If ADR program is created with an assistance of the
company, it is called a sponsored ADR. Such shares can be registered within the securities exchange
commission and comply with reporting requirements, and thus be traded on an organized stock exchange.
Without such registration and reporting compliance, they can be traded on the over-the counter market. Table 5.
Comparison of equity instruments Instrument Types Characteristics Investors Market Common shares Common
(ordinary) shares, Puttable common shares, ADRs GDRs Corporate ownership Companies, state, financial
institutions, non-financial intermediaries, individual investors Stock exchange Preferred shares cumulative
preference shares, non-cumulative preference shares, redeemable preference shares, convertible preference
shares, participating preference shares, stepped preference shares. Hybrid security, Features of equity and debt,
Callability Financial institutions, non-financial intermediaries, individual investors Preferred stock market /
stock exchange Private equity Venture capital fund shares Private equity fund shares Private placements,
investments of pool of funds, Partnerships or private limited form of companies Venture capital companies,
institutional investors, individual investors (business angels) Private equity market Advantages of ADRs
include  easy and direct access to funding in the foreign market; 80  building company name recognition in
the foreign country;  reliable quoting of share prices;  close following by investment analysts. Disadvantages
of ADRs:  A costly investment alternative;  For large institutional investors vs small retail investors
differences in prices and return;  Market for ADRs can be illiquid;  Multiple listing can result in share price
differences in various markets globally. Global Depository Receipts (GDRs) are negotiable receipts issued by
financial institutions in developed countries against shares of foreign companies. GDRs can be simultaneously
issued in US and Europe. Financial institution collects and distributes dividends paid by the foreign firm to the
GDR (also ADR) investor. Thus financial institutions facilitate access to world equity markets by
intermediating between world investors and companies in developing and transition countries. Check Question
What are advantages and disadvantages of issuing American Depository Receipts and Global Depository
Receipts to issuing companies and to investors? 5.2. Primary equity market When equity shares are initially
issued, they are said to be sold in the primary market. Equity can be issued either privately (unquoted shares) or
publicly via shares that are listed on a stock exchange (quoted shares). Public market offering of new issues
typically involves the use of an investment bank in a process, which is referred to as the underwriting of
securities. Private placement market includes securities which are sold directly to investors and are not
registered with the securities exchange commission. There are different regulatory requirements for such
securities. In the private equity market, venture capital is often provided by investors as ‘start-up’ money to
finance new, high-risk companies in return for obtaining equity in the company. In general private placement
market is viewed as illiquid. Such a lack of liquidity means that buyers of shares may demand a premium to
compensate for this unappealing feature of a security. 5.2.1. Primary public market Initial public offering (IPO)
means issuing public equity, i.e. when a company is engaged in offering of shares and is included in a listing on
a stock exchange for the first time. It allows the company to raise funds from the public. If a company is already
listed and issues additional shares, it is called seasoned equity offering (SEO) or secondary public offering
(SPO). When a firm issues equity at a stock 81 exchange, it may decide to change existing unquoted shares for
quoted ones. In this case the proceeds from sale of shares are received by initial investors. However, when a
company issues newly created shares, the raised funds are received by the company. Process of going public.
The issuing company has to develop a prospectus with detailed information about the company operations,
investments, financing, financial statements and notes, discussion on the risks involved. This information is
provided to potential investors for making decision in buying large blocks of shares. The prospectus is
registered within and approved by the securities exchange commission. Afterwards the prospectus is sent to
institutional investors, meetings and road shows are organized in order to present the company. Concept Road
show – travelling of company managers through various cities and making presentations for large institutional
investors. Share issues are often underwritten by banks. A bank, which is underwriting a share issue agrees, for
a fee, to buy any shares not acquired by investors. This guarantees that the issuing company receives the
funding that it expects. In the case of rights issues, firms sometimes avoid paying a fee to underwriters by using
the deep discount route. In a rights issue, failure to sell the new shares would result from the share price (prior
to the issue) falling below the sale price of the new shares. Concept To underwrite – an act of guaranteeing a
specific price to the issuer of the security. Lead underwriter – key investment bank withinn a group of
investment banking firms that are required to underwrite a portion of a corporation’s newly issued shares. The
deep discount method prices the new shares at such a low level that the market price is extremely unlikely to
fall so far. The share offer price is determined by the lead underwriter, which takes into account the prevailing
market and industry conditions. During the road show the lead underwriter is engaged in bookbuilding, i.e. a
process of collecting indications of demanded number of shares by investors at various possible offer prices.
IPO factors. Public equity markets play a limited role as a source of new funds for listed corporations. Because
of information asymmetry, companies prefer internal financing (i.e., retained earnings) to external financing.
Myers and Majluf (1984) have introduced the pecking-order theory, which states that companies adopt a
hierarchy of financial preferences. If external financing is needed, firstly, companies prefer debt funding. Equity
is issued only as a last resort. Statistics on company sources of financing support this view. On the other hand,
during equity markets growth and share price increase periods IPO market tend to increase dramatically, while
the drop in share prices is followed by decrease in net issuance of public equity. A large number of the issues in
the late 1990s were ‘new economy’ offerings, like the technology, media, and telecommunications sector.
Exercise A one for four rights issue assumes offering one new share for every four held. A one for four rights
issue may be at 160 Euro when the current share price is 200 Euro. The cost of: 4 shares each 200 Euro equal to
800 Euro 1 right each 160 Euro equals to 160 Euro Thus, 5 shares cost 960 Euro (192 Euro each). 82 It is to be
expected that the rights issue would cause the share price to fall by 200 Euro – 192 Euro = 8 Euro. Among other
factors the economic cycle is considered to play a significant role in a company’s decision to issue public
equity. Equity is often used to finance long-term investments, which fluctuate over the business cycle. Shiller
(2003) has related the timing of equity issuance with investor sentiment. Developments in investor optimism
over time may have an impact on the cost of equity, thus influencing the amount of equity issued. E.g.,
excessive increases in risk aversion resulting in falling stock market prices could raise the cost of equity,
preventing companies from new equity issues. Companies also issue equity in order to finance the acquisition of
other companies, either by using the cash proceeds of public offerings or by issuing shares, which are
subsequently exchanged for the shares of a target company. Therefore merger and acquisition (M&A) cycles
can also be expected to correlate with equity issuance activity. There are important advantages and
disadvantages of initial public offerings (IPOs). Advantages of IPOs:  Possibility to obtain funds to finance
investment.  The price of a company’s shares acts as a measure of the company’s value.  Increases of
company financial independence (e.g. from banks) due to listing of a company’s shares on a stock exchange. 
Possibility to diversify investments of current company owners by selling stakes in the company in a liquid
market.  Increased recognition of the company name.  Improved company transparency.  A disciplining
mechanism for managers. Disadvantages of IPOs:  High issuance costs due to underwriters’ commission, legal
fees, and other charges.  High costs due to disclosure requirements.  Risk of wider dispersed ownership. 
Separation of ownership and control which causes ‘agency problems’.  Divergence of managers’ and outside
investors’ interests.  Information asymmetry problems between old and new shareholders.  Risk of new
shareholders focusing on short-term results. Exercise Instead of exercising the right to buy at 160 Euro, the
investor can sell the right. The price could be around 192 Euro – 160 Euro = 32 Euro, because the buyer has the
right to buy shares for 160 Euro when they are prospectively worth 192 Euro. A one for one rights issue may be
used. 1 share each 200 Euro equal to 200 Euro 83 1 right each 40 Euro equals to 40 Euro Thus, 2 shares cost
240 Euro (120 Euro each) Therefore, instead of exercising the right to buy at the discounted price an investor
could sell the rights. In the one for one case, the rights might be sold for 120 Euro – 40 Euro = 80 Euro Note
that the one for four rights issue at 160 Euro would raise the same amount of money as the one for one rights
issue at 40 Euro (the latter involves selling four times the number of shares at a quarter of the price). IPO
market has received negative publicity due to several problems: Spinning. Spinning occurs, when investment
bank allocates shares from an IPO to corporate executives. Bankers’ expectations are to get future contracts
from the same company. Laddering. When there is a substantial demand for an IPO, brokers encourage
investors to place the first day bids for the shares that are above the offer price. This helps to build the price
upwards. Some investors are willing to participate to ensure that the brokers will reserve some shares of the
next hot IPO for them. Excessive commissions. These are charged by some brokers when the demand for an
IPO is high. Investors are willing to pay the commissions if they can recover the costs from the return on the
very first day, especially when the offer price of the share is set significantly below the market value. The
literature contains strong evidence that IPOs on average perform poorly over a period of a year or more. Thus
from a long term perspective many IPOs are overpriced. Since introduction of Sarbanes-Oxley Act in US,
which aimed at improving company reporting processes and transparency, initially returns from IPOs in general
have been lower. Check Question Why IPO is often underpriced? Check Question What are advantages and
disadvantages of IPOs to issuing companies and investors? 5.3. Secondary equity market Equity instruments are
traded among investors in a secondary market, in which no new capital is raised and the issuer of the security
does not benefit directly from the sale. Secondary markets are also classified into organized stock exchanges
and over-thecounter (OTC) markets. Apart from legal structure, numerous historical differences are found in the
operations of national stock markets. The most important differences are in the trading procedures. The trading
on secondary markets takes place among investors, however most often through specialised intermediaries -
stock brokers (dealers), who buy or sell securities for their clients. 84 Securities’ trading in the secondary
market form the means by which stocks or bonds bought in the primary market can be converted into cash. The
knowledge that assets purchased in the primary market can easily and cheaply be resold in the secondary market
makes investors more prepared to provide borrowers with funds by buying in the primary market. Effective
secondary market is an important basis of successful primary market. If transaction costs are high in the
secondary market the proceeds from the sale of securities will be reduced, and the incentive to buy in the
primary market would be lower. Also high transaction costs in the secondary market might tend to reduce the
volume of trading and thereby reduce the ease with which secondary market sales can be executed. Therefore
high transaction costs in the secondary market could reduce primary market asset liquidity. In consequence
there can be adverse effects on the level of activity in the primary market and hence on the total level of
investment in the economy. 5.3.1. Organized exchanges Stock exchanges are central trading locations, in which
securities of corporations are traded. These securities may include not only equity, but also debt instruments as
well as derivatives. Equity instruments can be traded if they are listed by the organized exchange, i.e. included
in a stock exchange trading list. The list is formed of instruments that satisfy the requirements set by the
exchange, including minimum earnings requirements, net tangible assets, market capitalization, and number and
distribution of shares publicly held. Each stock exchange specifies the set of requirements. Advantages of
listing on the stock exchange to the corporation and its shareholders are:  The ability to sell shares on the stock
exchange makes people more willing to invest in the company.  Investors may accept a lower return on the
shares and the company can raise capital more cheaply.  Stock exchange provides a market price for the shares,
and forms basis for valuation of a company.  The information aids corporate governance, allows monitoring
the management of the company.  Listing makes takeover bids easier, since the predator company is able to
buy shares on the stock market.  The increased transparency may reduce the cost of capital. However there are
several disadvantages of listing, which include:  Listing on the stock exchange is costly for the company.  It
requires a substantial amount of documentation to be prepared, e.g. audited and prepared according to IFRS
financial statements.  It increases transparency, which may cause problems in terms of market competition and
in takeover cases. Stock market dealers and brokers fulfill specific functions at the equity market. Dealers make
market in securities, maintain securities inventories and risk their own funds. In 85 contrast to dealers, who risk
their own funds, brokers do not own securities, but execute matching of buyers and sellers for a specific fee.
Concept Dealer – an agent who buys and sells securities as a principal on its own account, rather than as a
broker for his clients. Dealer may function as a broker, or as market maker. Dealers stand ready to buy at the bid
price and to sell at the ask price, and making profit from the average spread. However, when the stock prices are
going down, dealers experience loss of value of stock inventory. This forms the primary risk for the dealer.
Concept Broker – an agent who executes orders to buy and sell securities on behalf of his clients in exchange
for a commission fee. In order to profit from different price movements directions dealers make positioning.  If
the dealer expects the stock prices to increase, it buys the stock and takes a long position. Profit is earned, if the
stock is sold at a higher price.  If a dealer expects the stock price to decline, he tries to benefit from a short
position. In a short sale the security is borrowed and sold in the expectation of buying this security back later at
a lower price. The investor tries to sell high and buy low, profiting from the difference. Proceeds from a short
sale cannot be used by the shortseller, and must be deposited at the broker. The shortseller must pay any cash
dividends to the lender of the security. This rule is related to the amount of drop in stock prices by
approximately the after-tax amount of a cash dividend after the dividend payment date. Stock exchanges apply
downstick restrictions on short sales in order to prevent from panic selling and driving stock prices sharply
down. If the dealer’s forecast is wrong, the dealer must close the position at unfavorable price and absorb the
loss. This creates the risk of dealer bankruptcy, and forces stock exchanges as well as securities exchange
commissions to impose the specific regulations in order to prevent this type of price manipulations. Concept
Short sale – the sale of the security, which is not owned by the seller at the time of trade. Security dealers are
heavily levered. Typically the dealer’s equity forms a small percentage of the market value of his inventory.
Most dealers financing is in the form of debt (e.g. bank loan). Majority of dealer debt financing is in the form of
repurchase agreements (REPO, see chapter on Money markets). There are several types of stock exchange
members:  Commission brokers – who execute buy and sell orders for the public for the fee. This is the largest
group of market participants, acting as agents of lenders or buyers of financial securities. They may find the best
price for someone who wishes to buy or sell securities.  Odd-lot brokers – a group of brokers, who execute
transactions of fewer than 100 shares. These brokers break round lots (a multiple of 100 shares) into odd-lots
and vise versa for a fee.  Registered trader – who owns a seat on a stock exchange and trades on his own
account. Large volume of trades, along with the possibility of speedy execution of 86 orders, allow the traders
to cover their large investments into the seat of a stock exchange.  Specialists – who are market makers for
individual securities listed on an organized stock exchange. Their purpose is to reduce variability of the
securities prices. When there are too many sell orders, the specialists have to perfume a role of buyers to keep
the prices from falling for a period. When there are too many buy orders, the specialists have to perfume a role
of sellers to prevent the temporary rise in prices.  Issuing intermediary - who undertakes to issue new securities
on behalf of a borrower. An issuing house acts as an agent for the borrower in financial markets. This task is
usually carried out by investment banks  Market-maker is an intermediary who holds stock of securities and
quotes a price at which each of the securities may be bought and sold. Market-making is usually performed by
the securities divisions of the major banks  Arbitrageur - who buys and sells financial assets in order to make a
profit from pricing anomalies. Anomalies occur when the same asset is priced differently in two markets at the
same time. Since financial markets are well informed and highly competitive, usually these anomalies are very
small and do not last long. Anomalies are usually known, thus there is no risk of arbitrage, which makes it
different from speculation.  Hedger - who buys or sells a financial asset to avoid risk of devaluation of
currency, change of interest rates or prices of the securities in the market. Concept Arbitrage – is the
simultaneous purchase of an undervalued asset or portfolio and sale of an overvalued but equivalent asset or
portfolio, in order to obtain a riskless profit on the price differential. It takes advantage of market inefficiencies
in a risk-free manner. Stock exchanges set quite high commissions for all member firms. The competition from
other types of markets, e.g. OTC or third market (direct trading transactions), force stock exchanges to move to
negotiated commission schedule, where lower fees can be applied to larger transactions. Majority of
transactions at the stock exchanges are fully automated. Small buy and sell orders are matched by computers.
5.3.2. Over-the-counter (OTC) market Over-the-counter (OTC) market is the marketplace for trading financial
instruments, which are generally unlisted financial instruments. These markets are networks of dealers, who
make markets in individual securities. Common equity shares that are traded on it can be listed and unlisted
shares. Concept Over-the-counter (OTC) market – a market for securities made up of dealers. It is not an
organized exchange, and trading usually takes place by electronic means. Two large segments of OTC markets
can be distinguished: 87  Unorganized OTC markets with unregulated trading taking place between
individuals. Typically these markets do not restrict possibilities to buy and sell outside of organized exchanges.
 Highly organized and sophisticated OTC markets, often specializing in trading specific company shares.
Examples of organized over-the-counter markets are the NASDAQ and upstairs markets in the United States.
Trading takes place via a computer network. Market makers display the prices at which they are prepared to buy
and sell, while investors trade with the market makers, usually through brokers. The upstairs market is mainly
used by institutional investors and handles large buy and sell orders (block trades). Institutions place orders
through brokers, who an attempt to find a transaction counterparty. In the absence of such a counterparty, the
broker attempts to execute the order with market makers. 5.3.3. Electronic stock markets Since the middle of
1990s a number of electronic stock markets were created for disclosing and executing stock transactions
electronically. While publicly displaying buy and sell orders of stock, they are adapted mainly to serve
execution of orders institutional investors mainly. Registered and regulated electronic stock exchanges
developed from electronic communication networks (ECN). Some electronic communication networks (ECNs)
exist along with official exchanges. Concept Electronic communication networks – order-driven trading
systems, in which the book of limit orders plays a central role. The popularity of ECNs stems from the
possibility to execute security trade orders efficiently. They may allow complete access to orders placed on
other organized or electronic exchanges, and thus eliminate the practice of providing more favourable quotes
exclusively to most important clients. As a result quote spreads between the bid and ask prices are reduced.
Since ECNs can execute orders of stocks listed and traded on organized or other electronic exchanges, they
form the increasing competition among the stock exchanges. Examples of well known electronic trading
systems include Instinet (acquired by NASDAQ), Archipelago (merged into NYSE), SETS (London Stock
Exchange’s premier electronic trading system). As an alternative to organized stock exchanges the so called
alternative trading systems (ATS) have developed, based on the idea there is no necessity to use an intermediary
in order to conduct a transaction between two parties. In fact the services of a broker or a dealer are not required
to execute a trade. The direct trading of stocks between two customers without the use of a broker or an
exchange is called an ATS. There are two types of alternative trading systems (ATS):  crossing networks; 
dark pools. Electronic crossing networks do not display quotes but match large buy and sell orders of a pool of
clients (dealers, brokers, institutional investors) anonymously. These networks are batch processors that
aggregate orders for execution. Market orders are crossed once or a few times per day at prices, which are
determined in the primary market for a security. 88 The trade price is formed as a midpoint between bid and ask
prices, observed in the primary market at a certain time. There is a variety of ECNs, depending upon the type of
order information that can be entered by the subscriber and the amount of pretrade transparency that is available
to participants. An example of an electronic crossing network is POSIT. Concept Electronic crossing networks
– order-driven trading systems, in which market orders are anonymously matched at specified time, determined
in the primary market for the system. Electronic crossing networks provide low transaction costs and
anonymity, which are important advantages for large orders of institutional investors. They are specifically
designed to minimize market impact trading costs. However, there is no trading immediacy, since the traders
have to wait until the crossing session time to execute the orders and an offsetting order entered by other market
participant. Thus their execution rates tend to be low. Besides, if they draw too much order flow away from the
main market, they can reduce the quality of the prices on which they are basing their trades. Dark pools are
private crossing networks, which perform the traditional role of a stock exchange and provide for a neutral
gathering place at the same time. Their participants submit orders to cross trades at prices, which are determined
externally. Thus they provide anonymous (“dark”) source of liquidity. Dark pools are electronic execution
systems that do not display quotes but execute transactions at externally provided prices. Buyers and sellers
must submit a willingness to transact at this externally provided price in order to complete a trade. The key
advantage of dark pools systems is that they are designed to prevent information leakage and offer access to
undisclosed liquidity. A separate form of computerized trading is program trading, which is defined as
simultaneous buying and selling of a large portfolio of high rated stocks with a significant aggregate value.
Another understanding of programme trading refers to the use of computer system (Designated order
turnaround (DOT)), which allows traders to send orders to many trading posts at the exchange. Program trading
is used to reduce the susceptibility of stock portfolio to stock market movements, e.g. by selling a number of
stocks which become overpriced, or by purchasing of stocks which become underpriced. The critics of program
trading state that it is one of the major reasons for decline or rise in the stock market and increases market
volatility. Due to these concerns, stock exchanges implement collars, which restrict program trading when a
wide stock index changes (e.g. by 2 percent) from the closing index on the previous trading day. When the
collars are imposed, program trading for the sell orders becomes allowed when the last movement in the stock
price was up (or “uptick”). Conversely, when program trading is for the buy orders, it becomes allowed when
the last movement in the stock price was down (or “downtick”). Such restrictions are supposed to half
stabilizing effect on the market. 5.4. Secondary equity market structure Secondary markets are characterized
based on the trading procedures. 89 5.4.1. Cash vs forward markets Cash markets are markets where stocks are
traded on a cash basis and transactions have to be settled within a specified few days period. Typical period is
three days after the transaction. In order to increase the number of trades most cash markets allow margin
trading. Margin trading allows the investor to borrow money or shares from a broker to finance the transaction.
Forward markets are markets in which in order to simplify the clearing operations, all transactions are settled at
a predetermined day, e.g. at the end of a period (month). This is a periodic settlement system, in which a price is
fixed at the time of the transaction and remains at this value in spite of market price changes by the settlement
time. In order to guarantee a position, a deposit is required. Such a system does not prevent short-term
speculation. Some cash markets provide institutionalized procedures to allow investors to trade forward, if they
desire. 5.4.2. Continuous markets and auction markets Continuous markets are markets where transactions take
place all day and market makers are ensuring market liquidity at moment. Dealer market is the market in which
dealers publicly post bid and ask prices simultaneously, and these become firm commitments to make
transaction at the prices for a specific transaction volume. Investors are addressing the dealers offering the best
price (quote). Auction market is a market in which the supply and demand of securities are matched directly and
the price is formed as an equilibrium price. An open outcry system allow brokers to negotiate loudly until price,
which is an equilibrium of buy and sell orders, is determined. In a call auction market all orders are put into an
order book until an auction and are executed at a single price. Liquidity requires that such trades take place one
or several times during a day. Such trading procedures are aimed at defining the auction price that maximizes
the trading volume. Concept Call auction – a method of determining the market price of a security by finding
the price, which balances buyers and sellers. Such price fixing takes place periodically each day at defined time.
5.4.3. Order-driven markets and quote-driven markets The mechanism by which buyers and sellers interact to
determine price and quantity of securities in the trade is called market structure. There are two overall market
structures for trading financial instruments:  order driven and  quote driven. 90 Order-driven market structure
allows buyers and seller orders submit their orders through their broker. The latter sends these orders to a
centralized location, where orders are matched and the transaction is executed. Concept Order - driven market –
a market without active market makers, in which buy and sell orders directly confront each other. An auction
market. There are different forms of order-driven markets. In call markets, the price is determined several times
at specified moments. In that way, orders can be collected and the auction takes place at the specified time. This
type of auction is widely used for initial public offerings of equity (and new issues of government debt). The
call market mechanism has disappeared in secondary markets for bonds and equity, and has been replaced by
continuous trading systems. In continuous auction markets, public investors send their instructions (‘orders’) to
buy or sell to brokers. Typically order-driven trading systems are computerized. If not all orders at a price can
be executed, a priority is given to the oldest order. Order driven markets are highly formalised as the auction
rules for matching trades have to be specified in great detail to ensure an orderly and fair trading process.
Advances in information technologies have supported the development of order-driven markets, in particular for
equity trading. The combination of smart trading rules (software) with fast computers (hardware) allows an
almost instantaneous matching of orders. A group of stock exchanges worldwide (e.g. Paris, Frankfurt stock
exchanges) use electronic order-driven systems, which allow all limit orders to be stored in the central order
book. A new arriving order is immediately matched with the previously submitted orders from the order book.
The trader can view all submitted orders and foresee what trades will be executed if a new order is entered. The
highest limit order and the lowest limit order are in fact the bid and ask prices of the market. One of the
examples of trading platform of the order-driven system is XETRA, used by Frankfurt stock exchange. Quote-
driven market structure is the one, in which market makers or dealers quote the prices at which the public
market participants are trading. Market makers provide a bid quote (to buy) and an ask quote (to sell). Market
makers or dealers earn profit from the spread between the two quotes and the turnover of the shares. Concept
Quote-driven market – a market in which dealers (market makers) adjust their quotes continuously to reflect
supply and demand. This is a dealer market. Also called price-driven market. Anyone who wants to trade in a
quote-driven market must trade with a dealer. Either the investors negotiate with the dealers themselves or their
brokers negotiate with the dealers. Quote-driven markets require little formal organisation, however require
mechanisms for publishing the dealers’ price quotations and for regulating the conduct of dealers. Stock
exchanges usually provide the dealers or market makers with privileged access to certain administrative
procedures or market information. In return for these privileges, dealers have particular obligations, i.e. to quote
‘firm’ bid and ask prices at which they guarantee to make trades of up to specified volumes. A typical quote-
driven system is applied by NASDAQ, in which an automated system posts firm stock quotes of the dealers,
who place equivalent buy limit orders and sell limit orders. However, when posting the quotes, the dealers do
not know, which trades will be generated. 91 5.4.4. Hybrid markets Hybrid market structures are the ones,
which have elements of, for example, quotedriven and order-driven market structures. A market that integrates
traditional floor trading with electronic auction trading has been developed by NYSE (US). Another example is
Euronext, which uses an order-driven trading system with a centralised electronic order book. Euronext also
enables small and medium-sized listed companies to hire a designated market maker to act as ‘liquidity
provider’ in their stock. London Stock Exchange combines electronic order-driven trading with liquidity
provision by market makers. Market structures are often compared from the point of view of their transparency
and liquidity. In spite of expectations of the same market prices both in quote-driven and order-driven markets,
in reality quote-driven markets tend to be more fragmented. Dealers quote different bid and ask prices,
information on executed orders can be made available with some delay (to allow dealers some time to off-load
large trades in the market). As a result, order-driven markets tend to be more transparent than quote-driven
markets. Liquidity can be also different. Investors can trade immediately in continuous order-driven markets,
but have to wait for the next price fixing in a call market. The price, however, depends on the availability of
sufficient number of orders, i.e. liquidity. Thus investors may prefer to negotiate price individually with dealers
in quote-driven markets. In quotedriven markets information about transactions may be delayed also. 5.5.
Equity market transactions 5.5.1. Bid-ask spread When a security is traded, a dealer, operating as a market-
maker, quotes a price at which he/she is prepared to sell – the offer price – and a price at which he/she is willing
to buy – the bid price. In the transaction the buyer pays the ask price and the seller receives the bid price. The
ask price is always above the bid price. Concept Ask price – the price at which market maker is willing to sell a
security. Also called an offer price. Concept Bid price – the price at which market maker is willing to buy a
security. The difference is called the bid–ask spread and is the profit of the dealer: Spread = ask price – bid
price. The market bid-ask spread is the excess of the lowest ask price over the highest bid price and is normally
smaller than the spreads of individual market-makers. Concept Bid - ask spread – the difference between the
quoted bid and ask prices. Example Company’s shares are quoted by a broker as bid for 49,8 Euro 92 and 50,0
Euro. The bid- ask spread in percentage is: Spread = (50,0 Euro – 49,8 Euro)/ 50,0 Euro = 0,2 / 50,0 = = 0,4% If
investor purchases the share and then immediately sells it before the market price of the share changes, he will
incur a cost of 0,4% of his investment for the round-trip transaction. The bid-ask spread of dealer can be seen as
the price to be paid by investors for his services. On the other hand, from the perspective of the dealer the
spread can be seen as a compensation for his costs and risks. The dealer typically holds an inventory of
securities during the day to be able to sell (and buy) immediately. From his return (i.e., the bid–ask spread), the
dealer has to cover the costs of holding his inventory (e.g., interest costs of financing the securities inventory)
and the risks (e.g., prices may move while the securities are in the inventory). From the perspective of investors,
dealers (in their role as market-makers) provide two important services:  possibility to execute a trade
immediately from inventory, without having to wait for a counterparty to emerge.  maintenance of price
stability in the absence of corresponding sell or buy orders. By trading from their own stockholdings, dealers
reduce price fluctuations. The dealer costs include the administrative costs of transferring shares. The dealer
risks arise from price fluctuations and information-based investors. For shares that are infrequently traded, such
as shares in smaller companies, the risks are greater, because positions are held for longer periods between
trades. If shares are held for a long time, the risk of losses from price falls is greater. As a result the bid-offer
spreads for such shares tend to be relatively high. Dealer risk is also related to the possibility of investors
possessing information that the dealer does not. Such investors are able to make profit at the expense of the
dealer. Investor can sell shares to the dealer at a high price, while he is informed about a possible fall of share
price. As a result the dealer may suffer the loss from a fall in the share price. The bid-offer spread is to provide
the dealer with compensation for bearing this kind of information risk. Dealers have a possibility to negotiate
special prices for large transactions. The spread can be broader for particularly large transactions (i.e., block
trades) to cover the price risk of such block trades before the dealer can sell on (or buy) the bought (sold)
securities to (from) other dealers in the market. Thus the spread is influenced by the following factors:  order
costs – costs of processing orders, including clearing costs and costs of recording transactions;  inventory costs
– include the costs of maintaining an inventory of particular shares;  competition – the larger the number of
market makers, the greater their competition, and the narrower is the spread;  volume – the larger the trading
volume, the more liquid are the shares, the less risk of share price change; 93  risk – the more risky are
company operations, the more volatile are its shares, the higher spread is set. Several research studies showed
that bid-ask spreads on specific large stock exchanges are wider as they should be. Due to specific trading
practice, market makers kept their profits margins wide. Some analysts called this phenomenon “under-the-
table-payment” for order flow or the right to execute customers’ trades. Therefore it abuses small investors, who
do not receive the best price for their quotes. Concept Order flow – the right to execute customers’ trades. 5.5.2.
Placing order An investor who wants to buy shares on a stock exchange has a possibility to submit different
types of orders through a broker. Market order is the simplest and most common. It requires that the shares
should be traded at the most favorable price available. The most favorable price is the lowest obtainable price
for a purchase, and the highest available price for a sale shares. The trade then takes place at a price that is
currently available in the market. Concept Market order – an order to buy or sell a security immediately at the
best obtainable price. Limit order places a limit on the price at which shares can be bought or sold. Thus it
specifies purchase or sale of shares at maximum buying price or minimum selling price, respectively. The
outstanding limit-orders are generally listed in a limit-order book, which allows automatic trade matching.
However in practice some possibility in setting the priority of orders remains. Limit orders remain on the limit
order book until they are withdrawn by the investors, or until they can be executed as a result of new orders
arriving. Concept Limit order – an order to buy or sell a security at a specified price or better, i.e. lower for a
buy order and higher for a sell order. Specific types of orders include:  Buy limit order (stop buy order), which
specifies that the purchase should take place only if the price is at, or below, a specified level.  Sell limit order
(stop loss order), which specifies a minimum selling price such that the trade should not take place unless that
price, or more, can be obtained.  Market-if-touched order becomes a market order if the share price reaches a
particular level. It is different from a limit order as there is no upper limit to the purchase price, or lower limit to
the selling price. As soon as trade in the market happens at the specified price, the order becomes a market
order. However, the specified price is not necessarily obtained.  Stop order is also an order that becomes a
market order if there is a trade in the market at a particular price. However it involves selling of shares after the
price has fallen to a specified level, or buying after the price has risen to a level. Stop orders are aimed at
protecting market participants’ profits, or limiting their losses. 94 They seek to ensure that a selling price is not
too low, or that a buying price is not too high. Example A broker is intending to by company X shares. He can
access the central limit order book directly on the internet. The following information sell orders (limit prices)
and buy orders (ask prices) is provided. Sell orders Buy orders Quantity Limits Limits Quantity 1000 58 49
2000 3000 54 48 500 1000 52 47 1000 1000 51 46 2000 1000 50 44 10000 A broker has an order to buy 1000
shares and enter a market order to buy those shares. A market order will be executed against a best matching
order. At what price will he buys the shares? Another dimension to an order is the length of time for which it
remains in force.  Fill-or-kill order is to be cancelled if it cannot be executed immediately.  Open order, or
good-till-cancelled order, remains in force until it is specifically cancelled by the investor. Example Company X
shares is traded at one of European stock exchanges and its last transaction has been at 40 Euro per share. An
investor entered a limit order to sell the shares at 41 Euro while the market price was still 40 Euro. Company X
shares are also traded on NASDAQ as an ADR. One ADR represents one fourth of the share (4 ADRs equal 1
share). ADR price is quoted by a market maker at 10-10,20. Suppose favourable information is disclosed to the
market participants, which drives company share prices to 45 Euro. Who are the parties exposed to losses at the
European stock exchange and on NASDAQ if they do not react immediately? Investors can also specify the
period of time for which the order should remain open, e.g. a day, a week, or a month. Example Market orders
for a company X shares have been entered on a crossing network for European shares. There is one order from
participant Z to buy 60000 shares, one order from 95 participant Y to sell 30000 shares and one order from
participant V to sell 40000 shares. Assume that the orders were entered in a chronological order and that the
network gives priority to the oldest orders. At the time specified for the crossing session, the company X shares
are transacted at 30 Euro on their primary market. What trades would take place on a crossing network?
Assume now that all orders are AON (all or nothing), which means that the whole block has to be traded at the
same price. What trades would take place? 5.5.3. Margin trading Investors can borrow cash to buy securities
and use the securities themselves as collateral. A transaction in which an investor borrows to buy shares using
the shares themselves as collateral is called margin trading or buying on margin. Concept Margin trading – an
arrangement in which an investor borrows money or shares from a broker to finance a transaction. The funds
borrowed to buy the additional stock are provided by the broker, who in his turn borrows from a bank. The
interest rate that bank charges broker for funds for this purpose is called the broker call rate or call money rate.
The broker charges the borrowing investor the call money rate plus a service charge. Stock exchange
regulations set margin requirement, which does not allow brokers to lend more than a specified percentage of
the market value of the securities. The aim of margin requirement is to discourage excessive speculation and
ensure greater stability in the markets. Margin requirement has to ensure that investors can cover their position
in case the value of their investments into shares reduces. In such a away the possibility of default on broker
loans should be reduced. In order to purchase shares on margin investors have to create an account with a
broker, which is called a margin account. The initial deposit of cash is called initial margin. Concept Margin
deposit – the amount of cash or securities that must be deposited as guarantee on a futures position. The margin
is a returnable deposit Stock exchange regulations set initial margin requirement, which is the proportion of the
total market value of the securities that the investor must pay as an equity share, and the remainder is borrowed
from the broker. Example Assume an investor buys 200 shares of a stock at 30 Euro per share for 6000 Euro of
stock on 50% margin and the maintenance margin is 30%. By purchasing 6000 Euro of a stock on 50% margin,
the investor must put up 3000 Euro of cash (or other equity) and so borrows 3000 Euro. The investor, however,
must maintain 30% margin. Accordingly, if the stock price declines 21,43 Euro the stock position has a value of
4286 Euro (21,43 Euro × 200 shares). With a loan of 3000 Euro, the equity in the account is 1286 Euro (4286
Euro – 3000 Euro), or 30% of the account value (1286 Euro / 4286 96 Euro = 30%). If the price of the stock
decreases below 21,43 Euro, the investor must deposit more equity to bring the equity level up to 30%. As time
passes, the market value of the shares is changing. The investor’s equity position then represents the value of
shares, which is left to the investor after the loan from the broker is paid back. In order to reduce the possibility
of default, the stock exchange regulation rules establish a maintenance margin requirement. This is the
minimum proportion of the equity in the investor’s margin account to the total market value. Concept
Maintenance margin – the minimum margin that an investor must keep on deposit in a margin account at all
times. Example Consider a margin example for a short position. An investor shorts (borrows and sells) 200
shares of a stock at 30 Euro for a total stock value of 6000 Euro. With an initial margin of 50%, the investor
must deposit 3000 Euro (in addition to leaving the 6000 Euro from the sale in the account). This leaves the
investor with a balance of 9000 Euro (which does not change with the stock price since it is in cash). However,
the investor owes 200 shares of the stock at the current market price. Assuming the maintenance margin is 30%,
if the stock price rises to 34,62 Euro the 200 shares are worth 6923 Euro or 30% of the market value of the
position (2077 Euro / 6923 Euro) and additional margin must be posted. The use of borrowed funds for
investments into shares can magnify the returns on the investment. However, when borrowed funds are used,
any losses are also magnified. Exercise Assume investor X has 59500 Euro to invest and is considering buying
corporation’s shares at a price of 59,5 Euro per share. With his 59500 Euro investor X can buy 1000 shares
(ignoring commissions). Suppose investor’s X broker can arrange for him to borrow an additional 59500 Euro
so that investor X can buy an additional 1000 shares. Thus by investing 119000 Euro, he can purchase a total of
2000 shares. The 2000 shares will be used as collateral for the 59500 Euro borrowed, and investor X will have
to pay interest on the amount borrowed. By borrowing funds, an investor creates financial leverage. Investor X,
for a 59500 investment, realizes the consequences associated with a price change of 2 000 shares of the
corporation rather than 1 000 shares. He will benefit if the price rises but will be worse off if the price falls
(compared to borrowing no funds). If the price of corporation’s shares rises to 68,5 Euro per share, ignoring
commissions and the cost of borrowing, investor X will realize a profit of 9 Euro per share on 2,000 shares, or
18000. Had investor X not borrowed 59500 Euro to 97 buy the additional 1000 shares, his profit would be only
9000. If the price of corporation’s shares decreases to 52,5 Euro per share, then, by borrowing to buy 1000
additional shares, investor X will lose 7 Euro per share on 2000 shares instead of 7 Euro per share on just 1000
shares. The return from the investment into securities is influenced by the proportion of the investment that
comes from borrowed funds. The return on stock purchased on margin is defined: r = (SP – INV – L + D ) /
INV where SP – is the selling price of securities, INV – is initial investment by investor not including borrowed
funds, L – loan payments on borrowed funds including principal and interest payments, D – dividend payments
on the security. Example Assume investor decides to purchase on margin company shares, which have current
market price of 60 Euro per share. Annual dividend is 3 Euro per share. The investor pays 30 Euro per share in
cash and borrows the remaining amount from a broker at 10% interest p.a. After a year the share is sold in the
market at 90 Euro per share. The return for the investor is equal: r = (90 – 30 – 33 + 3 ) / 30 = 100% However,
if the share price declines to 40 Euro and is sold for that price, the return over a year will be equal to: r = (40 –
30 – 33 + 3 ) / 30 = - 66,7% If the investor’s margin account falls below the minimum maintenance margin
(which would happen if the share’s price fell), the investor is required to transfer additional cash. The investor
receives a margin call from the broker specifying the additional cash to be put into the investor’s margin
account. If the investor fails to put up the additional cash, the broker has the authority to sell the securities for
the investor’s account. Because of potential margin calls, a large volume of margin lending exposes the stock
market to potential crisis. When a sudden huge downturn in the market happens, many margin calls are
submitted. This may force investors to sell their share holdings, if they do not have sufficient cash to transfer in
order to reach required maintenance margin. Such sales place additional downward pressure on share prices and
magnify the negative effect in the market. 5.5.4. Short selling In a short selling, investor place an order to sell a
security that is not owned by the investor at the time of sale. Investors sell the stock short (or short the stock)
when they expect decline of the stock price. They arrange to have their broker borrow the stock from other
investor, and the borrowed stock is delivered to implement the sale. To cover their short position, investors must
subsequently purchase the stock and return it to the party that lent the stock. Thus investor, 98 who owns the
stock is unaffected when his shares are borrowed, are not aware about the fact that their shares were borrowed.
If the stock price declines by the time the short-seller purchases it in the market in order to return to the
investor, from whom he has borrowed, the short seller earns a profit from the difference between the initial
selling price and the subsequent purchase price of the stock. However, his profit will be less, if he has to pay to
the investor, from whom he has borrowed the stock, dividends which the investor would have received if he had
not borrowed the stock. The risk of a short sale is that the stock price may increase over time, which forces the
short-seller to pay a higher price for the stock than the price at which it was initially sold. Stock markets and
financial analysts provide information on level of short sale. Several indicators are used to measure the short
position on stock:  a degree of short positions. It is a ratio of the number of shares that are currently sold short,
divided by the total number of shares outstanding. Statistics shows, that most often this measure is in the range
of 0,5-2%. A high measure of 3% shows a large number of short positions in the market, which may indicate
that a large number of investors expect the stock price to decline.  Short interest ratio for specific shares. It is
the number of shares which are currently sold short, divided by the average daily trading volume over the recent
period. The higher the ratio, the higher the level of short sales. The ratio of 20 or more reflects an unusually
high level of short sales, indicating that many investors believe that the stock price is currently overvalued. For
some stock this ratio may exceed 100 at particular points in time.  Short interest ratio for the market. The
higher the ratio, the higher the level of short selling activity in the market overall. Investors, who have
established a short position, quite often request a stop-buy order to limit their losses. 5.5.5. Stock trading
regulations Stock market regulations aim at ensuring fair treatment of all investors in the market. Stock trading
is regulated by national securities exchange commissions and by individual stock exchanges. It is widely
understood, that the development of financial markets and success of new issues of securities cannot be handled
without efficient and fair secondary stock markets. Analysis of average real returns on stock in the well
developed markets indicate that historically it has been about 6% percent higher than return on Treasury bills,
which reached on average only 1% p.a. The difference between the return on stocks and the riskfree-rate is a
measure of risk premium on equities. However, the size of this risk premium is not justified by the stock
market’s risk exposure, if only investors are assumed to be unreasonably averse to risk. The research has shown
that only 0,35% of an equity premium can be justified as risk premium. Such persistent overpricing of risk
premium is called an equity premium puzzle. Concept Equity premium puzzle – the persistent overpricing of
risk premium on stocks. 99 If the equity premium puzzle is the result of security mispricing, then there is an
arbitrage opportunity. It means that investor can gain by borrowing at the Treasury bill rate and investing in
stocks. Borrowing limitations and transaction costs may reduce this arbitrage profit, but not eliminate it. The
concern about the fair and ethical stock market trading require imposing discipline on individuals and
institutional investors. The organized stock exchanges introduce surveillance of all transactions at the
exchanges. Computerized systems are installed to detect unusual trading of any particular stock. Any abnormal
price or trading volume of particular stock or unusual trading practices of market participants is investigated.
Additional regulations on imposing good corporate governance practice for listed companies are imposed
through introduced corporate governance codes. Regulations require disclosure of financial statements, having a
majority of independent directors (not employees of the companies) on their boards of directors. Such
requirements are aimed at reducing existing or potential conflicts of interest between management and minority
as well as majority shareholders, focusing management on maximizing stock value for company shareholders.
Specific regulation concerns are related to restrictions on trading in case of market downturns. Stock exchanges
can impose circuit breakers, which are restrictions on trading when stock prices or stock indexes reaches a
specified threshold level. The necessity of such restriction became vivid during stock market crashes, e.g of
NYSE in October 1987 and the later ones. When market maker swamp market with sell orders, stock prices
cannot reflect the fair value any longer and move into a freefall. The market experiences huge liquidity crisis,
which feeds panic and exacerbates the price decline. As a result of such experience, in order to provide time for
market participants to regroup and obtain backup sources of liquidity, a series of circuit breakers are put to use.
Concept Circuit breakers – automatic halts or limitations in trading that are triggered upon the attainment of
certain stipulated price moves. The NYSE prevailing circuit breakers have three threshold levels for a daily
change of Dow Jones Industrial average index from its previous closing level: Level 1 – 10%, Level 2 – 20%,
Level 3 – 30%. If the Level 1 threshold is reached, there is a brief 30 or 60 minute halt in trading. If the Level 2
threshold is reached, there is a slightly longer 1 to 2 hour halt in trading. If the Level 3 threshold is reached, the
market is closed for a day. NASDAQ and other large international exchanges impose similar circuit breakers.
Concept 50 point collar – provision that prohibits computer assisted trading if Dow Jones Industrial average
index rises or falls by 50 points. Concept 250 point rule – provision that halts all trading for one hour if Dow
Jones Industrial average index falls by 250 points in a day. Trading halts may be imposed on particular stocks if
stock exchanges believe that market participants need more time to receive and absorb material information,
which can affect stock price. Such trading halts are imposed of stocks that are associated with mergers and
acquisitions, earning reports, lawsuits and other important news. The purpose of them is to ensure that market
has complete information before trading on the news. A halt may last a few minutes, hours or several days.
Trading is resumed after it is believed that the market has complete information. This does not prevent investors
from a trading loss in response 100 to the news. However, it can prevent from excessive optimism or pessimism
about a stock, and can reduce stock market volatility. Drawbacks of trading halts are related to slowing down
the inevitable adjustment of stock prices to the news. 5.6. Equity market characteristics 5.6.1. Stock indicators
Trading of stocks in the secondary market is related to stock price changes. Investors monitor stock price
quotations, provided in financial websites and press. Though format is different, most of tem provide similar
information. Stock exchanges provide information on market capitalization, which is the market’s valuation of
the firm and is found by multiplying the number of shares by their market price. Earnings per share are net
profits attributable to common shareholders divided by the number of common shares outstanding. Annual
dividend is a net profit portion distributed to the shareholders over the last year on a per share basis. Dividend
yield is the annual dividend per share as a percentage of the stock’s actual price. The price/earnings ratio (P/E
ratio) is the reciprocal of the earnings yield. It conveys the same information but avoids the use of percentages.
Concept Price / earnings ratio (P/E ratio) – the ratio of the stock market price to the earnings per share.
Sometimes called earnings multiplier. If a firm has a high P/E ratio, the indication is that the market values it
highly for some reason other than current earnings. The usual presumption is that future earnings are likely to
grow rapidly and the price increased in its anticipation. Shares of another company in the same sector might be
judged ‘cheap’ if their P/E ratio were low by comparison (for no obvious reason). Stock quotations also include
volume of shares traded the previous day. Stock price quotations show the “last” or closing price on the
previous session. 5.6.2. Stock market indexes Stock market indexes are measures of the price performance of
stock portfolios, which are formed to represent a stock market as a whole or a specific segment of the market, or
subindexes. The well- known indices include the Dow Jones Industrial Average, the Standard & Poor’s 500 in
the United States; the FTSE 100 in the United Kingdom; the Nikkei 225 in Japan; the DAX in Germany; the
CAC 40 in France; and the Hang Seng in Hong Kong. National stock markets have at least one index, and some
countries with well developed stock markets (in particular the United States) have numerous indexes. Indices
can be categorized by the way:  the number of stocks included;  the method of weighting the stock prices; 
the method of averaging. 101 The number of stocks can vary from a small number of largest most liquid
company stocks to a wide portfolio of all stocks traded on a particular market. The indexes based on a small
number of stocks have the advantage of easy calculation; however they can hardly represent stock market as a
whole. Weighting of the stock prices is diverse. Contribution of individual stock prices to an index may be
unweighted (as in the case of the Financial Times Ordinary Share Index), value weighted (for example the
Financial Times Stock Exchange (FTSE) 100), price weighted (such as the Dow Jones Industrial Average). In
the case of unweighted indexes all stocks equal influence irrespective of the sizes of the companies. Average of
daily rates of share price change is calculated each day and gives stock price change average on one day. The
product of such changes starting from a base date provides the index. The calculation involves two stages: 1)
averaging stock price changes on a single day; 2) compounding the daily averages over time. Example An
average of 10% rise of share prices on one day is followed by an average 20% rise of share prices the next. This
gives a rise of 32% over the two days: 1.1 x1.2 =1.32. Thus unweighted index is equal to 1,32. Indexes have a
number of uses:  to measure and monitor market movements;  To provide a means of ascertaining changes in
aggregate wealth over time.  To perform a role as barometers of the economy; in particular stock market
movements tend to be leading indicators which means that they provide indications of likely future changes in
the level of activity in the economy as a whole. Fourth, they provide a means of evaluating the performance of
fund managers by providing benchmarks against which portfolio managers can be compared.  To provide the
basis for derivative instruments such as futures and options;  To provide the framework for the creation of
tracker funds, which is to reflect the performance of a stock market.  To be used by capital market models, in
particular the capital asset pricing model (for discount rates for capital projects, estimating required rates of
return on shares, deriving fair rates of return for utilities). Value weighted and arithmetically averaged indexes a
key ones. In order to measure stock market values, an index has to reflect accurately the total market
capitalization. An arithmetically averaged value-weighted index accurately measures the aggregate value of the
stocks covered by its index. A reliable measure of the total value of the market is also required for measuring
changes in aggregate wealth over time and as a basis for derivative instruments. Example Suppose index is
based on just three stocks whose prices and numbers of shares issued are the following. Stock A Price 50Euro,
total 10 million shares Stock B Price 100Euro, total 10 million shares 102 Stock C Price 200Euro, total 5
million shares The changes relate to just one day (so no compounding over time is involved). Supposed (a) that
stock A rises in price by 15% during the day while the other two prices remain unchanged, and (b) that stock C
undergoes a 15% price rise while the other two prices remain constant during the day. Before the price rise, the
index equals 100. In the event of a 15% rise in the price of A, the new index will be (using arithmetic means):
(New value / Old value) x 100 = = (1, 15 + 1 + 1) / (1 +1 +1) x 100 = 1,05 x 100 =105 If the price of C rises by
15%, the new index will be: (New value / Old value) x 100 = = (1 + 1 + 1,15) / (1 +1 +1) x 100 = 1,05 x 100
=105 It can be seen that a 15% rise in either stock price has the same effect on the index despite the fact that C
has a higher stock price and is issued by a larger company. Arithmetically averaged value-weighted stock
indices are the only indices that are macroconsistent, i.e. it is possible for all investors to hold the index
portfolio simultaneously. An index portfolio is a portfolio of shares that matches a stock index in terms of its
constituent shares and their relative proportions. The larger number of stocks is covered by an index, the more
effective it is. Indices that provide a very broad coverage, and hence reliably reflect the whole market, are
referred to as broad capitalization indices. A good broad capitalization index is characterized by completeness
and investability. This should make it possible for fund managers to buy all the shares in the index. Investability
is particularly important for the managers of index tracker funds, but may require some sacrifice of
completeness in order to eliminate illiquid stocks. The calculation of value-weighted indices has moved towards
a free-float basis and away from a total capitalization basis. Free float includes only those shares that are
available for purchase, rather than all shares. The free float basis excludes shares held by governments,
founding families, and non-financial companies. The stock-index weighting is thus based on the total value of a
company’s shares available for purchase, and not on the full market capitalization of the company. Weighting
for multi-country stock indices is subject to discussion. One view is to weight each country by its contribution
to global market capitalization. However the ratio of stock market capitalization to national income (GDP)
varies considerably between countries. Another view is to use national income (GDP) rather than market
capitalization for weighting. .This approach would provide a more stable weighting since relative GDP is less
volatile than relative market capitalization. Exercise Three companies belong to a group and are listed on the
stock exchange: 103 Company A owns 20% of company B, Company B owns 30% of company C, Company C
owns 10% of company A. Each company has a total of market capitalization of 100 million Euro. You wish to
adjust for cross-holding to reflect the weights of these companies in a market capitalization-weighted index.
What adjustments would you make to reflect the free-float? Two types of emerging-market stock index are
available. There are indices based on total market capitalization and indices based on the shares available for
foreign investors. The performances of the two different types of index can be significantly different. Stock
indexes are used by institutional investors as benchmarks for performance measurement. Index tracker funds
aim to replicate the performance of an index. Although most stock indexes are based on arithmetic averages,
there are some that use geometric averaging. However geometric averaging has particular problems. The
geometric mean overestimates the effects of rises in the prices of smaller company stocks and underestimates
the effects of changes in the stock prices of larger companies. Since large corporations are large because of
rapid growth in the past, it follows that the use of geometric means gives too little weight to the stock prices of
rapidly growing companies and too much weight to the stock prices of slow growth companies. So the use of
geometric means underweights stocks, whose prices rise rapidly, and overweights stocks, whose prices increase
slowly. In consequence, over time, indices based on geometric means tend to understate the true rate of increase
in stock prices. The cumulative effect of such understatement over time can substantially distort the calculated
market rise. 5.6.3. Stock market indicators In order to characterize and compare national as well as international
stock markets, a number of indicators are being used. Market size is characterized by market capitalization.
Relative national market capitalizations give indications of the importance of each country to international
investors. Market capitalization weights are used in the global benchmarks. Thus market size forms the basis for
global investment strategies. Market liquidity. In liquid markets investors can be more active and design various
arbitrage strategies. Market illiquidity tends to imply higher transaction costs. Thus those investors, who
measure performance relative to a global benchmark, will tend to be more passive on such illiquid markets.
Market illiquidity can be measure by transaction volume and turnover ratio. Turnover ratio is sometimes called
share turnover velocity. Concept Turnover ratio or share turnover velocity – is the ratio between the annual
transaction volume and the market capitalization. Price volatility is an important measure in the secondary
market, but might also be important to the operations of the primary market. High volatility means that buyers
in the primary market are subject to a considerable risk of losing money by having to sell at a 104 lower price in
the secondary market. This can reduce the motivation to buy in the primary market. Two factors that affect the
price volatility of securities in the secondary market are the depth and breadth of that market. The depth of the
market is based on the likely appearance of new orders stimulated by any movement in price. If a rise in price
brings forth numerous sell orders, the price rise will be small. A decline in price that stimulates many buy
orders would be a small decline. A deep market would be characterized by the appearance of orders that tend to
dampen the extent of any movement in price. Greater depth is thus associated with lower volatility. Breadth of
that market reflects the number and diversity of the traders in the market. If there is large number of market
participants with differing motivations and expectations, then there is less likely to be substantial price changes,
compared to when there is small number of traders, or when the traders have common views such that they buy
or sell together. A broad market is a large heterogeneous market characterized by relative price stability.
Concentration. Also called degree of concentration can be measured based on market capitalization for specific
stock exchanges, as well groups of stock exchanges in a region. This an important measure for investors
interested to know if a national market is formed of a large number of diverse companies, or concentrated on a
few companies. Institutional investors are reluctant to invest in small companies, fearing that they offer poor
liquidity. Besides, it is easier for investors to track performance of a market index (based on market
capitalization weights), if it is dominated by a few large issues. A market dominated by a few large companies
provides less opportunities for risk diversification and active portfolio strategies. 5.6.4. Transaction execution
costs Transaction costs are an important aspect of implementing an investment strategy. However, measurement
of trading costs meets difficulties. Trading costs consist of two major components:  explicit costs and 
implicit costs. Explicit trading costs are the direct costs of trading, such as broker commissions, fees, and taxes.
The main explicit cost is the commission fee, which is paid to the broker for execution of an order. Commission
costs are fully negotiable and vary systematically by broker type and stock market mechanism. The commission
fee may be set, dependent upon both the price per share and the number of shares in the transaction. In addition
to commissions, other explicit costs include custodial fees, which are the fees charged by an institution that
holds securities in safekeeping for an investor, and transfer fees, consisting of the fees associated with
transferring an asset from one owner to another. Implicit trading costs represent such indirect costs as the price
impact of the trade and the opportunity costs of failing to execute in a timely manner or at all. Whereas explicit
costs are associated with identifiable accounting charges, no such reporting of implicit costs occurs. Implicit
trading costs include  impact costs, 105  timing costs, and  opportunity costs. The impact cost of a
transaction is related to the change in market price due to supply and demand imbalances, caused by the trading
transactions. Bid-ask spread estimates fail to capture the fact that large trades — those that exceed the number
of shares the marketmaker is willing to trade at the quoted bid and ask prices — may move prices in particular
direction. That is, large trades may increase the price for buy orders and decrease the price for sell orders. The
resulting market impact, or price change due to the transaction can be described as the deviation of the
transaction price from the “unperturbed price” that would prevail if the trade did not occur. The timing cost of a
trade is measured as the price change between the time the market participants assume responsibility for the
trade, and the time they complete this responsibility for the transaction. Timing costs occur when orders are on
the trading desk of a buy side company (e.g., an investment management company), but are not yet released to
the broker, because the trader fears that the trade may swamp the market. The opportunity cost of a trade is the
“cost” of securities not traded. This cost results from missed or only partially completed trades. These costs are
the natural consequence of the trade order delays. For example, if the price moves too much before the trade can
be completed, the asset manager will not make the trade. In practice, this cost is measured on shares not traded
based on the difference between the market price at the time of decision and the closing price 30 days later.
Commission fees and impact costs are actual and visible; however, the opportunity costs and timing costs are
the costs of forgone opportunities and are invisible. Opportunity costs can arise for two reasons. Firstly, some
orders are executed with a delay, during which the price moves against the investor. Secondly, some orders
incur an opportunity cost because they are only partially executed or are not executed at all. Exercise An asset
manager follows an active international asset allocation strategy. The average execution cost for a buy or a sell
order is forecasted at 0,5 percent. On average the manager turns the portfolio over 1,5 times a year. The annual
expected return before the transactions costs is 10 percent. What is the annual return net of execution costs?
Several methods of reduction of transaction costs are applied by institutional investors:  Internal crossing, i.e.
manager attempts to cross the order with an opposite order for another client of the firm;  External crossing,
i.e. manager sends the order to an electronic crossing network;  Principal trade, i.e. the manager trades through
the dealer, who guarantees full execution at a specified discount or premium to the prevailing price. The dealer
then acts as principal, because he commits to taking the opposite side of the order at the firm price.  Agency
trade, i.e. when fund manager negotiates a competitive commission fee and selects a broker on the basis of his
ability to reduce total execution costs. This way the search for the best execution is delegated to the broker. 
Use of dealer indications of interest (IOI). Some party may wish to engage in an opposite trade for a stock or a
basket of stocks. Pooling IOIs from various dealers helps to identify possible pools of liquidity. 106  Use of
futures. There is an opportunity cost associated with the delay of execution of large trade. The fund manager
could use futures to monitor the position while the trade is executed. Seeking to control (minimize) the costs,
institutional investors have developed computerautomated programs to enter trading orders. The use of
computer programs for this purpose is known as algorithmic trading. Once an asset manager makes a decision
to buy or sell a large stock position, the program separates the trade into several smaller orders so as to
minimize transaction costs. Sometimes algorithmic trading is confused with automated trading. The latter uses
computer programs to make investment decisions about which shares to buy or sell. Algorithmic trading is used
to determine how to place the order. However, algorithmic trading does not require that the decision of which
shares to buy or sell be made by automated trading. 5.7. Stock market efficiency Investors do not like risk and
they must be compensated for taking on risk—the larger the risk, the more the compensation. An important
question about financial markets, which has implication for the different strategies that investors can pursue, is:
Can investors earn a return on financial assets beyond that necessary to compensate them for the risk?
Economists refer to this excess compensation in the stock markets as an abnormal return. Whether this can be
done in a particular financial market is an empirical question. If a strategy is identified that can generate
abnormal returns, the attributes that lead one to implement such a strategy is referred to as a market anomaly.
This problem of how efficiently financial market is pricing the assets traded in those market, is referred to as
market efficiency. An informationally efficient market is defined as a financial market where asset prices
rapidly reflect all available public information. Concept Efficient market – a market in which any relevant
information is immediately impounded in asset prices. This means that all available information is already
impounded in an asset’s price, so investors should expect to earn a return necessary to compensate them for
their opportunity cost, anticipated inflation, and risk. That would seem to preclude abnormal returns. Check
question What are market forces that tend to make financial markets informationally efficient? As investors
attempt to capitalize on new information, which is not already accounted for in prices, the stock prices should
adjust immediately. It is commonly agreed that investors over- or under-react to information. This does not
mean markets are inefficient unless the reaction is biased (consistently over- or under-reacting). In this case
investor, who recognizes the bias, will be able to earn abnormally high risk adjusted returns. Check question
How should investors behave in a market that is informationally efficient? How does this differ from behaviour
in a market that is not informationally efficient? This concept is illustrated in Figure 14. Before the information
becomes public, the security has an old value. The new information hits the market. In an efficient market the
price instantly adjusts to its new equilibrium level. If the market is inefficient, the market 107 may underreact or
overreact to new information. If there is underreaction, the price adjustment is gradual. If there is overreaction,
the market price overshoots the new equilibrium value. If market is inefficient, between the time of the news
revelation and the adjustment to the new equilibrium value, informed investors would be able to profit at the
expense of less sophisticated investors. Figure 14. Market reaction to new information According to Fama
(1970), there are three levels of efficiency:  Weak form efficiency  Semi-strong form efficiency  Strong form
efficiency Weak form of market efficiency suggests, that current asset prices reflect all past prices and price
movements, i.e. all trade-related information. In other words, all worthwhile information about previous prices
of the stock has been used to determine today’s price. So the investor cannot use the same information to predict
tomorrow’s price and still earn abnormal profit. Empirical evidence from the most of world stock markets
suggests that these markets are weak-form efficient. In other words, it is not possible to outperform (“beat”) the
market by using information on past stock prices. Concept Random walk theory – a theory stating that all
current information is reflected in current security prices and that future price movement are random because
they are caused by unexpected news. The view that price changes cannot be predicted has been called the
random walk hypothesis. According to it, price changes are drawn from a probability distribution which does
not change over time. This constant distribution assumption is a subset of weak form of efficiency. Weak form
of efficiency can hold, even though the distribution of prices shifts over time. New information Underreaction
Perfect efficiency Overreaction Old value New value Time Price 108 Semi-strong form of market efficiency
suggests that current stock prices reflect all publicly available information. The difference between public
information and market related information is that public information also includes announcements of company
events, economic and political news and events. Thus, if investors employ investment strategies based on the
use of publicly available information, they cannot earn abnormal profits. It does not mean that prices change
instantaneously to reflect new information, but rather that information is accounted for rapidly in stock prices.
Testing semistrong efficiency raises two serious problems. First, a model of the determinants of the stock prices
has to be chosen. Second, tests of the model have to distinguish between the anticipated and unanticipated
information. Fully anticipated information should be already incorporated into security prices. Only
unanticipated information or surprises have an impact on stock prices. Empirical evidence supports the idea that
the largest world stock markets are for the most part semi-strong efficient. This, in turn, implies that careful
analysis of companies that issue stocks cannot consistently produce abnormal returns. Strong form of market
efficiency assumes that asset prices reflect all public and private information. In other words, the market (which
includes all investors) knows everything about all securities, including information that has not been released to
the public. The strong form implies that you cannot make abnormal returns from trading on inside information,
where inside information is information, which is not yet public. Corporate insiders (directors, large
shareholders) are a group of market participants, who are involved in management and have access to non-
public information. Profit from insider information through short-term trading gains is illegal. However, they
are allowed to buy and sell securities of the company they are employed in, for long-term investment purposes.
Such transactions are called insider trading and have to be disclosed to securities exchange commission and to
the public. Stock market analysis has shown that when insiders are trading company shares, usually their results
are good. Therefore, insider reports to securities exchange commission has become an important source of
investor’s information. In merger and acquisition transactions the price of the acquired firms stock tends to rise
significantly before public announcement of the transaction. The assumption is made, that some insiders may be
profiting from non-public information. Another group of research is related to investment fund earnings
analysis. For example, it has shown that average fund earns fair rates of return at the certain the risk levels.
However in some studies the experts forecasted interest rates do not beat the simple extrapolation of the current
interest rates. The studies showed that the current interest rate is a better forecast of the next period interest rate
than the experts’ forecasts. Besides, investment advisory services have not managed to produce return larger
than a fair return. This evidence is consistent with market efficiency hypothesis. On the whole, the strong form
of market efficiency is not supported by the empirical studies. In fact, event studies state that the opposite is
true; gains are available from inside information. Thus, various stock markets, as the empirical evidence
suggests, are essentially semi-strong, but not strong efficient. Check question What are the differences among
the three forms of market efficiency? 109 Check question How can you describe empirical evidence concerning
the three forms of the efficient market hypothesis? The implications for market efficiency for issuers of shares
is that if the financial markets in which they issue securities are semi-strong efficient, issuers should expect
investors to pay a price for those shares that reflects their value. This also means that if new information about
the issuer is revealed to the public (for example, concerning a new product), the price of the security should
change to reflect that new information. Concept Volatility – a measure of uncertainty about the future price of
an asset. Typically measured by the standard deviation of returns on the asset. 5.8. Stock valuation In order to
make investment decisions investors conduct valuation of stocks. They search for undervalued stocks for
investing and sell holdings of stocks if they are considered overvalued. There are two approaches to what
information is useful in the selection of stocks and the timing of the purchase of stocks:  fundamental analysis
and  technical analysis. 5.8.1. Fundamental analysis Fundamental analysis is one of the methods of valuing
stocks, which involves the analysis of a company’s operations to assess its economic prospects. It is based on
fundamental financial characteristics (e.g. earnings) about the company and its corresponding industry that are
expected to influence stock values. The analysis is based on financial statements of the company in order to
investigate the earnings, cash flow, profitability, and financial leverage. The fundamental analysis includes
analysis of the major product lines, the economic outlook for the products (including existing and potential
competitors), and the industries in which the company operates. This analysis results in projections of earnings
growth. Based on the growth prospects of earnings, the fair value of the stock using one or more of the equity
valuation models is determined. The fair value is based on present value calculations. Concept Present value –
the current value of a future cash flow. It is obtained by discounting future cash flow by the market – required
rate of return. There are various models to estimate the fundamental value of company shares. One approach is
to estimate expected earnings and then multiply by expected price/ earnings ratio. Another approach is to
estimate the value of the assets of the company. Check question Describe the price/earnings multiple approach
to investing. What determines the company’s multiple? Are multiples stable over time? What does this
approach assume about market efficiency? 110 The estimated fair value is compared to the market price to
determine if the stock is fairly priced in the market, cheap (a market price below the estimated fair value), or
rich (a market price above the estimated fair value). Traditional fundamental analysis has several limitations. It
does not quantify the risk factors associated with a stock and how those risk factors affect its valuation. In a
perfectly efficient market all securities are always correctly priced. The market price equals to the fundamental
value of the security. In a market that is partially inefficient, the market prices deviate from fundamental value.
Financial analysts aim to discover the fundamental value ahead of the rest of the market participants before the
market prices approach the fundamental value in order to make profits. The actions of such profitseeking
investors push the market towards efficiency. 5.8.2. Technical analysis The aim of the technical analysis is to
identify stocks that are candidates for purchase or sale, and the investor can employ technical analysis to define
the time of the purchase or sale. Such analysis is used not only for investigation of common shares, but also in
the trading of commodities, bonds, and futures contracts. This analysis can be traced back to the seventeenth
century, where it was applied in Japan to analyze the trend in the price of rice. The father of modern technical
analysis is Charles Dow, a founder of the Wall Street Journal and its first editor in the period of 1889 -
December 1902. Technical analysis ignores company fundamental information, focusing instead on the study of
internal stock market information on price and trading volume of individual stocks, groups of stocks, and the
overall market, resulting from shifting supply and demand. Technical analysts believe that stock markets have a
dynamic of their own, independent of outside economic forces. Concept Technical analysis – a forecasting
method for asset prices based solely on information about the past prices. Technical analysis is aimed to
determine past market trends and patterns from which predictions of future market behavior are derived. It
attempts to forecast short-term price movements. The methodology of analysis is based on the belief that stock
market history tends to repeat itself. If a certain pattern of prices and volumes has previously been followed by
particular price movements, it is suggested that a repetition of that pattern will be followed by similar price
movements. Question What is technical analysis? Why is there a difference between technical analysis and
efficient markets? The study of past patterns of variables such as prices and trading volumes allows investors to
identify times when particular stocks (or sectors, or the overall market) are likely to fall or rise in price. The
focus tends to be on the timing of purchases and sales. H. Levy has suggested that technical analysis is based on
the following assumptions: 1. The market price of securities (such as shares and bonds) is determined by supply
and demand. 2. Supply and demand are determined by numerous rational and irrational factors. These include
both objective and subjective factors. 111 3. Apart from minor fluctuations the prices of individual securities,
and the level of the market as a whole, tend to move in trends which persist for significant periods of time. 4.
Trends change in reaction to shifts in supply and demand. These shifts in supply and demand can be detected in
the action of the market itself. Assumptions 3 and 4 are controversial. Supporters of the efficient market
hypothesis (EMH) take the view that new information is very quickly reflected in security prices. If information
is very quickly reflected in prices, trends do not have an opportunity to emerge. Technical analysts believe that
new information does not arrive in the market at a single point in time; they take the view that new information
comes to the market over a period of time. For example new information may be available first to insiders,
second to professionals, and lastly to the public. As the information gradually becomes more widely available,
the share price gradually moves to its new equilibrium price. Technical analysts look for the beginning of a
movement from one equilibrium price to another without attempting to predict the new equilibrium price. They
attempt to profit from forecasting the direction of movement; that is they try to identify trends and profit from
them. Whatever the reason for a change in price, if the share price responds sufficiently slowly, a trend emerges.
A slow response of prices to shifts in supply and demand provides the potential to profit from technical
analysis. There are many technical analysis and trading techniques, including chart and non-chart ones. Price
charts are a more frequent technique. Price charts are made for each day, or other chosen time interval, with the
help of a vertical line. The top of the vertical line indicates the highest price reached during the day and the
bottom shows the lowest price. A short horizontal line on each vertical line indicates the closing price on the
day. A variety of price charts include line charts, Japanese candlestick charts, a point-andfigure. One aim of the
charts is to find areas where price reversals are frequent since this is seen as presaging a substantial price
movement (break out from a trading range).This would appear as a horizontal stretching out of the chart.
Technical analysts use a vast number of chart patterns. Price channels (Trend channels). Trend channels can be
horizontal, upward or downward sloping. The share price remains within the channel, and some points in time
breaks out of the channel. If it breaks out of the channel in a downward direction, the chartist may interpret this
as a signal to sell the stock since it is seen as forecasting a fall in the stock price, and vise versa. Price channels
are often interpreted in terms of the bounds providing limits to the extent of variation of share prices, such that
share prices tend to remain within the bounds. Reversal patterns. Chartists frequently believe that when the
direction of a share price (or market index) changes, characteristic chart patterns may develop as the turn
occurs. One of those reversal patterns is head-and-shoulders configuration. The highest peak is the head, and the
lower peaks are the shoulders. When the share price falls below the lower peak, further price fall is forecasted
and eventually constitutes a sell signal. Converse reasoning would explain the use of reverse head-and-
shoulders, which indicates that stock prices will rise and that therefore shares should be bought. 112 Moving
averages. Technical analysts use not only prices relating to individual dates, but also moving averages. A
moving average is an average of a series of previous prices, for example the average of the last 200 daily prices.
(Each day the oldest price is removed from the calculation of the average and the most recent price introduced).
Chart patterns can be based on moving averages as well as daily prices. One popular technique is to use moving
averages and daily prices on the same chart. If the current price is a predetermined percentage above or below
the moving average, a buy or sell signal may be indicated. For the market as a whole, the proportion of stocks
currently above their moving average is seen as an indicator of general market sentiment. Points at which a
chart of daily prices crosses a chart of moving averages are seen as significant. A daily price chart that crosses a
moving average chart from below might be seen as providing a buy signal. The signal may be dependent upon
whether the moving average is rising or falling at the time. Studies have suggested that moving average
strategies could be successful, e.g. stock returns following buy signals from a moving average rule were higher
than those following sell signals. Dow theory. This is one of the oldest technical tools, aimed to forecast the
future direction of the overall stock market. Dow theory is based on the belief that market movements are
analogous to movements of the sea. It sees three simultaneous movements in the market. Daily and weekly
fluctuations correspond to ripples. Secondary movements (which last a few months) are the waves. Primary
trends of a year or more are analogous to tides. It is the primary trend that is referred to as either a bull or a bear
market. The daily or weekly movements are seen as having little or no predictive value. However, secondary
movements in stock indices are used to forecast changes in the direction of the primary trend. A bull market is
characterized by both high and low points of successive secondary movements moving in an upward trend,
especially if this were accompanied by rising volumes of stocks traded. Each new peak is above the previous
peak, and each new trough is above the previous trough. Trading volume should increase with moves made in
the direction of the primary trend; for a rising primary trend, volume should be heavier for advances than for
falls. The market is sustained by rising support levels and would break through successively higher resistance
levels. When the market eventually falls through a support level and then is unable to bounce back beyond a
previous resistance level, the beginning of a bear market is signaled. A bullish primary trend is seen as being
initiated by informed investors, who anticipate a recovery. Subsequently uninformed investors start buying,
thereby reinforcing the upward trend. While the uninformed investors continue to buy, the informed investors
start to sell. Sales by informed investors cause the temporary downturns (the waves). Elliot wave theory. The
theory sees markets as moving in cycles. There are very long-run cycles that last many decades. Superimposed
on these are cycles of shorter duration. In turn there are cycles of even shorter duration superimposed upon the
latter cycles. This pattern of cycles within cycles continues down to cycles of very short duration. Analysis of
the Elliot cycles is based on waves. Each cycle has eight waves. Five waves carry the market up and three
waves carry it down. At the end of the cycle the market is higher than at the beginning. The pattern of waves
entails a succession of support and resistance levels, similarly to Dow theory. Elliot wave theory assumes that
markets are driven by investor psychology. After a fall in prices, investor optimism is seen as growing slowly at
first but later the 113 optimism becomes excessive and leads to a bubble at which prices peak. The bubble
bursts and the market is then carried lower in the wave pattern. Elliot wave theory is sometimes supplemented
by the use of Fibonacci numbers. Fibonacci numbers seem to fit the pattern of development of a range of natural
phenomena from the reproduction of petals on a flower to the formation of galaxies. They are also believed to
explain stock market developments. Fibonacci numbers are taken from a sequence in which each number is
found by adding together the previous two in the series. The sequence runs 1, 1, 2, 3, 5, 8, 13, 21, 34, and so
forth. Users of the theory employ various combinations and ratios of Fibonacci numbers to predict market tops
and bottoms, along with support and resistance levels. Elliot wave theory sees cycles as comprising eight
waves, five on the upswing and three on the downswing, which are Fibonacci numbers. Technical analysts also
use other indicators, such as filter rules, relative strength, and short interest ratios. Filter rule states that an
investor should buy when a stock price (or market index) has risen by a predetermined percentage above a
previous low point. Conversely, the investor should sell when the price or index falls by a particular percentage
below a previous high. The percentages are decided by the investor, but they should be established prior to the
market movements. Relative strength is measured by the ratio of a stock price to a market index. Changes in the
ratio are taken to indicate buy or sell opportunities. For a momentum trader a rise in the ratio is a signal to buy
the stock (and a fall is a signal to sell).A contrarian trader would interpret a rise in the ratio as a sell signal (and
a fall as a buy signal). The short interest ratio is the ratio of short sales to total trading. A rise in the ratio has
two opposite interpretations. First, a rise in the ratio as indicative of bearish sentiment, and hence is a sell
signal. Second, a rise is a buy signal, since it is believed that the short positions will have to be covered by stock
purchases. These stock purchases would tend to push up stock prices. Trin statistic is the ratio of the average
trading volume in stocks with declining prices to average volume in stocks rising prices. Ratio above 1 show a
bearish market, since a relatively high volume of trades in declining stocks is indicating net selling pressure.
Conversely, ratios below 1 are seen as indications of a bullish market. Trading volume is considered an
indication of the strength of a trend. If a price movement is accompanied by a relatively high quantity of trades,
it is considered more significant than the price movement in a low trading volume market. Breadth of the
market shows the extent to which movement in a market index is reflected widely in the price movements of
individual stocks. The most common measure of breadth is the difference between the number of stocks that
rise and the number that fall. If the difference is large, the market movement is considered to be strong, since it
is widespread. A market rise is viewed stronger, if prices of large majority of stocks are rising. Conversely,
market rise is viewed as weaker, when only prices of stocks of a few large capitalization companies are
increasing. Mutual fund cash holdings, if they increase, might an indication of a market rise based on belief that
the cash will be used to buy shares. This demand for shares would tend to push prices up. Conversely, low
mutual fund cash holdings are seen as a bearish signal. Put-call ratio. Put options give the right to sell shares at
a specified price, and are bought by investors who expect share prices to fall. Call options give the right to buy
shares at a specified price, and are bought by investors who expect share prices to rise. The ratio of puts bought
to calls bought is used as an indicator of the expectations of investors. 114 However technical analysts have
different interpretations of the ratio. Some see a high putcall ratio as a sign of a bearish market based on the
belief that it indicates that investors in general expect stock price falls. Others have a contrarian view, and see a
high put-call ratio as a buy signal. Contrarian analysts base their analysis on the belief that investors are usually
wrong. Technical analysis is often, though regarded as an essential tool of investment analysis by market
practitioners, however is criticized by academics. The criticism from academics tends to focus on the absence of
a coherent body of theory to explain technical analysis, and on the difficulty of using statistical tests to ascertain
its effectiveness. The past theories proposed by technical analysts tended to be ad hoc and inconsistent. There
has been no coherent rationale as to why technical analysis should work. However, the recent development of
behavioral finance is contributing to the emergence of theoretical justifications of technical analysis. If social
and psychological forces influence stock market behavior in consistent ways, technical analysis could be seen as
a technique for identifying those forces and forecasting their effects. Besides, behavioral finance can also be
applied to explain the behavior of technical analysts. Technical analysts may be influenced by the same social
and psychological biases as other market participants. Those biases would tend to influence technical analysts’
interpretations of their charts and other data. The forecasts of technical analysts could be affected by the same
biases, which the analysts may be seeking to identify among other market participants. Institutional investors
tend to use technical analysis alongside other methods of investment analysis. The research evidence on the
ability of institutional investors to outperform stock market indices indicates that, at best, such outperformance
is marginal. This evidence throws doubt on the effectiveness of investment analysis, including technical
analysis. However since the stock market in aggregate is equal to the sum of investment portfolios, such
findings might be expected. Investment analysis may be a zero-sum game in that those making profits make
them at the expense of other analysts. 5.9. Processes of consolidation of stock exchanges The importance of
equity finance in the world markets is growing, although there are large differences across stock exchanges. The
market capitalisation of the largest world markets (e.g. NYSE, NASDAQOMX, Euronext, London Stock
Exchange (LSE)) are much higher than those of other stock exchanges. Stock market is highly concentrated. For
example, measured by trading activity, the market share of the five largest stock exchanges in Europe exceeded
90 per cent in 2009, with the LSE having the largest share of total EU turnover. The stock-market concentration
level is almost identical in terms of market capitalisation. This high level of concentration may be explained by
the fact that financial exchanges exhibit network externalities, as higher participation of traders on both sides of
the market positively affects market liquidity and increases traders’ utility. For some of the key stock markets it
appears that even if market capitalisation is similar in value (e.g. LSE and Euronext), there are significant
differences in the turnover. This suggests that when shares are more actively traded, the stock market provides
for a deeper and more liquid market. Despite the increase in equity finance, public equity markets play a limited
role as a source of new funds for firms that raise external financing generally via bank loans or debt securities.
Still, the number and value of initial public offerings (IPOs) grew spectacularly from the mid-1990s. 115 The
recent development of the stock exchanges has shown an intensive regional crossborder consolidation, which is
especially vivid among EU stock markets. Euronext resulted from a merger of the Paris, Amsterdam, Brussels,
and Lisbon stock exchanges during 2000–2002. Stock exchanges of Copenhagen, Stockholm, Helsinki, Tallin,
Riga, Vilnius, and Iceland merged between 2004 and 2006, creating the OMX Nordic Exchange. It was
followed by a merger of NASDAQ and OMX Nordic Exchange to form NASDAQOMX. In June 2007 Italy’s
stock-exchange operator Borsa Italiana accepted a takeover from the LSE. In 2006, a trans-Atlantic stock
exchange merger took place between Euronext and the New York Stock Exchange (NYSE), strengthening its
position as the largest securities trading venue in the world. In 2007, two other trans-Atlantic deals were
announced: an acquisition of the International Securities Exchange (New York) by Deutsche Börse and a
merger between NASDAQ and OMX to form NASDAQOMX. Processes of consolidation are fostered by
multiple share listings of the companies. Multiple share listing happens when company shares are listed on
more than one stock exchange. They can also be simultaneously traded on formal stock exchanges and OTC
markets. Stocks of very large multinational companies list their shares on several national stock exchanges.
Trading in such stocks can effectively be global and may operate on a 24-hour basis (as one exchange closes,
trading may continue on others). Further globalization of financial markets is related to the tendency for
financial markets in different countries to become integrated into a single market. A major factor leading to
globalization has been the development of telecommunications. Other factors have been the tendencies towards
international diversification of portfolios, and deregulation of national financial markets. Consolidation is
viewed to have several advantages. Larger exchanges enjoy economies of scale that reduce trading costs, which
in turn attracts more traders and listed companies. After the merger market capitalisation of the merged stock
exchanges has grown faster than that of its smaller competitors. While consolidation allows an exchange to
exploit economies of scale, it may also reduce competition and thus lower an exchange’s incentive for financial
innovation (in the form of developing new, cheaper, trading mechanisms). The impact of competition is
interesting in equity trading. Competition may reduce trading fees, but fragmentation of the order flow between
exchanges may reduce the liquidity of equity trading. However, some of the stock market studies have found
evidence of reduced fees and improved liquidity. Liquidity is improved as some brokers automate the routing
decision between the two exchanges to obtain the best execution price. In that way, the order flow at the two
exchanges is indirectly combined. There are still some challenges for further consolidation in stock markets.
First, the clearing and settlement infrastructure in Europe has remained fragmented so far. Studies suggest that
post-trading costs per transaction in the EU are substantially higher than in the US. Next, cross-border
exchanges like Euronext and NASDAQ OMX force national financial supervisors to co-operate. 5.10. Summary
Equity markets exist to facilitate the transfer of funds from savers of funds to investors, which need to raise
money. Organized stock exchanges as well as over the counter markets ensure that a secondary market provides
a means for existing investors to sell their equity securities. 116 Newly issued shares are sold in the primary
market by public offer, tender, placement, or through a rights issue. In addition to common (ordinary) shares
there are various types of preferred shares. Stock exchanges may be order-driven, quote-driven, or a hybrid of
these two systems. In all stock market trading systems share prices are determined by the demand and supply.
The key types of orders are market orders, which accept the existing share price, and limit orders which specify
upper limits to buying prices or lower limits to selling prices. Most individual investors buy equity instruments
indirectly through institutional investors such as pension funds, insurance companies, and investment funds.
Therefore most of the trading on stock exchanges is done through institutional investors. Some types of
institutional investment, like investment funds or exchange-traded funds (ETFs), trade their own shares on a
stock exchange directly. Stock markets operate most efficiently if they have sufficient depth and breadth. A
deep market has a large number of traders, who ensure that small price movements raise many new buy or sell
orders. This helps to avoid excessive share price volatility, since price falls are met by new purchase orders, and
price rises are met by new sell orders. A broad market contains traders with differing opinions such that some
will be forecasting price rises whilst others expect falls. The diversity of views helps to prevent large price
swings. When stock markets are characterized by uniformity of opinion, extreme share price movements can
result. If the overwhelming majority of investors expect a rise, there would be many buyers and few sellers.
Sharp price rises (a bubble) would result. If the majority expects a price fall, sales would dominate purchases
and share prices could fall dramatically (and a stock market crash can occur). Key terms  Initial public offering
(IPO)  Leveraged buy-out  Stock repurchases  Bid-ask spread  Market order  Limit order  Short sale 
Program trading  Transaction costs  Buying on margin  Maintenance margin Further readings 1. Baele, L.,
A. Ferrando, P. Hördahl, E. Krylova, and C. Monnet (2008), Measuring European Financial Integration, in: X.
Freixas, P. Hartmann, and C. 117 Mayer (eds.), Handbook of European Financial Markets and Institutions,
Oxford University Press, Oxford, p.165–194. 2. European Central Bank (2006), Equity Issuance in the Euro
Area, Monthly Bulletin, May, p.89–99. 3. Fama, Eugene F. (1965), “Random Walks in Stock Market Prices,”
Financial Analysts Journal, No. 21 (5), p.55–59. 4. Fama, Eugene F (1990), “Stock Returns, Expected Returns,
and Real Activity,” Journal of Finance, No. 45 (4), p.1089–108. 5. Fama, Eugene F. and Kenneth R. French
(1992), “The Cross-Section of Expected Stock Returns,” Journal of Finance, No. 47 (2), p.427–65. 6. Foucault,
T. and A. J. Menkveld (2008), Competition for Order Flow and Smart Order Routing Systems, Journal of
Finance, No. 63, p.119–158. 7. Kazarian, E. G. (2006), Integration of the Securities Market Infrastructure in the
European Union: Policy and Regulatory Issues, IMF Working Paper 06/241. 8. Levy H. (1978). Equilibrium in
imperfect market. A constraint on the number of securities. American Economic Review, No. 68, September, p.
643-658. 9. LSE, NYSE, OMX, Nasdaq, Euronext . . . Why Stock Exchanges Are Scrambling to Consolidate,
(2006), Knowledge@Wharton, Wharton School, University of Pennsylvania. 10.Morck, Randall, Andrei
Shleifer, and Robert W. Vishny (1988), “Management Ownership and Market Valuation: An Empirical
Analysis,” Journal of Financial Economics, No. 20, p.293–315. 11.Myers and Majluf (1984). Corporate
Financing and Investment Decisions when Firms have Information that Investors do not Have, Journal of
Financial Economics, No. 13, 187–221. 12.Schich S., Wehinger G. (2003). Prospects for Stock exchanges//
Financial market Tends, No. 85, OECD. 13.Shiller (2003). From Efficient Markets to Behavioral Finance,
Journal of Economic Perspectives, No. 17, p.83–104. 14.Serifsoy, B. and M. Weiß (2007), Settling for
Efficiency – A Framework for the EuropeanSecurities Transaction Industry, Journal of Banking and Finance,
No. 31, p.3034–3057. Relevant websites  www.nasdaqomx.com  www.nyse.com 
www.londonstockexchange.com  www.finance.yahoo.com 118 Review questions and problems 1. Discuss the
concept of asymmetric information. Explain how it may cause managers to serve company investors. 2.
Describe how interactions between buyers and sellers affect the market value of the firm. 3. Why do firms
engage in IPOs? 4. What is the danger of issuing too much equity shares in an IPO? 5. What is the role of the
investment bank that serves the underwriter in an IPO? How can it ensure, that the firm does not issue too much
shares? 6. What factors influence the offer price in an IPO? 7. Explain the differences between generating funds
from a venture capital firm and through an IPO. Why does a firm do a road show before it goes to an IPO? 8.
Explain why the stock price of a firm may rise when the firm announces that it is repurchasing its shares. 9.
Discuss the statement: “IPO transfers wealth from unsophisticated investors to large institutional investors who
get in at the offer price and get out quickly.” 10. A pharmaceutical company is going through an IPO. It plans to
issue 5 million shares at 12 Euro per share. The investment bank suggests that the offer price for the shares
should be 10 Euro per share to ensure that all the shares should be sold easily. Explain the dilemma for the
pharmaceutical company. What is the advantage of following the advice of the investment bank? What is the
disadvantage? Is the investment bank incentive to place the shares aligned with the interests of the
pharmaceutical company? 11. Explain the difference between a market order and a limit order. 12. How can
margin requirement affect the potential return and risk from investing in shares? 13. What is the maintenance
margin? 14. How would the return on stock be affected by a lower initial investment and a higher loan amount?
Explain the relationship between the proportion of funds borrowed and the return. 15. Describe the short selling
process. Under what conditions investor might consider short selling a specific stock? 16. What are electronic
communication networks (ECNs)? 17. What is programme trading? 18. Describe the functions securities
exchange commission. 19. What is the role of depository? 20. Assume a company’s shares are priced at 50 Euro
per share. The company has declared 1Euro per share dividend. An investor purchases the stock on margin
paying 30 Euro per share and borrowing the remainder from the dealer at 10 % annualized interest. What is the
return to the investor, if after one year the stock is sold at a price of 60 Euro per share? 119 21. What determines
the size of the bid-ask spread? 22. Calculate the bid-ask spread for 100 000 shares of X company for the
following market prices in US NYSE: a) bid price 11 7/8, ask price 12 ¼; b) bid price 44 1/4, ask price 44
17/64; c) bid price 35 3/8, ask price 35 ½. 15. A company with 20 million Euro assets and 45 million Euro
liabilities is technically insolvent. Which of the following investment projects is preferred by stockholders and
which is preferred by bondholders? a) 22 million investment into a project, which will be worth 24 million with
a probability of 60% and 20 million with a probability of 40%; b) 22 million investment into a project, which
will be worth 40 million with a probability of 5% and 20 million with a probability of 95%; c) explain, how
elimination of equity’s limited liability could resolve the problem? 16. A money market fund is started with
assets consisting of 75 day zero coupon debt instruments with a face value of 200 million Euro, and a simple
interest yield of 3,9%. a) what is the value of the fund liabilities sold to shareholders? b) if interest rates rise by
100 basis points, what is the net asset value of the money market fund’s assets? c) if the fund is liquid
immediately upon the increase in rates, what is the net asset value paid out to each fund shareholder? 17. What
is the impact on retirement benefits if a 2,5 billion Euro pension fund experiences a 2% default rate on its assets,
if a) it is defined benefit fund that pays retired people 35% of the average of their last three years of salary? b) it
is defined contribution fund that obligates the firm to contribute matching funds equal to 50% of the employees’
contributions; c) it is a defined contribution fund with no matching funds contributed to the employer. 18.
Calculate the net asset values and share prices of the following mutual funds: a) a 500 000 million shares of an
open – end money market fund with assets consisting of 91 day Eurodollars CDs with face value of 350 million
USD, which yields 6,25% annually, and 250 day prime-rated commercial paper with face value of 330 million
USD, which yields 6,1% annually (use simple yields on a 365 day basis); b) closed-end Baltic fund with assets
consisting of 10 years 6,7% annual coupon bonds, yielding 12,5% annually, with a face value of 25 million
Euro, and a perpetual preferred shares with a cumulative annual dividend of 7%, face value of 30 million Euro
and the annual yield of 12,4%. 120 6. DERIVATIVES MARKETS Mini contents  The meaning of hedging
against risk  Definition of derivatives markets  Financial futures and hedging against risk  Options and their
use 6.1. Hedging against risk Investments based on some underlying assets are known as derivatives. The
capital invested is less than the price of the underlying asset. This creates financial leverage and allows
investors to multiply the rate of return on the underlying asset. Because of this leverage, derivatives have
several uses,  Speculative or taking an advantage over specific profit opportunity,  Hedging a portfolio against
a specific risk. Participants in derivative markets own portfolios of financial securities, which must be taken into
consideration when understanding impact of any particular derivatives transaction. Any derivatives transaction
involves cash flows, which are more or less opposite to the cash flows generated by the other securities in the
portfolio. When the two sets of cash flows moves in the opposite direction, it is a hedge. When the two sets of
cash flows moves in the same direction, it is a speculative position. This is why speculative trades increase risk
exposure, while hedging reduces risk exposure. Hedging ensures counterbalancing cash flows, which reduce
dispersion of possible outcomes and therefore reduces the risk. Conversely, by adding more cash flows, which
move in the same direction, speculating increases profit when outcomes are favourable, but increases losses
when outcomes are unfavourable. Thus the risk is increased. The underlying cash position is the twin
transaction that is undertaken simultaneously with the derivatives trade. The underlying cash position motivates
the hedge transaction. If the underlying cash position consists of only one financial security, then it is called
microhedge. If the underlying cash position consists of a portfolio of financial securities, then it is called
macrohedge. Macrohedging is prevalent in financial institutions than in non-financial companies, which may be
hedging only a single financial security on their balance sheets. The hedge is always tailored to the hedger’s
underlying cash position. The hedger’s cash flows as well as his goals will determine the configuration of the
derivatives transaction. 6.2. Description of derivatives markets The establishment and growth of financial
derivatives markets has been major development trend in financial markets over the past thirty-five years.
Financial innovation and increased market demand led to a rapid growth of derivatives trading. Development of
financial derivatives was speeded up by the globalization of business, the increased volatility of foreign
exchange rates, and increasing and fluctuating rates of inflation. 121 Concept Derivatives - securities .bearing a
contractual relation to some underlying asset or rate. In general derivatives contracts promise to deliver
underlying products at some time in the future or give the right to buy or sell them in the future. They can be
based on different types of assets (such as equities or commodities), prices (such as interest rates or exchange
rates), or indexes (such as a stock-market index). The derivative contract can then be traded in a different
market from that in which the underlying product (equity, bonds, currency) is itself traded. Markets in which
underlying products are traded (such as the forex market) are often referred to as cash markets to distinguish
them from derivatives markets. Although cash and derivatives markets are separate, the derivatives markets are
linked to cash markets through the possibility that a delivery of the underlying product might be required. There
is a close relationship between the prices of derivatives contracts and the prices of the underlying assets they
represent, and that the value of a derivative, and hence its price, varies as the price in the cash market fluctuates.
However, in practice, derivatives seldom lead to the exchange of the underlying product. Instead, contracts are
closed out or allowed to lapse before the delivery date arrives. For portfolio managers change of the risk profile
through derivative transactions takes a very low cost. Without derivatives, portfolio managers have to conduct
transactions in the underlying cash markets (i.e., money, bond, or equity markets) at a higher cost, including the
costly transfer of securities. Thus the dynamic growth of hedge funds can be explained by the rise of low-cost
derivatives markets. Hedge funds typically exploit small price differences of similar financial products. Only
when the transaction cost is smaller than the price differential, then hedge fund takes a position. The types of
derivatives include:  Options,  Forwards,  Futures,  Swap contracts  Various forms of bonds. A forward
contract gives the holder the obligation to buy or sell a certain underlying instrument (like a bond) at a certain
date in the future (i.e., the delivery or final settlement date), at a specified price (i.e., the settlement price).
Forward contracts consist of futures and swaps. Futures contracts are forward contracts traded on organised
exchanges. Swaps are forward contracts in which counterparties agree to exchange streams of cash flows
according to predetermined rules. For example, an interest-rate swap is a derivative in which one party
exchanges a stream of interest payments for another party’s stream of cash flows. The most important
difference with options is that options give the holder the right (but not the obligation) to buy or sell a certain
underlying instrument at a certain date in the future at a specified price. Derivatives are traded on organised
exchanges or over-the-counter (OTC) market. Derivatives contracts traded and privately negotiated directly
between two parties belong to the OTC market, generally interest-rate linked derivatives, like swaps and
forward-rate agreements. All contract terms, such as delivery quality, quantity, location, date, and price, 122 are
negotiable in it. The total value of derivative contracts outstanding in global OTC markets is substantially
higher than the exchanges-traded amount. A trend is a provision of standard contracts, which makes it easier for
more participants to access the OTC markets. Besides, OTC trades are increasingly being cleared through
clearinghouses in much the same way as exchange-based contracts. Derivative contracts like futures and
options, which are traded in organised exchanges are generally standardised, based on electronic trading. The
traditional distinction between exchange-based and OTC derivatives is becoming less clear. 6.3. Forward and
futures contracts 6.3.1. Principles of forward and futures contracts A futures contract is a legally binding
commitment to buy or sell a standard quantity of a something at a price determined in the present (the futures
price) on a specified future date. The buyer is called the long, and the seller is called the short. Futures contracts
are “zero sum games”. Concept Futures contracts - a customized contract to buy (sell) an asset at a specified
date and a specified price (futures price). The contract is traded on an organized exchange, and the potential
gain/ loss is realized each day (marking to market). The forward contract is a private agreement between the
two parties and nothing happens between the contracting date and the date of delivery. Concept Forward
contract - a customized contract to buy (sell) and asset at a specified date and a specified price (forward price.
No payment takes place until maturity. Forwards and futures contracts markets include diverse instruments on:
 Currencies;  Commodities;  Interest rate futures;  Short-term deposits;  Bonds;  Stock futures;  Stock
index futures;  Single stock futures (contract for difference). There is no money exchanged when the contract
is signed. To ensure that each party fulfills its commitments, a margin deposit is required. The exchanges set a
minimum margin for each contract and revise it periodically. Margin is determined depending upon the risk of
the individual contract Futures prices fluctuate every day. Therefore all contract positions are marked to market
at the end of every day. If net price movements result in gain on a position of the previous day, the customer
immediately receives cash in the amount of the gain. And vise versa, if there is a loss, the customer must cover
the loss. As soon as a customer’s account falls 123 below the maintenance margin, the customer receives a
margin call to fill up the initial margin. If this is not done immediately, then the broker closes down the position
on the market. In effect future contracts are canceled every day and replaced by new contracts with a delivery
price equal to the new futures price, i.e. the settlement price at the end of the day. It is rare for a futures contract
to be used for the exchange or physical delivery of the underlying instruments. Many contracts have no facility
for the exchange of the financial instrument. Thus financial futures markets are independent of the underlying
cash markets, and are operating in parallel to those markets. Most future contracts are closed out by an
offsetting position before the delivery occurs. A long offsets by going short and the short offsets by going long
at any time before the delivery date. Offsetting does not involve incremental brokerage fees because the fee to
establish initial short position includes the commission to take the offsetting long position, i.e. the round trip
commission. The total number of outstanding contracts is called open interest. For every outstanding contract
one person is short (has taken a short position) and one is long (has taken a long position. If a particular
transaction involves a new long and a new short, the open interest increases by one contract. If a transaction
involves offsetting by an existing long and offsetting by an existing short, the open interest decreases by one
contract. However, if a transaction is made by offsetting an existing short or long, and if the other side of
transaction is a new investor, the open interest remains unchanged. Each futures exchange has a clearing house
to keep track of the short and long positions. Concept Open interest or a financial instrument at some specified
future date. The main economic function of futures is to provide a means of hedging. A hedger seeks to reduce
an already existing risk. This risk reduction could be achieved by taking a futures position that would provide
profit in the event of a loss on the underlying position (and a loss in the case of a profit on the underlying
position). Concept Long hedge – a long anticipatory hedge generally involving buying futures contracts in
anticipation of spot purchase. Concept Short hedge – a short hedge involves selling futures contracts to cover
the risk on a position in the spot market. This is the most common use of hedging in investment management.
The most common products underlying futures contracts are foreign currencies (exchange rates), interest rates
on notional amounts of capital, and stock exchange indices. The futures contracts are themselves tradable – that
is, they can be bought and sold in futures markets. To increase their tradability, futures contracts are
standardized in terms of both time period and amount. They specify the quantity and quality of the underlying
product, the agreed price and the date of delivery. The procedure of marking to market of futures contract,
which implies that all potential profits and losses are immediately realized, is the basis for the key difference
between the forward and future contracts. A forward contract may or may not be marked to market. Where the
counterparties are two high-credit-quality entities, the two parties may agree not to mark positions to market.
124 However, if one or both of the parties are concerned with the counterparty risk of the other, then positions
may be marked to market. When a forward contract is not marked to market, then there are no interim cash
flows. Because there is no clearinghouse that guarantees the performance of a counterparty in a forward
contract, the parties to a forward contract are exposed to counterparty risk, the risk that the other party to the
transaction will fail to perform. When hedging the specified source of risk two questions have to be answered: 
Which contract should be used?  What amount should be hedged? The answer to the first question depends
upon the source of risk, which will dictate the use of some specific stock market index, interest rate or currency
contract. The answer to the second question depends upon optimal hedge ratio to be used. The hedge ratio is the
ratio of the size of the (short) position to be taken in futures contract to the size of the exposure (the value of the
portfolio to be hedged). Hedge ratio = ( Number of contracts x Size x Spot price ) / V where V – is the market
value of the underlying asset position. The number of contracts to be sold if hedge ratio, that is to be
implemented, is known, can be derived from this equation: N = Hedge ratio x V / ( Size x Spot price) Example
Assume the manager of a futures fund has 1000000 Euro. The fund manager buys FTSE 100 futures relating to
1000000 of shares when the FTSE 100 stands at 5000.The futures mature in one year. Let’s determine the key
characteristic of the contract The number of futures contracts bought will be equal: 1,000,000/(5000 x 10) = 20
contracts Does any of the 1000000Euro need to be used in the purchase of the futures? Yes, the initial margin
must be provided The approximate capital gain on the fund over a year, if the FTSE 100 rises by 7%, will be
equal to 7% (minus the net cost of carry). In order to find the total return on the fund, interest on the money on
deposit plus interest on maintenance margin (i.e. interest on approximately 1,000,000) should be added to the
capital gain. 6.3.2. Forward and futures valuation Valuation of all derivative models are based on arbitrage
arguments. This involves developing a strategy or a trade wherein a package consisting of a position in the
underlying (that is, the underlying asset or instrument for the derivative contract) and borrowing or lending so
as to generate the same cash flow as the derivative. The value of the package is then equal to the theoretical
price of the derivative. If the market price of 125 the derivative deviates from the theoretical price, then the
actions of arbitrageurs will drive the market price of the derivative toward its theoretical price until the arbitrage
opportunity is eliminated. The pricing of futures and forward contracts is similar. If the underlying asset for
both contracts is the same, the difference in pricing is due to differences in features of the contract that must be
dealt with by the pricing model. A futures price equals the spot (cash market) price at delivery, though not
during the life of the contract. The difference between the two prices is called the basis: Basis = Futures price –
Spot price = F – S The basis is often expressed as a percentage of the spot price (discount or premium) =
Percentage basis = ( F – S ) / S Futures valuation models determine the theoretical value of the basis. This value
is constraint by the existence of profitable riskless arbitrage between the futures and spot markets for the asset.
In a well-functioning market, when arbitrageurs implement their strategy by selling the futures and buying
underlying asset, this would force the futures price down so that at some price for the futures contract, the
arbitrage profit is eliminated. This strategy that results in the capturing of the arbitrage profit is referred to as a
cash-and-carry trade. The reason for this name is that implementation of the strategy involves borrowing cash to
purchase the underlying asset and “carrying” that underlying asset to the settlement date of the futures contract.
In general, the formula for determining the theoretical price of the contract, assuming that lending and
borrowing rates are both the same and equal to financing cost, and that there is no margin, becomes: Theoretical
futures price = Spot price + (Spot price) x (Financing cost - Cash yield) where financing cost - is the interest
rate to borrow funds, cash yield - is the payment received from investing in the asset (e.g. dividend) as a
percentage of the cash price. Example Assume that the underlying asset price is 100 Euro, financing cost is 1%
and cash yield is 2%. Then the theoretical futures price is: 100 Euro + [100 Euro × (1% − 2%)] = 99 Euro The
future price can be above or below the spot (cash) price depending on the difference between the financing cost
and cash yield. The difference between these rates is called the cost of carry and determines the net financing
cost. Positive carry means that the cash yield exceeds the financing cost, while the difference between the
financing cost and the cash yield is a negative value. Negative carry means that the financing cost exceeds the
cash yield. Zero futures happen when the futures price is equal to the spot (cash) price. At the settlement date of
the futures contract, the futures price must equal the spot (cash market) price. The reason is that a futures
contract with no time left until delivery is equivalent to a spot (cash market) transaction. Therefore, as the
delivery date approaches, the futures price is converging to the spot (cash market) price. This happens as
financing cost and the yield that can be earned by holding the underlying asset, and finally the cost of carry,
approaches zero, when the delivery date approaches. 126 However, the borrowing rate is usually higher than the
lending rate. The impact of this difference is important when defining theoretical futures price. In the cash-and-
carry trade, the theoretical futures price based on borrowing rate becomes Theoretical futures price = Spot price
+ (Spot price) ×(Borrowing rate -Cash yield) In the reverse cash-and-carry trade, the theoretical futures price
based on lending rate becomes: Theoretical futures price = Spot price + (Spot price)×(Lending rate - Cash yield)
Both equations together provide a band between which the actual futures price can exist without allowing for an
arbitrage profit. The first equation establishes the upper value for the band while the second equation provides
the lower value for the band. The reverse cash-and-strategy trade requires the short selling of the underlying. It
is assumed in this strategy that the proceeds from the short sale are received and reinvested. In practice, for
individual investors, the proceeds are not received, and, in fact, the individual investor is required to deposit
margin (securities margin and not futures margin) to short sell. For institutional investors, the underlying may
be borrowed, but there is a cost to borrowing. This cost of borrowing can be incorporated into the model by
reducing the cash yield on the underlying. For strategies applied to stock index futures, a short sale of the
components stocks in the index means that all stocks in the index must be sold simultaneously. This may be
difficult to do and therefore would widen the band for the theoretical future price. For valuation of stock index
futures the fair value premium is used. The excess of the fair futures price over the spot (i.e. actual) stock index
is called the fair value premium. The formula for the fair value premium is: FP = I x [{(r - y)/100} x{d/365}]
where FP is the fair value premium, I is the spot FTSE 100 Index, r is the interest rate, y is the expected
percentage dividend yield on the index portfolio, and d is the number of days to maturity of the futures contract.
Exercise Assume that the rate of interest on risk-free bank deposits were 2.5% p.a.. If money could be borrowed
at the same rate of interest, estimate the price of a FTSE 100 futures contract which matures in four months on
the basis of a spot index of 4000 and a zero expected rate of dividend yield on the FTSE 100 portfolio. How
would the answer change if the expected rate of dividend yield were 0.5% p.a. (while the other values were as
before)? Short cash and carry involves selling the borrowed stock and buying futures. In this case the excess of
interest over dividends is a net inflow and this gain should be matched by having a guaranteed future purchase
price that exceeds the spot sale price by the amount of this net inflow. The money from the stock sale is put on
deposit. In the case of short selling, the borrower of the stock must pay sums equivalent to the dividends to the
lender of the stock. The excess of interest over dividends is a net inflow that should be matched by a capital loss
guaranteed by the futures price. Exercise Assume a fund manager has 10000000 Euro for a futures fund. The
fund has an investment horizon of one year. The FTSE 100 stands at 5000.The one-year interest rate is 4% and
the expected rate of dividend yield on the FTSE 100 over the 127 coming year is 2%.The fund manager puts
10000000 Euro in a bank deposit and obtains market exposure by buying FTSE 100 futures. a) How many
futures contracts, with a one-year maturity, are required for a fund that has a 10000000 Euro exposure to the
FTSE 100? b) What is the fair futures price? c) What is the rate of capital gain on the fund if the FTSE 100 rises
by 6% over the year, and the futures price is initially at its fair level? d) What is the total return on the fund if
the FTSE 100 rises by 6% over the year? e) How would the answers to (a),(c), and (d) change if the futures
contracts were to provide a market exposure of 20000000 Euro (while the sum of money on deposit remains at
10000000 Euro)? f) Is it the case that the whole of the 10000000 Euro can be kept in a bank deposit? Exercise
Assume that the FTSE 100 is 4500, the three-month interest rate is 3% p.a., and the expected rate of dividend
yield on the FTSE 100 over the next three months is 2% p.a. a) What is the fair price of a futures contract due to
mature in three months? b) If financial institutions face transaction costs of 0,1% on both purchases and sales of
stock, plus 0,2% tax on purchases, what is the no-arbitrage band of futures prices? c) If speculators expect that
the FTSE 100 will be 4700 in three months from the present, what would you expect to happen in the futures
and spot markets? 6.3.3. Use of forwards and futures Going long or short in futures market without any
offsetting position is described as taking a speculative position. In a futures hedge an investor offsets a position
in the cash (spot) market with a nearly opposite position in the futures market. The objective is to reduce the
overall risk position. The hedged position has lower expected return than an unhedged position. In a long hedge
the investor takes a long position in futures. In a short hedge the investor takes a short position in futures. A
very important type of hedge occurs when an investor with the long position in the spot market simultaneously
take a short position in the futures contracts. In short hedging the hedger may be able to find a futures contract
for a virtually identical item as hedgers cash (spot) position. Then the gains (losses) in the spot market are offset
by the gains (losses) in the futures market. This offset is shown in the figure bellow. 128 Figure 15 . Profit
profile for perfect hedge The Figure 15 provides profit profiles. Assume, the investor goes long in the spot
market at 50 Euro. As the spot price increases (decreases) the investor gains (loses) exactly the same amount.
The profit profile for a spot position is offset exactly by the short futures position. Profit profile for the net
position is a horizontal line, indicating no change in the value of the net position as the spot price changes. Flat
profile represents a perfect hedge. However most often identical or similar future contracts do not exist. In this
situation, the hedger must utilize a short position in a similar, but different asset. This is called a cross hedge.
The relationship between a spot position and a futures contract in a cross hedge is not a perfect straight line. It is
shown as a dotted line in the figure below. Here it is assumed that the investor takes a long position in the spot
market in grade A investment assets, and offsets by taking short position in the futures market in grade B
investment assets. Grade B asset prices are assumed to move half as fast as grade A asset prices. The Figure 16
shows profit profile for long spot grade A investment assets, short futures grade B investment assets and the net
position. The gains and losses on the spot position are cut in half for grade A investment assets by the short
hedge. Figure 16. Profit profile for a cross hedge Short Futures Long Spot Hedge 0 P Profit Loss Short Futures:
Grade B Long Grade A Hedge P Profit Loss Hedge 0 129 The hedger can estimate the slope of the line (β) by
using regression analysis in order to find the best-fitting relationship. For every unit of the spot asset (cash
market), the hedger shorts β units of the futures. β is called the optimal hedge ratio. Exercise Assume a fund
manager anticipates the receipt of 5 million Euro in one month. The intention is to invest the money equally
between the three stocks X, Y, and Z. These stocks have betas of 0,9, 1,1, and 1,3 respectively. The FTSE 100
is equal now to 8800.How can the fund manager hedge against a rise in stock prices using futures? The optimal
hedge ratio is not a perfect hedge, because the link between the spot and futures is not perfect. The optimal
hedge ratio is the best in the sense that the expected change in the hedged position is zero. 6.3.4. Futures
contracts: stock index futures For stock index futures the deliverable commodity (underlying asset) is a
common stock index. Some stock index futures are actively traded contracts. The stock index future price
depends upon the value of the stocks in the index, the dividends on these stocks, and the interest rate until the
delivery date on the futures contract. Arbitrage ensures that the futures contract should be equivalent of a
buying the stock in the index, borrowing the funds for this purchase, paying interest on the borrowed funds at
the delivery date, and receiving any dividends. F stock = P stock ( 1 + rd ) d – Div when P stock - is the current
market value of stocks in the index, r – the spot interest rate from now until delivery date, Div – amount of
dividends on these stocks. Unless the futures price is equal to P stock ( 1 + rd ) d – Div, arbitrage occurs. This
arbitrage is called program trading. The figure below illustrates the case, when the futures price is above P stock
( 1 + rd ) d – Div. Figure 17. Program trading arbitrage Actual futures Arbitrage profit Theoretical futures Spot
price Time Price 130 This arbitrage is to take short position in futures and buy the stocks in the index. The
arbitrage position is held until the futures and spot prices are once more in line. Both positions are closed for
profit. Such type of arbitrage involves the purchase and sale of large number of stocks in the index. In order to
uncover the arbitrage opportunity initially, a computer program is needed. Afterwards, the buy or sell orders for
a large number of stocks must be executed rapidly by computer program before the arbitrage profit opportunity
disappears. 6.3.5. Contracts for difference (CFD) A contract for difference (CFD) is an instrument that has
similarities with a futures contract. Frequently it is related to a particular stock, but could relate to any
marketable asset (or even non-marketable instruments such as stock indices). CFD contracts do not have fixed
expiry dates and can be closed at any time. A CFD is a deal between an investor and a broker. The investor is
expected to pay a deposit (typically 10% of the value of the shareholding to which the CFD is related). If losses
are made from the transaction, the broker takes cash from the deposit (margin) and the investor is required to
provide more cash in order to maintain the value of the deposit at 10%. If the position makes a profit, the
investor receives cash. An investor who takes a long position in a CFD relating to a share would profit from a
share price rise, and lose in the event of a share price fall. The profits or losses would be calculated by reference
to a specified share price (typically slightly above the share price when the contract was entered into; the offer
price of the share might be used). If the share price were above the specified price, there would be a profit equal
to the difference between the current price and the specified price. Conversely, there would be a loss equal to
the extent to which the current stock price is below the specified price. An investor with a long CFD is treated
as if the shares are bought with borrowed money and the broker can do in the absence of offsetting short
positions. The investor pays interest and receives dividends. An investor who takes a short position in a CFD
profits from price falls and loses from price rises. The extent of profit or loss is based on the difference between
the current share price and a share price slightly below the share price at the time that the contract was entered
into. The bid price of the share might be used also. An investor with a short CFD is treated as if the shares are
sold short and the receipts are put on deposit. The investor receives interest and pays sums equal to the share
dividends. Bid/offer prices might be quoted. Potential losses are very large in the event of prices moving
heavily against the anticipations of an investor. The use of stop-loss order ensures automatic closure of a
position in the event of a price movement beyond a particular level. However, there is a risk that the price
movement is so rapid, that closure occurs only after the price has moved significantly beyond the chosen stop-
loss price. A broker, who is providing CFDs, can take corresponding positions in the share. However if a broker
has investors on both the long and short sides, the need to take positions in the share is reduced since the cash
flows of long and short investors would match each other. Some concern has been expressed that if investors
use CFDs as a substitute for share purchases, liquidity is taken from the stock market. Although brokers take
offsetting 131 positions in the stock market, liquidity is reduced to the extent that there is matching between
long and short positions. By using CFDs investors can obtain leveraged investments or short positions on a
share (or other instrument).An almost identical alternative to CFDs is spread betting. 6.4. Swaps A swap is an
agreement whereby two parties (called counterparties) agree to exchange periodic payments. The cash amount
of the payments exchanged is based on some predetermined principal amount, which is called the notional
principal amount or simply notional amount. The cash amount each counterparty pays to the other is the agreed-
upon periodic rate times the notional amount. The only cash that is exchanged between the parties are the
agreed-upon payments, not the notional amount. A swap is an over-the-counter (OTC) contract. Hence, the
counterparties to a swap are exposed to counterparty risk. Swap can be decomposed into a package of derivative
instruments, e.g. a package of forward contracts. However, its maturity can be longer than that of typical
forward and futures contracts, it is negotiated separately, can have quite high liquidity (larger than many
forward contracts, particularly long-dated (i.e., long-term) forward contracts). The types of swaps typically used
by non-finance corporations are:  interest rate swaps,  currency swaps,  commodity swaps, and  credit
default swaps. Interest rate swap is a contract in which the counterparties swap payments in the same currency
based on an interest rate. For example, one of the counterparties can pay a fixed interest rate and the other party
a floating interest rate. The floating interest rate is commonly referred to as the reference rate. Currency swap is
a contract, in which two parties agree to swap payments based on different currencies. Commodity swap is a
contract, according to which the exchange of payments by the counterparties is based on the value of a
particular physical commodity. Physical commodities include precious metals, base metals, natural gas, crude
oil, food. A credit default swap (CDS) is an OTC derivative that permits the buying and selling of credit
protection against particular types of events that can adversely affect the credit quality of a bond such as the
default of the borrower. Although it is referred to as a “swap,” it does not have the general characteristics of a
typical swap. There are two parties in the CDS contract: the credit protection buyer and credit protection seller.
Over the life of the CDS, the protection buyer agrees to pay the protection seller a payment at specified dates to
insure against the impairment of the debt of a reference entity due to a credit-related event. The reference entity
is a specific issuer. The specific credit-related events are identified in the contract that will trigger a payment by
the credit protection seller to the credit protection buyer are referred to as credit events. If a credit event does
occur, the credit protection buyer only makes a payment up to the credit event date and makes no further
payment. At this time, the protection buyer is 132 obligated to fulfill its obligation. The contract will call for the
protection seller to compensate for the loss in the value of the debt obligation 6.5. Options 6.5.1. Options
definition An option is a contract in which the option seller grants the option buyer the right to enter into a
transaction with the seller to either buy or sell an underlying asset at a specified price on or before a specified
date. Options, like other financial instruments, may be traded either on an organized exchange or in the over-
the-counter (OTC) market. The specified price is called the strike price or exercise price and the specified date
is called the expiration date. The option seller grants this right in exchange for a certain amount of money called
the option premium or option price. The option seller is also known as the option writer, while the option buyer
is the option holder. The asset that is the subject of the option is called the underlying. The underlying can be an
individual stock, a stock index, a bond, or even another derivative instrument such as a futures contract. The
option writer can grant the option holder one of two rights. If the right is to purchase the underlying, the option
is a call option. If the right is to sell the underlying, the option is a put option. .Concept Call options: Options
that give the right to buy a given amount of a financial instrument or commodity at an agreed price within a
specified time but, like all options, do not oblige investors to do so. Concept Put options: Options that give the
right to sell a given amount of a financial instrument or commodity at an agreed price within a specified time,
but that do not oblige investors to do so. An option can also be categorized according to when it may be
exercised by the buyer or the exercise style:  European option can only be exercised at the expiration date of
the contract.  American option can be exercised any time on or before the expiration date.  Bermuda option or
Atlantic option – is an option which can be exercised before the expiration date but only on specified dates is
called. The terms of exchange are represented by the contract unit and are standardized for most contracts. The
option holder enters into the contract with an opening transaction. Subsequently, the option holder then has the
choice to exercise or to sell the option. The sale of an existing option by the holder is a closing sale. A profit
profile for a call option is provided in the figure bellow. Suppose an investor is buying a bond, which is
currently selling at its exercise price of 100 Euro, and holds this bond for three months until the option expires.
Possible profits or losses will be on the solid line. If a call option costs 4 Euro, this will be the maximum loss
for a call option 133 buyer. If the bond price at expiration is above the exercise, the profit equals P – E – 4 Euro.
Figure 18. Profit profiles for a call option The maximum profit that the option writer can realize is the option
price. The option buyer has substantial upside return potential, while the option writer has substantial downside
risk. The described call option is called a naked call option. This is a risky position because the potential of loss
is unbound. Another less risky contract is writing a covered call. Such a contract involves the purchase of the
underlying security and the writing of a call option on that security. Profit profile for the covered call is shown
in the Figure 19. If a call option is profitable, then it it is exercised and the covered call writer must sell the
underlying security at the exercise price (100 Euro). The maximum gain is 4 Euro, i.e. the original sale price of
the call option. If the call option is unprofitable, the covered call option writer receives 4 Euro for writing the
call, and this reduces the loss from owning the underlying security. The purchase of a call option creates a
position referred to as a long call position. The writer of a call option is said to be in a short call position. The
buying of a put option creates a financial position referred to as a long put position. The profit or loss for this
position at the expiration date depends on the market price of the underlying asset. As with all long option
positions, the loss is limited to the option price. The profit potential, however, is substantial: The theoretical
maximum profit is generated if asset’s price falls to zero. Writing a put option creates a position referred to as a
short put position. The profit and loss profile for a short put option is the opposite of the long put option. The
maximum profit from this position is the option price. 100 E 104 Write call Buy call Buy underlying security
Underlying asset at expiration Profit + 4 0 Loss 134 Figure 19. Profit profile for writing a covered call option
The theoretical maximum loss can be substantial, if the price of the underlying falls. If the price falls to zero,
the loss would be as large as the exercise price less the option price. Figure 20graphically shows this profit and
loss profile. Figure 20. Profit profile for a put option E Write covered call Buy underlying security Underlying
asset at expiration Profit Loss 0 C ● Profit Buy put Loss – pp ● 97 100 E Underlying asset at expiration 135 To
summarize, buying calls or selling puts allows the investor to gain if the price of the underlying asset rises.
Selling calls and buying puts allows the investor to gain if the price of the underlying asset falls. 6.5.2.
Components of the Option Price The theoretical price of an option is made up of two components:  intrinsic
value;  premium over intrinsic value. The intrinsic value is the option’s economic value if it is exercised
immediately. If no positive economic value would result from exercising immediately, the intrinsic value is
zero. For a call option, the intrinsic value is the difference between the current market price of the underlying
and the strike price. If that difference is positive, then the intrinsic value equals that difference; if the difference
is zero or negative, then the intrinsic value is equal to zero. Concept Intrinsic value of an option: The profit
available from immediately exercising an option. Where the value of the right granted by the option is equal to
the market value of the underlying instrument (the intrinsic value is zero), the option is said to be at-the-money.
If the intrinsic value is positive, the option is in-the-money. If exercising an option would produce a loss, it is
out-of-the-money. For a put option, the intrinsic value is equal to the amount by which the underlying’s market
price is below the strike price. Time premium of an option, or time value of the option, is the amount by which
the option’s market price exceeds its intrinsic value. It is the expectation of the option buyer that at some time
before the expiration date the changes in the market price of the underlying asset will increase the value of the
rights of the option. Because of this expectation, the option buyer is willing to pay a premium above the
intrinsic value. An option buyer has two ways to realize the value of an option position. The first way is by
exercising the option. The second way is to sell the option in the market. Put-Call Parity Relationship. For a
European put and a European call option with the same underlying, strike price, and expiration date, there is a
relationship between the price of a call option, the price of a put option, the price of the underlying, and the
strike price. This relationship is known as the put-call parity relationship. The relationship is equal to: Put
option price − Call option price = Present value of strike price + Present value of cash distribution − Price of
underlying asset Put-call parity implies that: Call option price >= Put option price - Lending present value of
exercise price The value Put option price - Lending present value of exercise price has been called Merton’s
lower bound. It follows that the cash flows from buying a call option can never be less than buying the
underlying security and borrowing the underlying value of the 136 exercise price. Merton’s bound is illustrated
in the Figure 21. As the price of the underlying asset rises, the value of the call approaches Merton’s bound, and
consequently, the value of a put gets very small. When the price of the underlying asset is small, the value of the
call option is small, and the value of a put becomes large. Figure 21. Merton‘s bound 6.5.3. Determinants of the
Option Price The factors that affect the price of an option include:  Market price of the underlying asset. 
Strike (exercise) price of the option.  Time to expiration of the option.  Expected volatility of the underlying
asset over the life of the option.  Short-term, risk-free interest rate over the life of the option.  Anticipated
cash payments on the underlying over the life of the option. The impact of each of these factors may depend on
whether (1) the option is a call or a put, and (2) the option is an American option or a European option. Market
price of the underlying asset. The option price will change as the price of the underlying asset changes. For a
call option, as the underlying assets’s price increases (all other factors being constant), the option price
increases. The opposite holds for a put option, i.e. as the price of the underlying increases, the price of a put
option decreases. Exercise (strike) price Shortsell Call price Price of underlying asset E $ Merton’s bound: P –
ED 137 The exercise price is fixed for the life of the option. All other factors being equal, the lower the exercise
price, the higher the price for a call option. For put options, the higher the exercise price, the higher the option
price. Time to expiration of the option. After the expiration date, an option has no value. All other factors being
equal, the longer the time to expiration of the option, the higher the option price. This is because, as the time to
expiration decreases, less time remains for the underlying asset’s price to rise (for a call buyer) or fall (for a put
buyer), and therefore the probability of a favorable price movement decreases. Consequently, as the time
remaining until expiration decreases, the option price approaches its intrinsic value. The impact of longer
remaining life is shown in Figure 22 Figure 22. Impact of longer remaining life on the value of a call option
Figure 23. Impact of the volatility of the underlying asset on the value of a call option C2 has a longer life than
C1 Merton’s bound is higher for C2 because D2 < D1 C P C2 P – ED2 P – E C1 P – ED1 E C2 P E C P – ED
C1 C2 has greater volatility of underlying asset P – E 138 Expected Volatility of the Underlying asset over the
life of the option. All other factors being equal, the greater the expected volatility (as measured by the standard
deviation or variance) of the underlying, the more the option buyer would be willing to pay for the option, and
the more an option writer would demand for it. This occurs because the greater the expected volatility, the
greater the probability that the movement of the underlying will change so as to benefit the option buyer at
some time before expiration. Figure 24. Impact of higher interest rate on value of call option Short-term, risk-
free interest rate over the life of the option. Buying the underlying asset requires an investment of funds. Buying
an option on the same quantity of the underlying makes the difference between the underlying’s price and the
option price available for investment at an interest rate at least as high as the risk-free rate. Consequently, all
other factors being constant, the higher the short-term, risk-free interest rate, the greater the cost of buying the
underlying asset and carrying it to the expiration date of the call option. Hence, the higher the short-term, risk-
free interest rate, the more attractive the call option will be relative to the direct purchase of the underlying. As a
result, the higher the short-term, risk-free interest rate, the greater the price of a call option. Anticipated cash
payments on the underlying over the life of the option cash payments on the underlying tend to decrease the
price of a call option. The cash payments make it more attractive to hold the underlying than to hold the option.
For put options, cash payments on the underlying tend to increase the price. 6.5.4. Option pricing models An
option pricing model uses a set of assumptions and arbitrage arguments to derive a theoretical price for an
option. Deriving a theoretical option price is much more complicated than deriving a theoretical futures or
forward price because the option price depends on the expected volatility of the underlying over the life of the
option. Several models have been developed to determine the theoretical price of an option. The most popular
one was developed by Fischer Black and Myron Scholes (1973) for valuing European call options on common
stock. C’ C C P C’ has a higher interest rate P – ED’ P – ED P – E 139 6.5.5. Mixed strategies in options trading
Call and put options and the buying and writing of options can be combined to try to profit from expected
conditions in the market. Some of such strategies are as follows: Cases where a trader either buys or writes
options but does not do both Straddle – a call and a put at the same strike price and expiry date Strangle – a call
and a put for the same expiry date but at different strike prices Strap – two calls and one put with the same
expiry dates; the strike prices might be the same or different Strip – two puts and one call with the same expiry
date; again strike prices might be the same or different In general, the buyer of these options is hoping for
market prices to move sharply but is uncertain whether they will rise or fall. The buyer of a strap gains more
from a price rise than from a price fall; the buyer of a strip gains more from a price fall. The writer in all four
cases is hoping that the market will remain stable, with little change in price during the life of the option.
Spreads: combinations of buying and writing options Butterfly – buying two call options, one with a low
exercise price, the other with a high exercise price, and writing two call options with the same intermediate
strike price or the reverse. Condor – similar to a butterfly, except that the call options which are written have
different intermediate prices. Both a butterfly and a condor are vertical spreads – all options bought or sold have
the same expiry date but different strike prices. Horizontal spreads have the same strike prices but different
expiry dates. With diagonal spreads both the strike prices and the expiry dates are different. Other mixed
strategies have equally improbable names. They include vertical bull call; vertical bull spread; vertical bear
spread; rotated vertical bull spread; rotated vertical bear spread. 6.6. Summary The need for sophisticated risk
management in the face of highly volatile exchange rates provides one of the principal reasons for the growth of
derivatives markets. These allow firms to hedge risk by taking out contracts in derivatives markets, which carry
the opposite risk to that which they face in the underlying markets. The principal types of derivatives are
futures, forwards, swaps and options. Futures promise the delivery of an underlying asset of a specified kind on
a given date, although delivery is seldom made. Options give the right to buy and/or sell an underlying asset,
although that right need not be taken up. In order to increase tradability, futures and options are highly
standardised. Both offer the possibility of very high rates of profit. Futures do this through the system of margin
payments. In the case of options, this occurs because buyers of options pay only the premium for the right to
trade at the specified price. Derivative contracts are offered in relation to exchange rates, short-term and long-
term interest rates and stock exchange indices. They are widely used for speculation as well as for risk
management. In recent years, options have become extremely complicated, with new forms of options contracts
appearing regularly. 140 Forward and futures contracts are likely to provide cheaper protection against loss than
options, but remove the profit opportunity if prices move in favour of the firm. Thus, options are generally
preferable if the hedger is uncertain about the direction the price of the underlying asset is likely to move. A
hedger who is confident about the direction in which the price will move is more likely to choose forward or
futures contracts or remain in an open position and accept the risk of a price change. A trader who is confident
that the price will fall may (a) sell the product before the price falls; (b) take an offsetting short position by
selling futures contracts; or (c) sell the currency forwards. This eliminates entirely her exposure to the price fall.
A trader who is uncertain in which direction the price will move may choose options. Even then, if she thinks
that the price is more likely to fall than to rise, financial futures are preferable to options because they are likely
to offer her cheaper protection. Options are preferable if the trader has no view or thinks that the price is more
likely to rise than fall. Derivatives markets have been controversial in recent years. Many companies have
experienced losses badly in these markets, and fears about causing serious problems for the international
financial system continue to be widespread Key terms  Options  Futures  Forwards  Swaps Review
questions and problems 1. Consider the relative advantages and disadvantages of using forward contracts,
futures contracts and options as means of speculation. 2. How do futures markets seek to protect themselves and
their clients against default risk? 3. Why might the increased protection provided to individual traders by the
derivatives markets increase the risk of the whole financial system running into difficulties? 4. Why did the US
central bank (the Federal Reserve) feel the need to rescue a privately owned and run hedge fund (LTCM) in late
1998? Should public resources be used in this way? 5. How many ways are there of a Latvian investor going
short in US dollars or giving itself the opportunity of going short? Why might a Latvian investor wish to go
short in US dollars? 6. Why is it more risky to write (sell) options contracts than to buy them? 7. Consider the
following statement: A speculator who felt that interest rates were likely to rise or a currency’s value decline
would go short in the relevant asset by selling a futures contract. a) Why would a speculator go short rather than
long in these two cases? b) What does going short in interest rates mean? c) How does selling a futures contract
allow one to go short?
Differentiation between real assets and financial assets,
What Is a Real Asset?
Real assets are physical assets that have an intrinsic worth due to their substance and properties. Real assets
include precious metals, commodities, real estate, land, equipment, and natural resources. They are appropriate
for inclusion in most diversified portfolios because of their relatively low correlation with financial assets, such
as stocks and bonds.
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Real Asset
The Basics of a Real Asset
Assets are categorized as either real, financial, or intangible. All assets can be said to be of economic value to a
corporation or an individual. If it has a value that can be exchanged for cash, the item is considered an asset.
Intangible assets are valuable property that is not physical in nature. Such assets include patents, copyrights,
brand recognition, trademarks, and intellectual property. For a business, perhaps the most important intangible
asset is positive brand identity.
Financial assets are a liquid property that derives value from a contractual right or ownership claim. Stocks,
bonds, mutual funds, bank deposits, investment accounts, and good old cash are all examples of financial assets.
They can have a physical form, like a dollar bill or a bond certificate, or be nonphysical—like a money market
account or mutual fund.
In contrast, a real asset has a tangible form, and its value derives from its physical qualities. It can be a natural
substance, like gold or oil, or a man-made one, like machinery or buildings.
Taxing Assets
Financial and real assets are sometimes collectively referred to as tangible assets. For tax purposes, the Internal
Revenue Service (IRS) requires businesses to report intangible assets differently than tangible assets, but it
groups real and financial assets under the tangible asset umbrella.
Most businesses own a range of assets, which typically fall into real, financial, or intangible categories. Real
assets, like financial assets, are considered tangible assets. For example, imagine XYZ Company owns a fleet of
cars, a factory, and a great deal of equipment. These are real assets. However, the company also owns several
trademarks and copyrights, which are its intangible assets. Finally, the company owns shares of stock in a sister
company, and these are its financial assets.
KEY TAKEAWAYS
 A real asset is a tangible investment that has an intrinsic value due to its substance and physical
properties.
 Commodities, real estate, equipment, and natural resources are all types of real assets.
  Real assets provide portfolio diversification, as they often move in opposite directions to financial assets
like stocks or bonds.
 Real assets tend to be more stable but less liquid than financial assets.
Advantages and Disadvantages of Real Assets
Real assets tend to be more stable than financial assets. Inflation, shifts in currency values, and other
macroeconomic factors affect real assets less than financial assets. Real assets are particularly well-suited
investments during inflationary times because of their tendency to outperform financial assets during such
periods.
In a 2017 report, asset management firm Brookfield cited a global value of real asset equities totaling US$5.6
trillion. Of this total, 57% consisted of natural resources, 23% was real estate, and 20% was in infrastructure. In
the firm's 2017 report on real assets as a diversification mechanism, Brookfield noted that long-lived real assets
tend to increase in value as replacement costs and operational efficiency rise over time. Further, the found that
cash-flow from real assets like real estate, energy servicing, and infrastructure projects can provide predictable
and steady income streams for investors.
Real assets, however, have lower liquidity than financial assets, as they take longer to sell and have higher
transaction fees in general. Also, real assets have higher carrying and storage costs than financial assets. For
example, physical gold bullion often has to be stored in third-party facilities, which charge monthly rental fees
and insurance.
Pros
 Portfolio diversification
 Inflation hedge
 Income stream
Cons
 Illiquidity
 Storage fees, transport costs
Real World Example of Real Assets vs Financial Assets
Although they are lumped together as tangible assets, real assets are a separate and distinct asset class from
financial assets. Unlike real assets, which have intrinsic value, financial assets derive their value from a
contractual claim on an underlying asset that may be real or intangible.
For example, commodities and property are real assets, but commodity futures, exchange-traded funds (ETFs)
and real estate investment trusts (REITs) constitute financial assets whose value depends on the underlying real
assets.
It is in those types of assets that overlap and confusion over asset categorization can occur. ETFs, for example,
can invest in companies that are involved in the use, sale or mining of real assets, or more directly linked ETFs
can aim to track the price movement of a specific real asset or basket of real assets.
Physically backed ETFs include some of the most popular ETFs in the world based on volumes, such as State
Street's SPDR Gold Shares (GLD) and iShares Silver Trust (SLV). Both invest in precious metals and seek to
mirror the performance of those metal. Technically speaking, though, these ETFs are financial assets, while the
actual gold or silver bullion they own are the real asset.
Related Terms
The Money You Can't See: Financial Assets
A financial asset is a non-physical, liquid asset that represents—and derives its value from—a claim of
ownership of an entity or contractual rights to future payments. Stocks, bonds, cash, and bank deposits are
examples of financial assets.
more
How to Profit From Real Estate
Real estate is real—that is, tangible—property made up of land as well as anything on it, including buildings,
animals, and natural resources.
more
Hard Asset
A hard asset is a tangible and physical item or object of worth that is owned by an individual or a corporation.
more
Understanding Intangible Assets
An intangible asset is an asset that is not physical in nature and can be classified as either indefinite or definite.
more
Commodity ETF
A commodity ETF is an exchange-traded fund that invests in physical commodities.
more
How to Analyze Property, Plant, and Equipment – PP&E
Property, plant, and equipment (PP&E) are long-term assets vital to business operations and not easily
converted into cash. Purchases of PP&E are a signal that management has faith in the long-term outlook and
profitability of its company.
Financial vs. Real Asset
by Sampson Quain; Updated December 03, 2018

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 2Understand Financial Company Cash Flow
 3Difference Between Cash Flow and Working Capital
 4What Expresses a Limitation of a Balance Sheet?
Assets are the lifeblood of your business, because they are valuable resources that determine the net worth of
your company. Many people make the mistake of thinking cash-on-hand is the most important asset for a
business, but the truth is that there are all kinds of important assets, including cash, inventory, real estate,
investment, buildings and equipment. These assets are further classified into real vs. financial assets. It’s
important for you to understand the distinction between real vs. financial assets because changes in either of
these types of assets can affect the trajectory of your business. Knowing the difference between real vs.
financial assets and the difference between real investment and financial investment can help you refine your
business goals and objectives.
Financial Assets Definition
Financial assets are tangible assets that you can quickly convert into cash. Stocks, bonds, cash reserves, bank
deposits, trade receivables, notes receivable and shares are all common examples of financial assets. These are
tangible or liquid assets that actually represent claims on the underlying value of the other types of assets such
as real estate and properties. The main characteristic of a financial asset is that it has some type of monetary
value, but that value is not tangible until it’s exchanged for cash. Financial assets also have classifications such
as equities and fixed income securities. Equities are shareholding rights to a business, and they are issued either
as common shares or preferred stock. Unlike preferred stock, common shares carry voting rights. Fixed income
securities are instruments of borrowing that earn fixed rates of interest over a specified duration. Public
institutions issue some types of fixed income securities, while others are issued by private entities. Examples
include treasury, municipal and corporate bonds.
Real Assets Definition
The real assets definition refers to value-generating physical assets that your business owns. Common examples
include land, buildings, inventory, precious metals, commodities, real estate, land and machinery. These
physical assets are important for your business because they carry some type of intrinsic value. Intrinsic value is
defined as the exact value of an asset as determined by factors such as location, function and acquisition costs.
Similarities Between Financial Assets and Real Assets
When you understand the financial assets definition and the real assets definition, it’s easier to see how they are
similar. For example, the valuations of financial and real assets are based on their potential to generate cash
flow. Both financial assets and real assets are also resources that can help your business survive a volatile
economic climate. Having cash reserves during a recession can help you pump money into your business when
revenues are lower. That’s also true if you own rental property, because you can lease that property out to a
tenant as a means of generating additional revenue when your sales are down.
Difference Between Financial Assets and Real Assets
You have to think about the difference between financial assets and real assets as being the same as the
difference between real investment and financial investment. Real investments are not as liquid as financial
investments, which means you can’t convert real assets into cash as quickly as you could convert financial
assets into cash. Another difference between real investment and financial investment is that real investments –
such as owning a building – can be less valuable over time, whereas cash flows generated by financial assets
experience constant growth. For example, the valuation of a building your business owns can decrease over
time due to depreciation. That’s typically not the case with financial assets such as cash reserves, stocks and
bonds. Although these assets can lessen in value over time, that decrease is often much less than that of a real
asset.
What Is a Financial Asset?
A financial asset is a liquid asset that gets its value from a contractual right or ownership claim. Cash, stocks,
bonds, mutual funds, and bank deposits are all are examples of financial assets. Unlike land, property,
commodities, or other tangible physical assets, financial assets do not necessarily have inherent physical worth
or even a physical form. Rather, their value reflects factors of supply and demand in the marketplace in which
they trade, as well as the degree of risk they carry.
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Financial Asset
Understanding a Financial Asset
Most assets are categorized as either real, financial, or intangible. Real assets are physical assets that draw their
value from substances or properties, such as precious metals, land, real estate, and commodities like soybeans,
wheat, oil, and iron.
Intangible assets are the valuable property that is not physical in nature. They include patents, trademarks, and
intellectual property.
Financial assets are in-between the other two assets. Financial assets may seem intangible—non-physical—with
only the stated value on a piece of paper such as a dollar bill or a listing on a computer screen. What that paper
or listing represents, though, is a claim of ownership of an entity, like a public company, or contractual rights to
payments—say, the interest income from a bond. Financial assets derive their value from a contractual claim on
an underlying asset.
This underlying asset may be either real or intangible. Commodities, for example, are the real, underlying assets
that are pinned to such financial assets as commodity futures, contracts, or some exchange-traded funds (ETFs).
Likewise, real estate is the real asset associated with shares of real estate investment trusts (REITs). REITS are
financial assets and are publicly traded entities that own a portfolio of properties.
The Internal Revenue Service (IRS) requires businesses to report financial and real assets together as tangible
assets for tax purposes. The grouping of tangible assets is separate from intangible assets.
KEY TAKEAWAYS
 A financial asset is a liquid asset that represents—and derives value from—a claim of ownership of an
entity or contractual rights to future payments from an entity.
 A financial asset's worth may be based on an underlying tangible or real asset, but market supply and
demand influence its value as well.
 Stocks, bonds, cash, CDs, and bank deposits are examples of financial assets.
Common Types of Financial Assets
According to the commonly cited definition from the International Financial Reporting Standards (IFRS),
financial assets include:
 Cash
 Equity instruments of an entity—for example a share certificate
 A contractual right to receive a financial asset from another entity—known as a receivable
 The contractual right to exchange financial assets or liabilities with another entity under favorable
conditions
  A contract that will settle in an entity's own equity instruments
In addition to stocks and receivables, the above definition comprises financial derivatives, bonds, money market
or other account holdings, and equity stakes. Many of these financial assets do not have a set monetary value
until they are converted into cash, especially in the case of stocks where their value and price fluctuate.
Aside from cash, the more common types of financial assets that investors encounter are:
 Stocks are financial assets with no set ending or expiration date. An investor buying stocks becomes part
owner of a company and shares in its profits and losses. Stocks may be held indefinitely or sold to other
investors.
 Bonds are one way that companies or governments finance short-term projects. The bondholder is the
lender, and the bonds state how much money is owed, the interest rate being paid, and the
bond's maturity date.
 A certificate of deposit (CD) allows an investor to deposit an amount of money at a bank for a specified
period with a guaranteed interest rate. A CD pays monthly interest and can typically be held between
three months to five years depending on the contract.
Pros and Cons of Highly Liquid Financial Assets
The purest form of financial assets is cash and cash equivalents—checking accounts, savings accounts, and
money market accounts. Liquid accounts are easily turned into funds for paying bills and covering financial
emergencies or pressing demands.
Other varieties of financial assets might not be as liquid. Liquidity is the ability to change a financial asset into
cash quickly. For stocks, it is the ability of an investor to buy or sell holdings from a ready market. Liquid
markets are those where there are plenty of buyers and plenty of sellers and no extended lag-time in trying to
execute a trade.
In the case of equities like stocks and bonds, an investor has to sell and wait for the settlement date to receive
their money—usually two business days. Other financial assets have varying lengths of settlement.
Maintaining funds in liquid financial assets can result in greater preservation of capital. Money in bank
checking, savings, and CD accounts are insured against loss of up to $250,000 by the Federal Deposit Insurance
Corporation (FDIC)—the National Credit Union Administration (NCUA) for credit union accounts. If for some
reason the bank fails, your account has dollar-for-dollar coverage up to $250,000. However, since FDIC covers
each financial institution individually, an investor with brokered CDs totaling over $250,000 in one bank faces
losses if the bank becomes insolvent.
Liquid assets like checking and savings accounts have a limited return on investment (ROI) capability. ROI is
the profit you receive from an asset less the cost of owning that asset. In checking and savings accounts the ROI
is minimal. They may provide modest interest income but, unlike equities, they offer little appreciation. Also,
CDs and money market accounts restrict withdrawals for months or years. When interest rates fall, callable CDs
are often called, and investors end up moving their money to potentially lower-income investments.
Pros
 Liquid financial assets convert into cash easily.
 Some financial assets have the ability to appreciate in value.
 The FDIC and NCUA insure accounts up to $250,000.
Cons
 Highly liquid financial assets have little appreciation
 Illiquid financial assets may be hard to convert to cash.
 The value of a financial asset is only as strong as the underlying entity.
Illiquid Assets Pros and Cons
The opposite of a liquid asset is an illiquid asset. Real estate and fine antiques are examples of illiquid financial
assets. These items have value but cannot convert into cash quickly.
Another example of an illiquid financial asset are stocks that do not have a high volume of trading on the
markets. Often these are investments like penny stocks or high-yield, speculative investments where there may
not be a ready buyer when you are ready to sell.
Keeping too much money tied up in illiquid investments has drawbacks—even in ordinary situations. Doing so
may result in an individual using a high-interest credit card to cover bills, increasing debt and negatively
affecting retirement and other investment goals.
Real World Example of Financial Assets
Businesses, as well as individuals, hold financial assets. In the case of an investment or asset management
company, the financial assets include the money in the portfolios firm handles for clients, called assets under
management (AUM). For example, BlackRock Inc. is the largest investment manager in the U.S. and in the
world, judging by its $6.5 trillion in AUM (as of March 31, 2019).
In the case of banks, financial assets include the worth of the outstanding loans it has made to customers.
Capital One, the 10th largest bank in the U.S., reported $372,537,597 billion in total assets on its first quarter
2019 financial statement; of that, $247,090,748 billion were from real estate-secured, commercial, and
industrial loans.
Related Terms
Real Asset, a Tangible Investment
A real asset is a tangible investment, such as gold, real estate or oil, that has an intrinsic value due to its
substance and physical properties.
more
What Are Nonfinancial Assets?
A nonfinancial asset is an asset with a physical value such as real estate, equipment, machinery, gold, or oil.
more
Near Money Definition
Near money is a financial economics term describing non-cash assets that are highly liquid, such as savings
accounts, CDs, and Treasury bills.
more
Liquid Asset
A liquid asset is an asset that can easily be converted into cash within a short amount of time.
more
Why Do Some Assets Sell Better Than Others? In a Word: Liquidity
Liquidity refers to the speed with which an asset or security can be bought or sold in the market, without
affecting its price—the ease of converting it to ready money, or cash. Cash is considered the most liquid of
assets.
more
Illiquid Definition, Risks, and Examples
Illiquid is the state of a security or other asset that cannot quickly and easily be sold or exchanged for cash
without a substantial loss in value.
Assets are basically items of the balance sheet that determine the net worth of a business. These assets are
further classified into financial and real assets.

Financial assets are cash or transactional instruments that are readily convertible into cash. Cash reserves, trade
receivables, notes receivable, shares and bonds are some of the common types of financial assets.

Real assets are value-generating properties and commodities owned by the business. They are essentially
physical items, such as land, buildings, inventory, precious metals and oil, over which a business can attach
intrinsic value. Intrinsic value is the exact value of an asset as determined by factors such as location,
functionality and acquisition costs.
A financial asset is a promise of future cash flows. It can be a specific promise, like a bond or trade receivable
that promises to pay $100 in six months, or a contingent promise, like a derivative that promises to pay $100 if
the S&P500 is below 2,000 in six months, or a non-specific promise, like an equity that pays whatever
dividends the Board of Directors votes to pay.
A real asset is tangible property like a building or a car.
Normally we think of financial assets as things that can be easily transferred or sold, and real assets are things
you own and use. There are grey areas such as:
1. If you own a detached home, that is a real asset. But if you “own” a co-op apartment, you actually have
shares in a corporation, plus a lease on your apartment. So that sounds technically like a financial asset,
but for practical purposes people think of it as a real asset, just like the detached home.
2. You bought a membership in a country club. That’s like a real asset in that it gives you the right to use
certain specific assets, and promises no cash flows. But it’s like a financial asset in that it’s a promise of
future services rather than ownership of any specific asset.
3. You have a non-assignable pension that pays you $1,000 per month. That’s like a financial asset in that
it promises future cash flows, but it cannot be transferred or sold.
Therefore, don’t think of this as a fundamental distinction that divides assets into two neat groups. Rather there
are pure financial assets, pure real assets and a bunch of stuff that has characteristics of both.
8.2k views · View 2 Upvoters
Dhruv Goel, Investment Advisor at Karvy Private Wealth (2017-present)
Answered Aug 22, 2018
The material wealth of a society is ultimately determined by the productive capacity of its economy, that is, the
goods and services its members can create. This capacity is a function of the real assets of the economy: the
land, buildings, machines, and knowledge that can be used to produce goods and services.
In contrast to real assets are financial assets such as stocks and bonds. Such securities are no more than
sheets of paper or, more likely, computer entries, and they do not contribute directly to the productive capacity
of the economy. Instead, these assets are the means by which individuals in well-developed economies hold
their claims on real assets.
Financial assets are claims to the income generated by real assets (or claims on income from the
government). If we cannot own our own auto plant (a real asset), we can still buy shares in Ford or Toyota
(financial assets) and thereby share in the income derived from the production of automobiles.
While real assets generate net income to the economy, financial assets simply define the allocation of income
or wealth among investors. Individuals can choose between consuming their wealth today or investing for the
future. If they choose to invest, they may place their wealth in financial assets by purchasing various securities.
When investors buy these securities from companies, the firms use the money so raised to pay for real assets,
such as plant, equipment, technology, or inventory. So investors’ returns on securities ultimately come from the
income produced by the real assets that were financed by the issuance of those securities.
1.3k views · View 3 Upvoters

Rob Scott, 7+ Years in FinTech

Answered Apr 7, 2017 · Author has 103 answers and 462.4k answer views
Real Assets are assets such land, machines, buildings and knowledge which can be used to produce goods and
services.
Financial Assets are claims to income from real assets and generally come in three distinguishing types: fixed
income, equity or derivatives. An example of such assets would be Bonds, stocks and futures, respectively.
3.1k views · View 1 Upvoter
Related QuestionsMore Answers Below
 Difference between physical and financial asset?
 Will financial asset be called as "tangible"?
  Differences between real assets and financial assets?
 What is the difference between the physical asset market and the financial asset market?
 What's the linkage between investment, real assets, and financial assets?

Vishal Agarwal
Answered Mar 8, 2017
Financial assets are such assets that are easily convertible in cash.
These are cash or transactional instruments for example derivatives and equities..
However, real assets are value generating assets. These are physical assets For example, land building, etc.
There is only one functional difference ie., Financial assets are easily convertible in cash.. But such is not
possible in real assets..
1.8k views · View 1 Upvoter · Answer requested by Mandeep

David Friedman, Spent some time in the trenches on Wall St.

Answered Mar 29, 2018 · Author has 7.8k answers and 10.4m answer views
Originally Answered: What is the difference b/n real asset & financial asset?
Real assets are things like real estate, collectibles (wine, art, etc.), precious metals (gold, silver, etc.), physical
commodities (as opposed to derivatives thereof, such as futures and forwards), and infrastructure (thanks Sean
Quinn for this suggestion).
Financial assets are things like cash, stocks, bonds, derivative instruments, etc. Note that some kinds of cash,
such as collectible coins and bills of historical value, are real assets, not financial ones.
Real Assets Vs. Financial Assets: The Best Way To Invest In 2019
Jun. 16, 2019 10:00 AM ET
|
Includes: ET, MMP, O, SPG, STAG

Jussi Askola
REITs, real estate, research analyst
MARKETPLACE
High Yield Landlord

Summary
Financial assets include things like stocks, bonds and cash.
Real assets include things like real estate, infrastructure and commodities.
Which is the best investment in 2019? The answer might surprise you.
Co-produced with Samuel Smith
Assets are the lifeblood of the economy, enabling us to store, transfer, and create wealth. They can typically be
classified as either “real” or “financial” assets.
Definitions
Before we dig into an investment comparison of the two types of assets, some definitions are in order:
 Financial assets are highly liquid assets that are either cash or can quickly be converted into cash. These
include the traditional investments such as stocks (i.e., equity) and bonds (i.e., fixed income). The
defining characteristic of a financial asset is that it has some type of known monetary value that can
readily be realized. However, it in and of itself lacks any intrinsic value.
 Real assets, on the other hand, are value-generating physical assets that a business and/or investor owns.
These include land, buildings, ships, and other infrastructure or commodities. The defining characteristic
of a real asset is that it has intrinsic value in and of itself does not rely on monetization and/or exchange
in order to provide value for its owner.
Similarities
Real and financial assets do share a key similarity: Their valuations are generally based on cash flow generation
potential. According to the discounted cash flow valuation method, the value of an asset is the sum of all of its
future cash flows discounted back to their present value. In the case of commodities, this is not quite the case,
though their value is still tied to investor sentiment regarding how current and future economic conditions will
impact their ability to help generate cash flow.
Differences
Real and financial assets also have some key differences:
(1) Real assets are typically less liquid than financial assets since they are usually more cumbersome to
exchange and their markets are not as efficient or populated.
(2) The value of real assets also is much more dependent on factors such as location, function, and operation
and exchange costs, whereas financial assets are typically fungible, thereby making them location independent.
Investment Comparison
Financial assets offer the advantage of convenience, liquidity, and efficiency whereas real assets are safer in that
they do not rely on a public marketplace to derive value for the owner while also being more inflation and
“ black-swan event” resistant … so, which is it?
Given that right now:
(1) Interest rates remain at historically low levels and stock market valuations are historically high:

source
(2) Allocations to real assets are expected to nearly double.
It would appear that the answer is a no brainer in favor of real assets. In fact, retirement pensions and
endowment funds – which have the mandate of generating highly reliable and regular income for distribution –
are no longer able to achieve their investing goals by focusing solely on bonds (LQD, VCLT, IEF) after a multi-
decade-long decline in interest rates and are instead looking to real assets to meet their needs. Already, trillions
of dollars have flown to real assets and the trend appears to be just getting started. In less than 10 years,
institutional capital in this space has grown by $20 trillion, and another ~$40 trillion is expected in the decade
ahead.
source
This is because, in a world of low interest rates and elevated stock market valuations, real assets offer:
1. Higher income yield: The 10-year Treasury may yield only 2.1%, but real assets will often trade at
yields in the 6%-10% range – and can be leveraged (using record low long term interest rates) to
generate even greater cash-on-cash returns.
2. Greater total returns: Real assets generate high income, but they also appreciate in value and grow
cash flow. A well-located office tower may yield 6% and grow in value by 3% per year. Add to that a bit
of leverage and you can reasonably expect double-digit total returns.
3. Inflation protection: One of the biggest and most underrated risks today is accelerating inflation. When
you invest in low yielding bonds, you are at big risk. Real assets, on the other hand, are well-protected
as their income and values tend to grow along with inflation. As such, they provide a good hedge against
inflation risk.
4. Valuable Diversification: Traditional assets (stocks and bonds) are highly volatile and adding real
assets to a portfolio has proven to lower volatility. As such, investors can profit from diversification
benefits while boosting returns and income.
Investors have historically been overly exposed to traditional assets, including stocks and bonds, and it's only
since 2000 that investors have started to heavily increase their allocation to real assets. Allocations to real assets
were only 5% in 2000. Today, it's closer to 25%. And in 10 years, this figure could reach up to 40%:
source
With interest rates expected to remain exceptionally low for years to come and the stock market is poised for
disappointing results due to high valuations, according to many economists and regarded investors; we believe
that allocation trends toward real assets should continue and even accelerate.

source
Real Asset Investing For Individual Investors
OK, so real assets win hands down. What next? How is the average do-it-yourself retirement investor supposed
to put this into practice to profit from the rush to real assets? While the arguments for real assets over financial
assets may seem convincing, many small investors – especially retirees – are intimidated and/or scared away by
their illiquidity, inefficiency (especially when purchased on a small scale), lack of passivity, and even liability.
Fortunately, you do not need to be a multi-billion-dollar institution to invest in real assets. At High Yield
Landlord, we specialize in helping the individual retirement investor enjoy the best of both worlds by investing
in financial assets that are directly backed by real assets. We have a strong preference for relying on these real
asset-backed financial assets rather than traditional physical real asset investments for monthly income due to
the numerous advantages they offer that lead to better risk and hassle adjusted returns over the long run. These
include:
 Economies of scale – Large portfolios of real assets are much cheaper to operate per unit than smaller
portfolios due to the fact that larger portfolios have greater bargaining power with suppliers, sales and
marketing agents, tenants, property management, and maintenance companies and can also spread fixed
costs out over a much larger amount of rental revenue, resulting in significantly higher profit margins.
 Safety through broad diversification – If one or two real asset investments encounter problems and/or
underperform, large portfolios can absorb this blow quite easily whereas small portfolios will be unable
to.
 Easy liquidity – The ability to quickly and cheaply buy and sell real asset investments through publicly
traded entities makes for considerably less risk, cost, and commitment than is born in typical physical
real asset investments.
 Professional management – Owning real assets managed by professionals with decades of experience
and – ideally – skin in the game, offers a huge investing competitive advantage over having to manage
real asset investments yourself or via a management team that lacks skin in the game and/or the decades
of experience boasted by the typical management team of a publicly-traded real asset entity.
 Total passivity – Real asset-backed financial assets are totally passive investments, unlike many other
forms of real asset investing.
 Transparency – Despite being totally passive, these entities are bound by law to release quarterly, semi-
annual, and/or annual reports on their business, providing tremendous transparency and insight into the
performance of your real assets.
 Occasionally trading at discounts to NAV– Thanks to the tendency for publicly-traded markets to
fluctuate wildly with daily news headlines that are often entirely disconnected from the underlying
performance of the real assets held in real asset backed financial assets, it's not uncommon for these
investments – despite all of their advantages – to trade at discounts to the value of their underlying
holdings. This provides savvy investors with the opportunity to achieve profits that exceed the already
superior total return outlook for real assets.
Depending on real asset-backed financial assets that pay safe and growing dividends for retirement income
combines the lucrative cash flow and long-term leveraged appreciation of real asset investing with the benefits
of passivity, liquidity, and easy diversification that can be found in financial asset investing. Additionally, the
monthly cash flow alleviates many of the worries that come with traditional financial asset market volatility by
preventing retirees from having to sell shares while prices are low since they only live off of the income.
Focusing on growing dividend income rather than the noise caused by volatile stock prices fits well with a long-
term investment strategy and removes some of the emotional risk associated with investing.
Finally, because high-quality real asset backed financial assets will only pay out excess cash flows as dividends,
retirees do not have to worry about reinvesting their dividends if they don't want to, knowing that these
investments retain all of the cash flow they need to sustain and even grow their business. As a result, investors
can spend 100% of their dividend income and still very likely see their income and portfolio value appreciate
over time. In contrast, real asset investors typically have to practice much more savvy math in forecasting for
themselves how much they will need to set aside for future repairs and/or to keep their properties competitive in
their local market.
Our Two Favorite Real Asset Classes:
Though we cover many different forms of real asset-backed financial assets, two of the most popular investment
sectors include:
(1) Commercial Real Estate via real estate investment trusts, commonly referred to as REITs. Just like mutual
funds, they allow investors of all kinds to invest in real estate without actually having to go out and buy,
manage and finance properties themselves. Besides, most REITs are publicly traded on a stock exchange and
allow investors to participate in the ownership of large scale, well diversified real estate portfolios in the same
way as investors would invest in any other industry. Specially designed for investors looking for superior
income, along with reasonably good price appreciation prospects over time, this vehicle is ideally suited to
retirees. Those looking for these benefits while also guarding against the downside will want to focus on
apartment communities, industrial buildings, grocery-anchored shopping centers, and net lease properties.
While some time ago, these highly profitable investments may have been reserved to high net worth individuals
and institutions, it is today easier than ever before to invest in real estate through readily liquid, high-yielding
REITs. Of the over 200 REITs trading on public exchanges today, a few popular examples include Realty
Income (O), Simon Property Group (SPG) and STAG Industrial (STAG).
(2) Energy Pipelines via master limited partnerships (commonly referred to as MLPs) and other companies that
own energy infrastructure. Just like commercial real estate, these assets generate a lot of cash and are an
essential component of our infrastructure. Pipelines generally offer even greater income than traditional real
estate properties but have lower appreciation potential in the long run. Just like with REITs, investors can get
exposure to high yielding energy pipelines through the purchase of MLPs. Popular examples include Energy
Transfer (ET) and Magellan Midstream Partners (MMP).
The Real Asset Portfolio: Putting It All Together
REITs and MLPs – along with several other real asset backed financial asset investments – are all high yielding
assets that allow us to generate over $5,000 in annual passive income from a small $70,000 Real Asset
Portfolio.
Source: High Yield Landlord Real Money Portfolio
Compared to traditional equities, our real asset portfolio also enjoys much more reasonable valuation metrics
trading at 9.5x cash flow on average and an 18% discount to estimated NAV. Most importantly, we are able to
generate a high 7.2% dividend yield that's well covered at a low 68% payout ratio.
With interest rates expected to remain lower for longer, we believe that these attractive attributes will continue
to attract more and more capital toward real assets. This will result in bidding up of prices, compressing yields,
higher valuations, and strong total returns to investors who position themselves early enough.
Closing Note
Still, 20 years ago, most investors would ignore real assets. Today, they are becoming a 40% allocation in the
portfolios of professional institutional investors:

source
As the saying goes...
"Follow the money."
With more and more capital chasing a limited number of deals, we expect real assets to continue appreciating
and outperform financial assets (stocks and bonds) in the coming decades.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the
next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation
for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is
mentioned in this article.
Real Assets vs Financial Assets
Posted on September 30, 2010 by Hajara Saleeth in Business, Finance
Real asset can be defined as “assets that are tangible or physical in nature such as property, plants and
equipments.As an example in our bank many real assets can be identified such as the buildings, computers,
lands that we own, ATM machines, vehicles, machineries such as note counters and etc.
Financial assets can be defined as “assets in the form of stocks, bonds, rights, certificates, bank balances, etc., as
distinguished from tangible, physical assets” (Pension Boards-UCC, 2009). For our bank financial assets can be
identified as our investments in bonds issued government and companies, bills issued by government and
companies, shares of other companies and debentures of other companies, loans we have lent, reserves we hold
at Central bank and etc.
Real assets are tangible and financial assets are intangible in nature. Real assets are used in day to business
operations to produce/generate an output where as financial assets are used to generate a return by investing
activities. In general by investing in real assets company generates an income by way of profits earned from
production utilizing the asset, rent (from lands) and gain/loss on disposals. By investing in financial assets
company earns dividends, interest income and capital gains/loss upon disposal of assets.
REAL ASSETS AND FINANCIAL ASSETS
Commodities are real assets. Real assets are sometimes called economic assets, as they can be used or
consumed. They are tangible and intangible assets with intrinsic value that offer a reasonable expectation of
inflation protection. Real estate, factories, patents, certain types of real options, and human capital are examples
of real assets. Economists distinguish between two types of real assets: durable and nondurable. Durable assets
are employed in the production of wealth but are not consumed in the process. Materials are used during
production and can be either durable or nondurable. For example, production of airplane travel uses durable
assets (airplanes, airports) as well as nondurable assets (jet fuel, roasted peanuts, etc.) that are used up in the
production process. Many other inputs are also required for airplane travel, of course, including human capital
(pilots, ground crews) and management of these assets by corporate executives.
Financial assets are claims on the income that is derived from the use of real assets. A financial asset may also
have an ownership claim on the real assets themselves. For example, the stockholders of an airline company are
entitled to share in the income generated by using real assets such as airplanes, jet fuel, and peanuts. If the
airline company owns the airplanes, the stockholders will also share in the profits or losses when airplanes are
sold.
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What Is the Difference Between Financial and Real Assets?

Credit: Cultura RM/Rimagine Group Limited/Collection Mix: Subjects/Getty Images

The main difference between financial and real assets is that financial assets are cash and securities, such
as stocks and bonds, whereas real assets represent tangible possessions, such as real estate, production
equipment and inventory. Generally, financial assets are more liquid than real assets because they can be
readily converted to cash. Real assets take considerably more time to sell.
Businesses are evaluated according to the assessment of both financial and real assets and the ability of each to
generate cash flow. Financial assets usually show continued growth and increased value, but the building and
vehicle components of the real assets lose value over time. Real estate is a stable real asset that generally
appreciates over time and adds value to the business portfolio.
Businesses require both financial and real assets to continue to deliver their products and meet the financial
obligations that enable them to remain in operation. Financial assets generate the income to purchase real assets,
and in turn, real assets are used to produce goods and services to generate revenue. A diversified portfolio with
a balance of financial and real assets creates a strong company that is able to weather the ups and downs of the
financial market.
Financial Assets vs Physical Assets Assets are commonly known as anything with a value that represent
economic resources or ownership that can be converted into something of value such as cash. Financial assets
and physical assets, both represent such ownerships of value, even though they are very different to each other
based on their features and characteristics. Since many easily confuse the two types of assets to be of similar
meaning, the following article provides a solid explanation of the difference between the two, and explore a few
points that may help readers understand the difference between these two types of assets. Financial Assets
Financial assets are intangible, meaning that they cannot be seen or felt and may not have a physical presence
except for the existence of a document that represents the ownership interest held in the asset. It is important to
note that the papers and certificates that represent these financial assets do not have any intrinsic value (the
paper held is only a document certifying ownership and is of no value). The paper derives its value from the
value of the asset that is represented. Examples of such financial assets include stocks, bonds, funds held in a
bank, investments, accounts receivable, company goodwill, copyrights, patents, etc. Regardless of the fact that
financial assets do not exist in physical form, they are still recorded in a firm’s balance sheet, to represent the
value that is held by them. Physical Assets Physical assets are tangible assets and can be seen and touched, with
a very identifiable physical presence. Examples of such physical assets include land, buildings, machinery,
plant, tools, equipment, vehicles, gold, silver, or any other form of tangible economic resource. From an
accounting point of view, physical assets refer to the things that may be liquidated when the entity wound up its
interest. Physical assets have a useful economic life, when it ascertains its age it may be disposed off. They
usually experience a reduction in value due to wear and tear of the asset through continuous use known as
depreciation, or may lose their value in becoming obsolete, or too old for use. Certain tangible assets are also
perishable, such as a container of apples, or flowers that need to be sold soon in order to ensure that they do not
perish and lose their value. What is the difference between Financial Assets and Physical Assets? The main
similarity between tangible and physical assets is that they both represent an economic resource that can be
converted into value, and both assets are recorded in a firm’s balance sheet. The main difference between the
two is that physical assets are tangible and financial assets are not. Physical assets usually depreciate or lose
value due to wear and tear, whereas financial assets do not experience such reduction in value due to
depreciation. However, financial assets may lose value to changes in market interest rates, fall in investment
returns or fall in the stock market prices. Physical assets also require maintenance, upgrades and repairs,
whereas financial assets do not incur such expenses. Differences between Money Markets and Capital Markets.
Major Points Money Markets Capital Markets Participant Institutional participants like RBI, banks, financial
institutions and finance companies. Individual investors are permitted to transact but do not normally do so
Financial institutions, banks, corporate entities, foreign investors and ordinary retail investors from the members
of the public. Instruments Short term debt instruments such as T-bills, trade bills reports, commercial paper and
certificate of deposit. Equity shares, debentures, bonds and preference shares etc. Investment Outlay
Transactions require huge sums of money and are quite expensive Do not require a huge financial outlay. The
value of units of securities is generally low i.e. Rs. 10, 100 and minimum trading lot of shares is kept small as
50 or 100 units. Duration Instruments usually have a maximum tenure of one year and may even be issued for a
single day. Deals in medium and long term securities such as equity share and debentures Liquidity Higher
liquidity since the DFHI the Discount Finance House of India has been established for the specific objective of
providing a ready market for these instruments. Considered as liquid instruments because they are marketable
on the stock exchanges, However it might be difficult to find a buyer sometimes with the fluctuations of the
stock market. Safety Minimum risk and are safer since the issuers mostly are the agencies of the Government
and also because of the shorter duration. Riskier because of the long duration and may be the issuing companies
fail to perform as per the projection shown during issue. Expected return Less High for long duration earnings
are through dividend and bonus shares. SPOT MARKET What It Is: Also called the cash market or the physical
market, the spot market is where assets are sold for cash and delivered immediately. How It Works/Example:
Spot markets differ from futures markets in that delivery takes place immediately. For example, if you wish to
purchase Company XYZ shares and own them immediately, you would go to the cash market on which the
shares are traded (the New York Stock Exchange, for example). If you wanted to buy gold on the spot market,
you could go to a coin dealer and exchange cash for gold. The foreign exchange (FOREX) market is one of the
largest spot markets in the world. People and companies all over the world are constantly exchanging one
currency for another as transactions occur all over the globe. Why It Matters: It is important to know the
difference between the spot market and the futures market as well as the difference between spot prices and
futures prices. This difference -- known as the time spread -- is important economically because it illuminates
the market's expectations about futures prices. For the most part, spot markets are influenced solely by supply
and demand, whereas futures markets are also influenced by expectations about future prices, storage costs,
weather predictions (for perishable commodities in particular), and a host of other factors. FUTURES
MARKET What It Is: Futures are financial contracts giving the buyer an obligation to purchase an asset (and
the seller an obligation to sell an asset) at a set price at a future point in time. How It Works/Example: Futures
are also called futures contracts. The assets often traded in futures contracts include commodities, stocks, and
bonds. Grain, precious metals, electricity, oil, meat, orange juice, and natural gas are traditional examples of
commodities, but foreign currencies, emissions credits, bandwidth, and certain financial instruments are also
part of today's commodity markets. There are two kinds of futures traders: hedgers and speculators. Hedgers do
not usually seek a profit by trading commodities but rather seek to stabilize the revenues or costs of their
business operations. Their gains or losses are usually offset to some degree by a corresponding loss or gain in
the market for the underlying physical commodity. Speculators are usually not interested in taking possession of
the underlying assets. They essentially place bets on the future prices of certain commodities. Thus, if you
disagree with the consensus that wheat prices are going to fall, you might buy a futures contract. If your
prediction is right and wheat prices increase, you could make money by selling the futures contract (which is
now worth a lot more) before it expires (this prevents you from having to take delivery of the wheat as well).
Speculators are often blamed for big price swings, but they also provide liquidity to the futures market. Futures
contracts are standardized, meaning that they specify the underlying commodity's quality, quantity, and delivery
so that the prices mean the same thing to everyone in the market. For example, each kind of crude oil (light
sweet crude, for example) must meet the same quality specifications so that light sweet crude from one producer
is no different from another and the buyer of light sweet crude futures knows exactly what he's getting. Futures
exchanges depend on clearing members to manage the payments between buyer and seller. They are usually
large banks and financial services companies. Clearing members guarantee each trade and thus require traders
to make good-faith deposits (called margins) in order to ensure that the trader has sufficient funds to handle
potential losses and will not default on the trade. The risk borne by clearing members lends further support to
the strict quality, quantity, and delivery specifications of futures contracts. Futures Exchanges There are several
futures exchanges. Common ones include The New York Mercantile Exchange, the Chicago Board of Trade,
the Chicago Mercantile Exchange, the Chicago Board of Options Exchange, the Chicago Climate Futures
Exchange, the Kansas City Board of Trade, and the Minneapolis Grain Exchange. Why It Matters: Futures are a
great way for companies involved in the commodities industries to stabilize their prices and thus their
operations and financial performance. Futures give them the ability to "set" prices or costs well in advance,
which in turn allows them to plan better, smooth out cash flows, and communicate with shareholders more
confidently. Futures’ trading is a zero-sum game; that is, if somebody makes a million dollars, somebody else
loses a million dollars. Because futures contracts can be purchased on margin, meaning that the investor can
buy a contract with a partial loan from his or her broker, futures traders have an incredible amount of leverage
with which to trade thousands or millions of dollars worth of contracts with very little of their own money. For
additional reading: http://web.mit.edu/rpindyck/www/Papers/Dynamics_Comm_Spot.pdf Primary and
Secondary markets The financial market is a world where new securities are issued to the public regularly. It is
a world full of varied financial products and services, tailored to the need of every individual from all income
brackets. These financial products are bought and sold on the capital market, which is divided into primary
market and secondary market. This post will be a detailed explanation of primary market and secondary market,
and will draw the distinction of primary market vs. secondary market. What Is Primary Market? The primary
market is also known as new issues market. Here, the transaction is conducted between the issuer and the buyer.
In short, the primary market creates new securities and offers them to the public. For instance, Initial Public
Offering (IPO) is an offering of the primary market where a private company decides to sell stocks to the public
for the first time. An important point to remember here is that in the primary market, securities are directly
purchased from the issuer. Capital or equity can be raised in primary market by any of the following four ways:
1. Public Issue As the name suggests, public issue means selling securities to public at large, such as IPO. It is
the most vital method to sell financial securities. 2. Rights Issue Whenever a company needs to raise
supplementary equity capital, the shares have to be offered to present shareholders on a pro-rata basis, which is
known as the Rights Issue. 3. Private Placement This is about selling securities to restricted number of classy
investors like frequent investors, venture capital funds, mutual funds and banks comes under Private Placement.
4. Preferential Allotment When a listed company issues equity shares to a selected number of investors at a
price that may or may not be pertaining to the market price is known as Preferential Allotment. The primary
market is also known as the New Issue Market (NIM) as it is the market for issuing long-term equity capital.
Since the companies issue securities directly to the investors, it is responsible to issue the security certificates
too. The creation of new securities facilitates growth within the economy. What Is Secondary Market? In
secondary market, the securities issued in the primary market are bought and sold. Here, you can buy a share
directly from a seller and the stock exchange or broker acts as an intermediary between two parties. The
secondary market is actually formed by another layer of investors who deal with primary market investor to buy
and sell financial securities such as bonds, futures and stocks. These dealings happen in the proverbial stock
exchange. National Stock Exchange (NSE) and New York Stock Exchange (NYSE) are some popular stock
exchanges. Majorly, the trade happens between investors without any involvement with the company that issued
the securities in the primary market. The secondary market is further divided into two kinds of market. 1.
Auction Market The auction market is a place where buyers and sellers convene at a place and announce the
rate at which they are willing to sell or buy securities. They offer either the ‘bid’ or ‘ask’ prices, publicly. Since
all buyers and sellers are convening at the same place, there is no need for investors to seek out profitable
options. Everything is announced publicly and interested investors can make their choice easily. 2. Dealer
Market In a dealer market, none of the parties convene at a common location. Instead, buying and selling of
securities happen through electronic networks which are usually fax machines, telephones or custom order-
matching machines. Interested sellers deliver their offer through these mediums, which are then relayed over to
the buyers through the medium of dealers. The dealers possess an inventory of securities and earn their profit
through the selling. A lot of dealers operate within this market and therefore, a competition exists between them
to deliver the best offer to their investors. This makes them deliver the best price to the investors. An example
of a dealer market is the NASDAQ. The secondary markets are important for price discovery. The market
operations are carried out on stock exchanges. A variation to the dealer market is the OTC market. OTC stands
for ‘Over the Counter’ market. The concept came into existence during the early 1920’s period through Wall
Street trading, which implied the prevalence of an unorganized system of dealers who conducted trades via
networks. Stock shops existed to buy and sell shares over-the-counter. In other words, these were unlisted
stocks which were sold privately. Over time, the notion of OTC underwent a change. These days the over-the-
counter denotes those stocks which are not traded over NYSE, NASDAQ or American Stock Exchange
(AMEX). The over-the-counter implies those stocks which are traded on thepink sheets or on over-the-counter
bulletin boards (OTCBB). Pink sheets are a name given to the daily list of stocks published with ask and bid
prices by the National Quotation Bureau. The OTCBB service is offered by the National Association of
Securities Dealers (NASD) which accurately displays the last sale prices, real time quotations and other volume
information of over-the-counter securities.
Types of Financial Markets
An Introduction to the Financial Markets
Make Financial Markets Work for You
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BY KIMBERLY AMADEO

Updated June 25, 2019

What are the financial markets? It can be confusing because they go by many terms. They
include capital markets, Wall Street, and even simply "the markets.” Whatever you call them, financial markets
are where traders buy and sell assets. These include stocks, bonds, derivatives, foreign exchange, and
commodities. The markets are where businesses go to raise cash to grow. It’s where companies reduce risks and
investors make money.
Types of Financial Markets
The Stock Market is a series of exchanges where successful corporations go to raise large amounts of cash to
expand. Stocks are shares of ownership of a public corporation that are sold to investors through broker-dealers.
The investors profit when the companies increase their earnings. This keeps the U.S. economy growing. It's
easy to buy stocks, but it takes a lot of knowledge to buy stocks in the right company.
To a lot of people, the Dow is the stock market. The Dow--the nickname for the Dow Jones Industrial Average-
-is just one way of tracking the performance of a group of stocks. There is also the Dow
Jones Transportation Average and the Dow Jones Utilities Average. Many investors ignore the Dow and
instead focus on the S&P 500 or other indices to track the progress of the stock market. The stocks that make up
these averages are traded on the world's stock exchanges, two of which include the New York Stock
Exchange and the NASDAQ.
How the stock market works depends on the actions and decisions of both buyers and sellers concerning their
perceptions on profitabilities of the companies being traded.
Mutual funds give you the ability to buy a lot of stocks at once. In a way, this makes them an easier tool to
invest in than individual stocks. By reducing stock market volatility, they have also had a calming effect on the
U.S. economy. Despite their benefits, you still need to learn how to select a good mutual fund.
The Bond Market is where organizations go to obtain very large loans. When stock prices go up, bond prices
go down. There are many different types of bonds, including Treasury Bonds, corporate bonds, and municipal
bonds. Bonds also provide some of the liquidity that keeps the U.S. economy functioning smoothly.
It's important to understand the relationship between Treasury bonds and Treasury bond yields. When Treasury
bond values go down, the yields go up to compensate. When Treasury yields rise, so do mortgage interest rates.
Even worse, when Treasury values decline, so does the value of the dollar. This makes import prices rise, which
can trigger inflation. Treasury yields can also predict the future. For example, an inverted yield curve heralds a
recession.
The Commodities Market is where companies offset their futures risks when buying or selling natural
resources. Since the prices of things like oil, corn, and gold are so volatile, companies can lock in a known price
today. Since these exchanges are public, many investors also trade in commodities for profit only. They have no
intention of purchasing large quantities of pork bellies, for example.
Oil is the most important commodity in the U.S. economy. It is used for transportation, industrial products,
plastics, heating, and electricity generation. When oil prices rise, you'll see the effect in gas prices about a week
later. If oil and gas prices stay high, you'll see the impact on food prices in about six weeks.
The commodities futures market determines the price of oil. What are futures? They are a way to pay for
something today that is delivered tomorrow. This removes some of the volatility in the U.S. economy. It allows
businesses to control future costs of the critical commodities they use every day.
Futures also increase a trader's leverage by allowing him or her to borrow the money to purchase the
commodity. This leverage can create outsize gains if traders guess right. It also magnifies the losses if traders
guess wrong. If enough traders guess wrong, it can have a huge impact on the U.S. economy, actually
increasing overall volatility. Commodities trading was responsible for record-high oil prices in 2008 and 2011,
which resulted in food riots and even the Arab Spring.
Another important commodity is gold. It's bought as a hedge against inflation. Gold prices also go up when
there is a lot of economic uncertainty in the world. In the past, every dollar could be traded in for its value in
gold. However, when the U.S. went off the gold standard, it lost this relationship to money. Still, many people
look at gold as a safer alternative to cash or currency.
Derivatives are complicated financial products that base their value on underlying assets. Sophisticated
investors and hedge funds use them to magnify their potential gains. In 2007, hedge funds increased in
popularity due to their supposed higher returns for high-end investors. Since hedge funds invest heavily in
futures, some argued they decreased the volatility of the stock market and, therefore, the U.S. economy. The
hedge fund investments in subprime mortgages and other derivatives caused the 2008 global financial crisis.
Even before this, hedge funds had demonstrated their risky nature. In 1997, the world's largest hedge fund at the
time, Long Term Capital Management, practically brought down the U.S. economy.
Forex Trading is a decentralized global market in which currencies are bought and sold. More than $5.3 trillion
are traded per day, and 87 percent involves the U.S. dollar. Almost one-fourth of the trades are done
by banks for their customers to reduce the volatility of doing business overseas. Hedge funds are responsible for
another 11 percent, and some of it is speculative. This market affects exchange rates and, thus, the value of the
dollar and other currencies. Exchange rates work on the basis of demand and supply of a nation’s currency, as
well as of that nation’s economic and financial stability.
Functions of Financial Markets
Financial markets create an open and regulated system for companies to acquire large amounts of capital. This
is done through the stock and bond markets. Markets also allow these businesses to offset risk. They do this
with commodities, foreign exchange futures contracts, and other derivatives.
Since the markets are public, they provide an open and transparent way to set prices on everything traded. They
reflect all available knowledge about everything traded. This reduces the cost of obtaining information because
it's already incorporated into the price.
The sheer size of the financial markets provides liquidity. In other words, sellers can unload assets whenever
they need to raise cash. The size also reduces the cost of doing business. Companies don't have to go far to find
a buyer or someone willing to sell.
What are Financial Markets?
Financial markets, from the name itself, are a type of marketplace that provides an avenue for the sale and
purchase of assets such as bonds, stocks, foreign exchange, and derivatives. Often, they are called by different
names, including “Wall Street” and “capital market,” but all of them still mean one and the same thing. Simply
put, businesses and investors can go to financial markets to raise money to grow their business and to make
more money, respectively.
To state it more clearly, let us imagine a bank where an individual maintains a savings account. The bank can
use their money and the money of other depositors to loan to other individuals and organizations and charge an
interest fee.
The depositors themselves also earn and see their money grow through the interest that is paid to it. Therefore,
the bank serves as a financial market that benefits both the depositors and the debtors.

Types of Financial Markets

There are so many financial markets, every country is home to at least one, though they vary in size. Some are
small while some others are internationally known, such as the New York Stock Exchange (NYSE) that trades
trillions of dollars on a daily basis. Here are some types of financial markets.

1. Stock market
The stock market trades shares of ownership of public companies. Each share comes with a price, and investors
make money with the stocks when they perform well in the market. It is easy to buy stocks. The real challenge
is in choosing the right stocks that will earn money for the investor.
There are various indices that investors can use to monitor how the stock market is doing, such as the Dow
Jones Industrial Average (DJIA) and the S&P 500. When stocks are bought at a cheaper price and are sold at a
higher price, the investor earns from the sale.

2. Bond market
The bond market offers opportunities for companies and the government to secure money to finance a project or
investment. In a bond market, investors buy bonds from a company, and the company returns the amount of the
bonds within an agreed period, plus interest.

3. Commodities market
The commodities market is where traders and investors buy and sell natural resources or commodities such as
corn, oil, meat, and gold. A specific market is created for such resources because their price is unpredictable.
There is a commodities futures market wherein the price of items that are to be delivered at a given future time
is already identified and sealed today.

4. Derivatives market
Such a market involves derivatives or contracts whose value is based on the market value of the asset being
traded. The futures mentioned above in the commodities market is an example of a derivative.

Functions of the Markets

The role of financial markets in the success and strength of an economy cannot be underestimated. Here are
four important functions of financial markets:

1. Puts savings into more productive use

As mentioned in the example above, a savings account that has money in it should not just let that money sit in
the vault. Thus, financial markets like banks open it up to individuals and companies that need a home loan,
student loan, or business loan.

2. Determines the price of securities

Investors aim to make profits from their securities. However, unlike goods and services whose price is
determined by the law of supply and demand, prices of securities are determined by financial markets.

3. Makes financial assets liquid

Buyers and sellers can decide to trade their securities anytime. They can use financial markets to sell their
securities or make investments as they desire.

4. Lowers the cost of transactions

In financial markets, various types of information regarding securities can be acquired without the need to
spend.

Importance of Financial Markets

There are many things that financial markets make possible, including the following:
 Financial markets provide a place where participants like investors and debtors, regardless of their size,
will receive fair and proper treatment.
 They provide individuals, companies, and government organizations with access to capital.
 Financial markets help lower the unemployment rate because of the many job opportunities it offers

Additional Resources
Thank you for reading CFI’s explanation of financial markets. CFI offers the Financial Modeling & Valuation
Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep
learning and advancing your career, the following resources will be helpful:
 London International Financial Futures & Options Exchange
 New York Mercantile Exchange (NYMEX)
 Stock Market
 Types of Markets – Dealers, Brokers, Exchanges
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What are some examples of financial markets and their roles?
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BY EVAN TARVER

Updated Oct 11, 2018

Some examples of financial markets and their roles include the stock market, the bond market, and the real
estate market. Financial markets can also be broken down into capital markets, money markets, primary
markets, and secondary markets.
New York Stock Exchange
A financial market can be thought of as a location where buyers and sellers meet to exchange goods or services
at prices predetermined by supply and demand. The New York Stock Exchange (NYSE) is a great example of a
physical financial market that is now a digital financial market too, where stocks are bought and sold at prices
determined by supply and demand.
The stock market is a financial market where financing is provided through the issuance, buying, and selling of
shares of stock. The stock market is considered a capital market because it provides financing for long-term
investments. While there are many specific examples of the stock market, the NYSE example above is the best.
Bond Market and Real Estate Market
The bond market is a financial market where financing is provided through the issuance, buying, and selling of
bonds. The bond market is considered a capital market because it provides financing for long-term investments,
although it's possible to buy or invest in bonds with maturities of less than one year. Financial instruments with
maturities of less than one year are normally considered to be sold in money markets.
Lastly, the real estate market is a financial market where financing is provided through the buying and selling of
physical properties. The real estate market is considered to be the best example of a capital market since almost
all real estate properties are highly illiquid and normally held for multiple years.
Financial Market
Definition: Financial Market refers to a marketplace, where creation and trading of financial assets, such as
shares, debentures, bonds, derivatives, currencies, etc. take place. It plays a crucial role in allocating limited
resources, in the country’s economy. It acts as an intermediary between the savers and investors by
mobilising funds between them.
The financial market provides a platform to the buyers and sellers, to meet, for trading assets at a price
determined by the demand and supply forces.
Functions of Financial Market
1. It facilitates mobilisation of savings and puts it to the most productive uses.
2. It helps in determining the price of the securities. The frequent interaction between investors helps in
fixing the price of securities, on the basis of their demand and supply in the market.
3. It provides liquidity to tradable assets, by facilitating the exchange, as the investors can readily sell
their securities and convert assets into cash.
 4. It saves the time, money and efforts of the parties, as they don’t have to waste resources to find
probable buyers or sellers of securities. Further, it reduces cost by providing valuable information,
regarding the securities traded in the financial market.
The financial market may or may not have a physical location, i.e. the exchange of asset between the parties
can also take place over the internet or phone also.
Classification of Financial Market


 By Nature of Claim
 Debt Market: The market where fixed claims or debt instruments, such as debentures or
bonds are bought and sold between investors.
 Equity Market: Equity market is a market wherein the investors deal in equity
instruments. It is the market for residual claims.
 By Maturity of Claim
 Money Market: The market where monetary assets such as commercial paper, certificate
of deposits, treasury bills, etc. which mature within a year, are traded is called money
market. It is the market for short-term funds. No such market exist physically; the
transactions are performed over a virtual network, i.e. fax, internet or phone.
 Capital Market: The market where medium and long term financial assets are traded is a
capital market. It is divided into two types:
 Primary Market: A financial market, wherein the company listed on an
exchange, for the first time, issues new security or already listed company brings
the fresh issue.
 Secondary Market: Alternately known as Stock market, a secondary market is an
organised marketplace, wherein already issued securities are traded between
investors, such as individuals, merchant bankers, stock brokers and mutual funds.
 By Timing of Delivery
 Cash Market: The market where the transaction between buyers and sellers are settled in
real time.
 Futures Market: Futures market is one where the delivery or settlement of commodities
takes place at a future specified date.
 By Organizational Structure
 Exchange Traded Market: A financial market, which has a centralised organisation
with the standardised procedure.
 Over-the-Counter Market: An OTC is characterised by a decentralised organisation,
having customised procedures.
Since last few year, the role of financial market has taken a drastic change, due toa number of factors which are
low cost of transactions, high liquidity, investor protection, transparency in pricing information, adequate legal
procedures for settling disputes, etc.
Types of Financial Markets that Traders Should Know
Reading time: 11 minutes
The financial market is a marketplace where financial securities are traded on both a national and global level.
Traders buy and sell those securities to gain potential profits while trying to keep their risks limited. Many
traders tend to focus on one financial market, for example, trading stocks or CFDs, but it is important to have an
all-round overview of all the financial markets, because they can impact each other. This article reviews the
most important financial markets and explains their global role.

Financial Markets Explained

What are financial markets?
The financial market is, at its core, not much different to other markets, where goods and produce are bought
and sold. But rather than the exchange of vegetables, clothing, or computers for a local or national currency, the
financial markets are focused on buying, selling, and holding of financial securities, products and instruments.
The financial markets have expanded exponentially over the past few decades, and now offer many types of
financial instruments.
Here are the most important ones:
 Forex - (Also known as: the Foreign Exchange Market or FX)
 Capital markets - such as stocks and bonds markets
 Derivatives markets - such as CFDs (Also known as: Contracts for Differences)
 Commodities markets - which include Gold, Silver and Oil
 Money markets - such as short-term debt
  Cryptocurrency markets - which include Bitcoin and Altcoins
 Mortgage markets - which offer long-term loans
 Insurance markets - which transfer risk for a premium

Source: Admiral Markets MT5 with MT5SE Add-on GBP/USD Daily chart (Data range: between 24 April 2017
to 28 September 2018) - performed on 28 September 2018 at 7:00 AM GMT - Please Note: Past performance
does not indicate future results, nor is it a reliable indicator of future performance.
Some of these financial markets are by their own nature more long-term focused, short-term oriented, or a
mixture of both. The mortgage market for instance, is where many long-term loans take place, whereas money
markets are focused on the short-term. Forex, stock, CFDs and commodities can be traded both short and long-
term. Professional traders can decide to engage in investments or trading, depending on their own approach and
trading style.
The financial markets serve an important purpose for the economy and offer six basic functions:
 Price determination
 Liquidity
 Efficiency (costs like transaction costs)
 Traditional borrowing and lending
 Information about flow of funds
 Risk sharing
Financial institutions help to facilitate the flow and movement of funds within the global markets and the
overall financial system. These institutions include commercial banks, investment banks, central banks,
insurance firms, brokers, and even non-banking financial institutions (such as credit unions).
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Financial Markets Today

Generally speaking, the financial markets appear to be the engine of international trade and the overall global
economy for the past 100 years. Especially the last 25 years, wherein the financial markets are becoming even
more complex, sophisticated, and important. At the start of the 21st century, the global financial markets
became more dynamic and were changing quickly. Nowadays there are less exchange controls, capital controls,
more global financial transactions, and more payment systems in general.
There is also rapid movement in terms of international capital flows, the development of new financial
instruments (such as cryptos), and new digital technologies. Overall, this is leading societies to more open,
advanced financial markets and methods. Although the above trends are valid for the financial markets in
general, each financial market has its own separate trends. We will discuss a few trends for the Forex and stock
markets.
Forex Market
The Forex market has become very popular over the past few decades, and has seen enormous growth of
volume in the last 30 years. Here is the trend explored in greater detail:
 1977 - $5 billion
 1987 - $600 billion
 1992 - $1 trillion
 2001 - $1.5 trillion
 2007 - $3 trillion
 2010 - $4 trillion
 2013 - $5.3 trillion
 2017 - $5.5 trillion
As you can see, the Forex volume has increased by a factor of 1000 within 40 years. It has also increased by
267% between 2001 and 2017, and by 40% between 2010 and 2017. These impressive growth figures show just
how important the foreign exchange market has become.
Stock Market
Another trend could be found in the global stock markets, where the US stock markets have arguably become
much more important compared with other parts of the world. The US stock market was a major winner in the
20th century, according to the book the "Triumph of the Optimists" (2002) written by Elroy Dimson, Paul
Marsh, and Mike Staunton. Their research indicates that three important changes have occured within the last
100 years:
 The US has achieved market dominance
 The exchanges were consolidated
 Secular (market activities occurring over the long term) sector rotation occurred
Here are some graphs that display information pertaining to the world's stock markets in both 1900 and 2000:

Source: Investopedia - ''Triumph of the Optimists - Dimson, et al.''

These graphs show how the US stock markets grew from 22% in 1900 to 47% in 2000. Their share more then
doubled, and almost reached 50%. Another country that grew in numbers besides the US was Japan, with an
increase of share from 4% to 13%. Most other regions lost market share. The UK dropped from 12% to 8%, and
the Euroland went from 25% to 13%. Some countries disappeared from the list, whereas others entered the list
for the very first time. Canada was not on the list in 1900, but had a 2% share in 2000. Other countries during
1900 managed to keep 7%, whereas 'New Markets' counted for 6% in 2000.
Source: Investopedia - ''Triumph of the Optimists - Dimson, et al.''
Business sectors changed substantially between 1900 and 2000. Sectors that were very strong in 1900, such as
railroads, lost substantial market share one century later. Railroads went from 62.8% in 1900 to 0.2% in 2000.
For instance, iron, coal and steel went from 5.2% to 0.3%. Other industries rose, such as banks and finance, and
retailers. Some sectors that were large in 2000 did not have any market share in 1900. Information technology
jumped from 0 to 23.1% in 2000. Pharmaceuticals, insurance, and diversified industries also saw large growth
in their shares.
Of course, the trends of the past century do not have to be the trends of this century. Luckily traders do not need
to know how the future will look like 100 years from now. They can choose to trade shorter time frames such as
one trading daily, weekly, or monthly. Ultimately, it is easier to understand what the financial markets might be
doing in the short-term rather than in the long-term, especially when analysing an entire century

U.S. Sector Weightings - 1900

Sectors 1900 2000 Difference

Railroads 62.8% 0.2% -62.6%

Banks and Finance 6.7% 12.9% 6.2%

Mining 0.0% 0.0% 0.0%

Textiles 0.7% 0.2% -0.5%

Iron, Coal, Steel 5.2% 0.3% -4.9%

Breweries and Distilleries 0.3% 0.4% 0.1%

Utilities 4.8% 3.8% -1.0%

Telegraph and Telephone 3.9% 5.6% 1.7%

Insurance 0.0% 4.9% 4.9%

Other Transport 3.7% 0.5% -3.2%

Chemicals 0.5% 1.2% 0.7%

Food Manufacturing 2.5% 1.2% -1.3%

Retailers 01.% 5.6% 5.5%

Tobacco 4.0% 0.8% -3.2%

Sectors Small In 1900 4.8% 62.4% 57.6%

Total 100.0% 100.0%

Source: Investopedia - ''Triumph of the Optimists - Dimson, et al.''

U.S. Sector Weightings - 2000

Sectors 2000 1900 Difference

Information Technology 23.1% 0.0% 23.1%

Banks and Finance 12.9% 6.7% 6.2%

Pharmaceuticals 11.2% 0.0% 6.2%

Telecommunications 5.6% 3.9% 1.7%

 Retailers 5.6% 0.1% 5.5%

Oil and Gas 5.2% 0.0% 5.2%

Diversified Industrials 5.1% 0.0% 5.1%

Insurance 4.9% 0.0% 4.9%

Utilities 3.8% 4.8% -1.0%

Media and Photography 2.5% 0.0% 2.5%

Breweries and Distilleries 0.4% 0.3% 0.1%

Mining 0.0% 0.0% 0.0%

Sectors Small In 2000 19.7% 84.2% -64.5%

Total 100.0% 100.0%

Similar sectors in base year of 2000 and 1900

Source: Investopedia - ''Triumph of the Optimists - Dimson, et al.''

Overview Of The Financial Markets

This part will provide an overview of the different types of financial markets that were mentioned earlier.
Forex Market
As mentioned before, the growth of the Forex market and its volume has been impressive in the last 40 years -
from $5 billion in 1977 to more than $5 trillion in 2017. There are a couple of key factors that are contributing
to this trend:
 Advanced computers
 More price volatility
 Better access to financial markets via brokers
 More trading tools and access to information
Forex is a type of market that is popular with traders who are looking for short and medium term trading
opportunities.
Derivatives Markets
Derivatives are securities that are connected to an underlying asset and are sometimes used as a hedge against
price changes. Options, futures and CFDs are all examples of derivatives. Speculators can use these instruments
to hedge against risk, or to take risk in order to make potential financial gain.
Commodities Markets
The commodity market comprises of hard commodities such as gold, oil, and soft commodities such as
agricultural and livestock products. Investors and traders can take part indirectly in a commodity by purchasing
stocks or directly by buying an option, future or a CFD.
Capital Markets
Capital markets include the stock and bond markets (both private and public sector bonds). There is a primary
market, where companies and governments issue new securities, and a secondary market, where previously
issued stocks and bonds are traded.
Insurance and Mortgage Markets
Mortgage markets revolve around long-term loans that are provided for buying property. These loans can be
traded on secondary mortgage markets. Insurance markets involve the insurer and the insured, where the risk is
transferred for a premium. Insurance companies have substantial cash reserves which they invest in stocks,
bonds, and derivatives markets.
Money Markets
Money markets are focused on very short-term debt, and involve local banks and central banks. Banks loan to
each other for short-term liquidity purposes. The central bank often acts as the lender of last resort.
Cryptocurrency Markets
Although it is a new market, Bitcoin and other Altcoins captured the headlines at the end of 2017 when strong
price volatility caused a surge in prices. The blockchain technology and mining system caused an increased
interest in the cryptocurrency market. How this market will continue, how it will shape the financial markets in
general, and whether it can create more value for consumers and the financial system or not is still something
that will be determined in the next few years.
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This material does not contain and should not be construed as containing investment advice, investment
recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such
trading analysis is not a reliable indicator for any current or future performance, as circumstances may change
over time. Before making any investment decisions, you should seek advice from independent financial
advisors to ensure you understand the risks.
There are a number of financial markets that suit specific needs to different investors.
Capital Markets
A capital market is one in which individuals and institutions trade financial securities. Institutions in the public
and private sectors have the ability to buy & sell securities on the capital markets in order to raise funds. Capital
markets comprise of both the primary and secondary markets.
Governments and corporations require capital to finance their operations and to undertake longer term
investments. An organization can raise money through the sale of securities – stocks and bonds in the
company’s name. These are bought and sold, speculatively, in capital markets.
Stock Markets
Stock markets allow investors to buy and sell shares in publicly listed companies. By doing this. they provide
companies with access to capital from investors. With a percentage of ownership by means of purchasing
“shares”, opens the investor to the potential of gains based on the company’s performance, both in appreciating
stock prices and possible, dividend payouts.
This market can be split into two main sections: the primary market and the secondary market. The primary
market is where new issues are first offered, with any subsequent trading going on in the secondary market.
Bond Markets
A bond is a debt investment in which an investor loans money to a corporate or government body, which
borrows the funds for a specific period of time at a fixed interest rate. Bonds are used by companies,
governments and corporations to produce liquidity for further advancement. Bonds can be bought and sold by
investors. Also referred to as the debt, credit or fixed-income market, it is huge in comparison to the stock
markets. The main categories of bonds are corporate bonds Treasury bonds, notes and bills, which are also
known as “Treasuries,” or in the U.K. “Gilts”
 Money Market
Is the market where, financial instruments with high liquidity and very short maturities are speculated. It is used
by investors as a means for borrowing and lending for short time periods, from several days up to a year. Money
market securities consist of negotiable certificates of deposit, bankers acceptances, U.S. Treasury bills,
commercial paper, Eurodollars, federal funds and repurchase agreements. Money market investments are also
called cash investments because of their short maturities.
The money market is used by a wide variety of investors, from a company raising money by selling commercial
paper into the market to an investor purchasing CDs as a safe place to hold finance in the short term. The money
market is typically seen as a safer place to put money due the highly liquid nature of the securities and short
maturities. Money market securities offer significantly lower returns than most other securities because of their
“safe nature”. Risk can still play its part, including the risk of default on securities such as commercial paper.
Cash or Spot Market
Investing in the cash or “spot” market is highly sophisticated, with opportunities for both big losses and big
gains. In the cash market, goods are sold for cash and are delivered immediately. By the same token, contracts
bought and sold on the spot market are immediately effective. Prices are settled in cash “on the spot” at current
market prices. This is notably different from other markets, in which trades are determined at forward prices.
The cash market is dynamic and fast moving, and generally unsuitable for novice investors. The cash markets
tend to be monopolised by institutional market players such as hedge funds, and corporate investors. The
products traded require access to extremely detailed information, reports and a high level of macroeconomic
analysis and investing abilities.
Derivatives Markets
The value is derived from its underlying asset or assets in the market (CFDs). A derivative is a contract, but in
this case the contract price is determined by the underlying market price of the core asset. The derivatives
market adds a further layer of complexity and is therefore not recommended for inexperienced investors.
However, it can be used as part of a risk management or portfolio diversification.
Examples of the most common derivatives are forwards, futures, options, swaps and contracts-for-
difference (CFDs) in an “over the counter” (no central exchange) market. Professional investors, institutions
and hedge fund managers use to varying degrees, they also play a significant role in private investing,
particularly with the Internet revolution.
 Forex and the Inter-bank Market
The inter-bank market is the financial system and trading of currencies among banks and financial institutions,
including retail investors and smaller trading parties. Some inter-bank trading is performed by banks on behalf
of large customers, most inter-bank trading takes place from the banks’ own accounts.
The Forex market is where currencies are traded. It is the largest, most liquid market in the world with an
average traded value that exceeds $3.9 trillion per day and includes all of the currencies in the world. The Forex
is the largest market in the world in terms of the total cash value traded, and any person, firm or government can
participate.
As with the Derivatives, it is an OTC market with no central marketplace for exchange. The Forex market is
open 24 hours a day, five days a week and currencies are traded worldwide among the major financial
institutions.
Primary Markets vs. Secondary Markets
A primary market issues new securities on an exchange. Corporations and governments obtain financing
through debt or equity based securities. Primary markets, also known as “new issue markets,” are facilitated by
underwriting groups, which consist of investment banks that will set a beginning price range for a given security
and then oversee its sale directly to investors, I.P.O.s (initial public offerings).
The primary markets are where investors have their first chance to participate in a new IPO. The issuing
company or group receives remuneration from the sale, which is then, generally, used to fund operations or
expand the business.
The secondary market is where investors purchase securities or assets from other investors, rather than from
issuing companies, they start trading in the secondary market on the NYSE, NASDAQ etc. depending on the
particular market they are related to, for listing and trading.
The secondary market is where higher volatility of exchange trading occurs on a daily basis. Primary markets
can see increased volatility over secondary markets because it is difficult to accurately gauge investor demand
for a new security until several days of trading have occurred. In the primary market, prices are often set
beforehand, whereas in the secondary market only basic forces like supply and demand determine the price of
the security.
Penny Stocks Market
The over-the-counter (OTC) market is a type of secondary market also referred to as a dealer market. The term
“over-the-counter” refers to stocks that are not trading on a stock exchange such as the NASDAQ, NYSE
or AMEX. This generally means that the stock trades either on the OTC or bulletin OTCBB (pink sheets).
Neither of these networks is an actual exchange, OTC and OTCBB, pink sheet companies have fewer
regulations to comply with than those that trade shares on an actual exchange. Most securities that trade this
way are penny stocks or are from very small companies that could be considered very high risk investments.
Role of capital and money markets in economic development,
The Role of the Capital Markets in Economic Development
Mar 24, 2019
Ensuring economic growth and development is a primary objective of all countries. According to the
World Bank, an estimated USD 4.0 trillion in annual investment is required for developing countries to
achieve the Sustainable Development Goals (SDGs) by 2030. In light of the investment requirement, there
is a greater need to develop and strengthen capital markets in order to mobilize commercial financing.
The role that capital markets have in financing infrastructure development, large enterprises, and Small
and Medium Enterprises (SMEs), and the links with economic growth, are increasingly being
highlighted.
Economists traditionally have looked to factors such as capital, labor and technology as the major factors
affecting economic growth. The recent financial crisis has shown that there are substantial economic
effects when there is lack of confidence in the financial systems. Therefore, the functioning of financial
systems has received special attention in academic literature in recent years. A well-functioning financial
system permits an economy to fully exploit its growth potential, as it ensures that the best investment
opportunities receive the necessary funding, while the inferior opportunities are denied capital; in this
regard, we endeavor to investigate the role that capital markets play in economic development. This focus
addresses the topic as follows:
i. Introduction to Capital Markets, where we highlight the capital market framework, key players
and products,
ii. How Capital Markets Facilitate Economic Development, where we look at the fundamental
channels through which capital markets are connected to economic growth and development,
iii. Challenges of Developing Capital Markets, where we highlight the effects on the economy when
capital markets don’t work as they are supposed to,
iv. Case Study - Capital Markets in South Africa, & Learnings for Kenya, and,
v. Steps Kenya Should Take to Expand its Capital Markets as Complementary to Bank Funding
Section I: Introduction to Capital Markets
Capital markets are a general category of markets that facilitate the buying and selling of securities with
medium-term and long-term maturity, of one year or more. Capital markets channel savings and
investment between suppliers of capital and users of capital through intermediaries. Examples of these
key players in the capital market’s process are:
a. Suppliers of Capital: Also known as surplus units, suppliers receive more money than they spend
or have immediate use for. They can be termed as investors. They provide their net savings to the
financial markets for a return on the capital provided. Examples include retail investors and
institutional investors,
 b. Financial Intermediaries: A financial intermediary is an institution or individual that serves as a
middleman among diverse parties in order to facilitate financial transactions. Common types
include commercial banks, investment banks, stockbrokers, fund managers, and stock exchanges,
c. Users of Capital: Also known as deficit units, users of capital spend more money than they receive
or need funds for investments or development. They are also termed as borrowers. They access
funds from the capital markets. Examples include businesses, the government and individuals.
Products in the capital markets are also referred to as capital market securities. These are debt securities,
with a maturity of more than one year, and equity securities. Funds received from these products are
mostly used to purchase capital assets, such as buildings, equipment, or machinery. The key capital
markets securities are as follows:
a. Bonds: These are medium to long-term debt securities issued by firms and governments to raise
large amounts of funds. Bonds are differentiated by the issuer and can be classified as Treasury
bonds, municipal bonds, or corporate bonds,
b. Equity Securities: An equity security represents ownership interest held by shareholders in an
entity realized in the form of shares of capital stock, which includes shares of both common and
preferred stock. They are classified as capital market securities because they have no maturity
and therefore serve as a long-term source of funds.
Section II: How Capital Markets Facilitate Economic Development
The capital markets are a network of specialized financial institutions, series of mechanism, processes
and infrastructure that in various ways facilitate the bringing together of suppliers and users of medium
to long-term capital. Capital markets connect the monetary sector with the real sector, which is the sector
of the economy concerned with the production of goods and services. Considering this role in the
economy, the capital markets play an important role in economic development as they facilitate growth in
the real sector by giving producers of goods and services, and entities tasked with infrastructure
development. access to long-term financing.
The fundamental channels through which capital markets are connected to the economy, economic
growth and development can be outlined as follows:
a. Creating a Bridge Between Suppliers of Capital and Users: The contact between agents with a
monetary deficit and the ones with monetary surplus can take place directly through direct
financing, but also through a financial intermediary in form of indirect financing, which is a
situation whereby specific operators facilitate the connection between the real economy and the
financial market. In this case, the financial intermediaries could be banks, investment funds,
pension funds, insurance companies, or other non-bank financial institutions,
b. Promoting Saving and Investments: The capital markets increase the proportion of long-term
savings (pensions, life covers, etc.) that is channeled to long-term investment. Capital markets
enable the contractual savings industry (pension and provident funds, insurance companies,
medical aid schemes, collective investment schemes, etc.) to mobilize long-term savings from small
individual household and channel them into long-term investments. It fulfills the transfer function
of current purchasing power, in monetary form, from surplus sectors to deficit sectors, in
exchange for reimbursing a greater purchasing power in future. In this way, the capital markets
enable corporations to raise funds to finance their investment in real assets. The implication will
be an increase in productivity within the economy leading to more employment, increase in
aggregate consumption and hence growth and development. It also helps in diffusing stress on the
 banking system by matching long-term investments with long-term capital. It encourages broader
ownership of productive assets by small savers. It enables them to benefit from economic growth
and wealth distribution, and provides avenues for investment opportunities that encourage a thrift
culture critical in increasing domestic savings and investments that translate to economic growth,
c. Facilitating Efficient Allocation of Scarce Financial Resources: The capital markets facilitate the
efficient allocation of scarce financial resources by offering a large variety of financial instruments
with different risk and return characteristics. This competitive pricing of securities and large
range of financial instruments allows investors to better allocate their funds according to their
respective risk and return appetites, thereby supporting economic growth,
d. Financing Utility and Infrastructure Development: The capital markets also provide equity
capital, debt capital and infrastructure development capital that have strong socio-economic
benefits through development of essential utilities such as roads, water and sewer systems,
housing, energy, telecommunications, public transport, etc. These projects are ideal for financing
through the capital markets via long dated bonds and asset backed securities. Infrastructure
development is a necessary condition for long-term sustainable growth and development. In
addition, capital markets increase the efficiency of capital allocation by ensuring that only projects
that are deemed profitable can successfully attract funds. This will, in turn, improve
competitiveness of domestic industries and enhance ability of domestic industries to compete
globally, given the current momentum towards global integration. The result will be an increase in
domestic productivity which may spill over into an increase in exports and, therefore, economic
growth and development,
e. Financing Private Public Partnerships, “PPPs”: Capital markets promote PPPs, thereby
encouraging participation of private sector in productive investments. The need to shift economic
development from public to private sector to enhance economic productivity has become
inevitable as resources continue to diminish. It assists the public sector to close the resource gap,
and complement its effort in financing essential socio-economic development, through raising
long-term project-based capital. It also attracts foreign portfolio investors who are critical in
supplementing the domestic savings levels and who facilitate inflows of foreign financial resources
into the domestic economy, thereby supporting economic growth.
Section III: Challenges of Developing Capital Markets
Economic growth in a modern economy hinges on an efficient and effective financial sector that pools
domestic savings and mobilizes capital for productive projects. The absence of effective capital markets
could leave most productive projects that carry developmental agendas unexploited. However, there are
challenges in developing capital markets as they are to a large extent dependent on the level of economic
and structural development of a country. Factors affecting the development of capital markets include;
a. Country Fundamentals: The size of the economy in terms of aggregate gross domestic product and
per capita income affect the development of capital markets. This explains in large part why, in
general, capital markets are at an embryonic stage in smaller and low-income countries, while
more developed countries have more robust capital markets. This can be explained as more
developed economies have greater institutional development, a larger institutional investor base,
higher levels of contractual savings such as pension funds, political stability and macroeconomic
stability.
b. Macroeconomic Policies Framework: An essential condition for well-functioning capital markets
is the existence of sound macroeconomic policy frameworks. Capital markets depend on investor
 confidence. Strong institutions thrive in stable macroeconomic conditions and investors can also
be confident that their capital will not be eroded by factors such as hyper-inflation and exchange
rate risks when there is a strong macroeconomic framework in place.
c. Access to Information: Access to information is a major factor that affects the development of
capital markets. Access to information gives investors’ confidence in the functioning of the capital
markets. Access to information and transparency allows for the monitoring of users of funds,
which increases investor confidence.
d. Regulatory Framework: To reliably extract the benefits of well-functioning markets, adequate
regulation of users of funds, investors, and intermediaries in addition to robust supervisory
arrangements to protect investors, promote deep and liquid markets, and manage systemic risk
are critical.
e. Efficient Market Infrastructure: Lack of adequate and efficient market infrastructure for issuing,
trading, clearing and settlement is a major issue for capital market development as it pushes away
potential investors to an economy.
f. Knowledge of Retail Investors: The lack of investor education for retail investors is another factor
affecting the development of capital markets. It is important to educate retail investors on
investment products and the benefits of saving, in order to channel savings to the capital markets.
Section IV: Case Study - Capital Markets in South Africa, & Learnings for Kenya
According to the Africa Financial Markets Index 2018, by Absa Group, while most capital markets in
African countries are relatively underdeveloped, those countries which introduced reforms that are
geared towards development of capital markets have been able to grow at relatively higher and
sustainable rates. The Africa Financial Markets Index tracks progress on financial market developments
of selected African countries annually across a range of indicators. These indicators are; (i) market
depth, (ii) access to foreign exchange, (iii) tax and regulatory environment, (iv) market transparency, (v)
capacity of local investors, (vi) macroeconomic opportunity, and (vii) legality and enforceability of
standard financial markets master agreements. According to the first report published in 2017 and the
subsequent report in 2018, South Africa ranked first in both occasions as the most developed financial
market in Africa, hence the reason we have picked it as a case study.
A summary of rankings from the report is highlighted in the table below, where the higher the score the
more developed the capital markets are based on the indicators above:

ABSA Africa Financial Markets Index

2017 2018

Country Aggregate Score Country

South Africa 92 South Africa

Mauritius 66 Botswana

Botswana 65 Kenya

Namibia 62 Mauritius

Kenya 59 Nigeria
According to the African Capital Markets Watch 2018 report by PWC, South Africa again ranks as the
most active capital market on the continent. This is supported by a strong financial markets
infrastructure and robust legal and regulatory frameworks. The South African capital markets consists
of:
 Equities: The Johannesburg Stock Exchange (JSE) is the largest exchange in Africa with over 400
listed firms and a market capitalization of USD 13.7 tn,
 Bonds: The South African-listed bond market is estimated to be ZAR 2.7 tn (USD 186.4 bn). It is
largely dominated by bonds issued by National Treasury, which account for 68.4% of the
outstanding debt, followed by bonds issued by the financial sector (16.0%) and state-owned
entities [parastatals] (11.2%). In terms of turnover, the monthly average amount traded on the
JSE is ZAR 2.3 tn (USD 158.8 bn),
 Derivatives: Derivatives are traded in exchanges under the umbrella of the JSE, and over-the-
counter (OTC). Exchange-traded products are standardized, and free of counterparty risk. The
JSE permits trading in equity, commodity (mainly agricultural), currency, and interest rate
derivatives,
 Real Estate: South Africa has the largest and most established REITs market in Africa. The South
African listed property sector has a market capitalization of approximately ZAR 380.0 bn (USD
26.2 bn) at the end of 2016, which is 6.4% of GDP.
South Africa continues to lead capital markets in Africa, supported by a strong financial markets
infrastructure and a robust legal framework. South Africa has developed its capital markets by;
a. Establishing Progressive Policies: South Africa has established progressive policies that support
the development of financial markets such as the ‘twin peaks’ strategy for improving financial
regulation, which separates regulatory functions between a regulator that performs prudential
supervision and one that performs market conduct supervision. This separation clearly defines the
objectives and mandates of the respective agencies and also separates the role of regulator and
promoter.
b. Promoting Investor Education and Financial Inclusion: South Africa has also introduced
frameworks to increase financial literacy with South Africa’s newly-created Financial Sector
Conduct Authority established to supervise financial markets and promote financial education. Its
consumer education department holds workshops on financial literacy and investor education,
particularly in rural areas and among groups that have been excluded from financial services.
c. Adopting Standardized International Markets Framework: South Africa also uses international
markets and standardized frameworks to develop its capital markets such as the Master
Agreement of the International Swaps and Derivatives Association, the Global Master Repurchase
Agreement and the Global Master Securities Lending Agreement, which helps the country to be
more prepared to drive product innovation and growth in the derivatives market and open up its
capital markets to international investors.
d. Using Technological Innovation: South Africa also makes use of technological innovation to make
its capital markets more efficient. For example, the South African Reserve Bank has set up an
electronic trading platform for primary dealers in an effort to improve liquidity and transparency
in the government bond market. There are plans to expand this to other market participants and
for other securities, including corporate bonds.
Due to the efficiency of the South African capital markets, businesses have credible alternative sources of
funding and they do not have to over-rely on banks in South Africa to have access to capital markets
funding. This makes South Africa an attractive destination for businesses, including multinationals to set
up operations.
Section V: Steps Kenya Should Take to Expand its Capital Markets as Complementary to Bank Funding
We look at what Kenya can learn from South Africa as South Africa has the most robust capital markets
in Africa. In our view, Kenya should adopt the following recommendations that will address the existing
bank dominance, reduce the funding reliance we have on banks, and support the expansion of capital
markets as an alternative to banks:
a. Focus Legislation and Policies to Stimulating the Capital Markets and Alternative Products, as
Opposed to Focusing Mainly on Banks: A lot of legislative action has focused on the banks, yet we
also need legislation to promote competing products that will diversify funding sources, which will
enable borrowers to tap into alternative avenues of funding that are more flexible and pocket-
friendly. This can be done through the promotion of initiatives for competing and alternative
products and channels. In developed economies, 40% of business funding comes from the banking
sector, with 60% coming from non-bank institutional funding such as capital markets and
alternative sources. However, in Kenya, 95% of all funding is bank funding, and only 5% from
non-bank institutional funding, showing that the economy is highly dominated by the banking
sector and should have more capital market products for funding businesses. Not to mention that
cost of bank funding is too high. To try and address cost of funding and access to funding, the
legislation has focused on the wrong issues such as legislating cost of borrowing and trying to
allocate a certain amount of loans to SMEs. Our view is that legislation ought to be more focused
on creating a more supportive environment to capital markets and alternative funding,
b. Support Product Development and Innovation: The capital markets regulators and participants
need to look at how to enhance non-bank funding, by encouraging product development and
innovation. The Total Assets Under Management (AUM) held by Unit Trust Fund Managers
declined slightly, by 0.7%, to Kshs 56.1 bn in 2017, from Kshs 55.5 bn recorded in 2016, while
commercial banks AUM grew by 8.3% over the same period, to Kshs 4.0 tn in 2017 from Kshs 3.7
tn in 2016. The capital markets regulators are already doing a lot, such as establishing REIT
regimes, derivatives and exchange traded funds, but more needs to be done to encourage product
development and innovation,
c. Consumer Education and Protection: The implementation of a strong consumer protection,
education agency and framework, to include robust disclosures on cost of credit, free and
accessible consumer education, enforcement of disclosures on borrowings and interest rates, while
also handling issues of contention and concerns from consumers,
d. Promote an Efficient Capital Markets Infrastructure: Efficient capital markets infrastructure is
crucial to developing deep and vibrant capital markets. The Capital Markets Authority (CMA)
could improve market efficiency by (i) making it easier for new and structurally unique products
to be introduced in the capital and financial markets. The market remains largely a plain vanilla
products market with equities and fixed income products, (ii) instituting predictable and
transparent timelines for processing submissions from market applicants and expedite processing
of applications. For example, an online portal showing when applications come in and how long
they take to be processed be helpful, and (iii) pushing for a one stop shop for applicants such that
an approval from the authority on products such as REITs would suffice, as opposed to current
structure where applicants have to chase other approvals from other agencies such as KRA,
 e. Addressing the Tax Advantages that Banks Enjoy: Level the playing field by making tax
incentives available to banks to be also available to non-bank funding entities and private
investment funds. For example, providing alternative and capital markets funding organizations
with the same withholding tax incentives that banking deposits enjoy, of a 15% final withholding
tax, so that depositors don’t feel that they have to go to a bank to enjoy the 15% withholding tax;
alternatively, normalize the tax on interest for all players to 30% to level the playing field,
f. Freeing Capital Markets Infrastructure from Banking Sector Control: To spur growth of capital
markets in areas such as Unit Trust Funds / Mutual Funds, we need to reduce the dominance of
banks in the capital markets infrastructure. For example, for a fund manager to set up a Unit
Trust Fund, they require a Custodian and a Trustee as part of the governance structure. In the
current capital markets governance structure framework, both the Custodian and the Trustees
have to be banks. It is understandable to have custody under banks because banks traditionally
play the roles of custody and safekeeping of assets. However, we should expand Trusteeship
beyond banks. In Kenya, being a trustee is based on Regulation 26 (1) of the Capital Markets
(Collective Investment Schemes) Regulations, 2001, which provides that a trustee must be a bank
or financial institution appointed by the Capital Markets Authority. However, when we look at
two other jurisdictions very relevant to us, that is South Africa and UK, the role of Trustees has
been expanded to include other entities:
a. In South Africa, Section 69 of the Collective Investment Scheme Control Act, 2002, a
Trustee may be: (a) a public company under the Companies Act; (b) a company or
institution incorporated under a special Act, excluding a close corporation referred to in
the Close Corporations Act, 1984 (Act No. 69 of 1984); (c) an institution or branch of a
foreign institution, which is entitled to carry on the business of a bank under the Banks
Act, 1990 (Act No. 94 of 1990); or (d) an institution which is registered as an insurer under
the Long-term Insurance Act, 1998 (Act No. 52 of 1998). The companies or institutions
listed above must also: (a) maintain capital and reserves together amounting to not less
than ZAR 10.0 mn (USD 0.7 mn); and (b) be registered by the registrar as a trustee or
custodian
b. In the UK, Section 55A, Part 4A of the Financial Services Act, 2012, Section 243, and the
GCA Collection Investment Scheme Information Guide 2019, a Trustee may be (a) an
individual; (b) a body corporate; (c) a partnership; or (d) an unincorporated association,
that has received permission from the Financial Conduct Authority to act as a Trustee, and
must be independent of the manager of the fund.
Looking at the above case studies, there is a compelling case to consider expanding our current closed
framework where Trusteeship is only open to banks, and in fact only 4 banks currently offer Trustee
services to the 18 currently registered Unit Trust Funds. It is arguably that banks may not support
capital markets products that are threatening to their own core banking business, thereby curtailing the
development of capital markets products that offer alternatives to banking products.
g. Increased Transparency: This can be achieved through a reduction of the opacity in debt pricing.
This will spur competitiveness in the banking sector and bring a halt to excessive fees and costs.
Recent initiatives by the CBK and Kenya Bankers Association (KBA), such as the stringent new
laws and cost of credit website being commendable initiatives,
In conclusion, a well-developed capital markets creates a sustainable, low-cost distribution mechanism
for multiple financial products and services across the country. This in turn helps the business
community to raise long-term funds that are used to purchase capital goods, thereby propelling their
growth and supporting the country’s economic growth. Capital markets also enhance efficient financial
intermediation. It increases mobilization of savings and therefore improves efficiency and volume of
investments, economic growth and development. Capital markets can create greater financial inclusion
by introducing new products and services tailored to suit investors’ preference for risk and return, as
well as borrowers’ project needs and risk appetite. One of the key missing pillars of the President's Big
Four Agenda is how to bring in private sector funding, we believe that the 7 points outlined above can
play a big role in mobilizing private sector funding of the Big Four Agenda.
The role of financial markets for economic growth
Speech delivered by Dr. Willem F. Duisenberg, President of the European Central Bank, at the
Economics Conference "The Single Financial Market: Two Years into EMU" organised by the
Oesterreichische Nationalbank in Vienna on 31 May 2001
Introduction
It is a great pleasure and honour for me to join the Oesterreichische Nationalbank for its 2001 Economics
Conference on "The Single Financial Market: Two Years into EMU". I would like to take the opportunity today
to talk about the role of financial markets for economic growth. I shall first consider whether the design of the
financial system matters for economic growth. Secondly, I shall say a few words about where the euro area
financial system is heading, two years after the introduction of the euro. After this I shall discuss the role of
monetary policy in the interplay between financial markets and economic growth. Towards the end, I shall
address, as just mentioned by Governor Liebscher, the role of central banks in prudential supervision.
Does the financial system matter for economic growth?
In the financial system funds flow from those who have surplus funds to those who have a shortage of funds,
either by direct, market-based financing or by indirect, bank-based finance. The former British Prime Minister
William Gladstone expressed the importance of finance for the economy in 1858 as follows: "Finance is, as it
were, the stomach of the country, from which all the other organs take their tone."
The financial system comprises all financial markets, instruments and institutions. Today I would like to
address the issue of whether the design of the financial system matters for economic growth. My view is that the
answer to this question is yes. According to cross-country comparisons, individual country studies as well as
industry and firm level analyses, a positive link exists between the sophistication of the financial system and
economic growth. While some gaps remain, I would say that the financial system is vitally linked to economic
performance. Nevertheless, economists still hold conflicting views regarding the underlying mechanisms that
explain the positive relation between the degree of development of the financial system and economic
development.
Some economists just do not believe that the finance-growth relationship is important. For instance, Robert
Lucas asserted in 1988 that economists badly over-stress the role of financial factors in economic growth.
Moreover, Joan Robertson declared in 1952 that "where enterprise leads, finance follows". According to this
view, economic development creates demands for particular types of financial arrangements, and the financial
system responds automatically to these demands.
Other economists strongly believe in the importance of the financial system for economic growth. They address
the issue of what the optimal financial system should look like. Overall, the notion seems to develop that the
optimal financial system, in combination with a well-developed legal system, should incorporate elements of
both direct, market and indirect, bank-based finance. A well-developed financial system should improve the
efficiency of financing decisions, favouring a better allocation of resources and thereby economic growth.
Both market and bank-based financial systems have their own comparative advantages. For some industries at
certain times of their development, market-based financing is advantageous. For example, financing through
stock markets is optimal for industries where there are continuous technological advances and where there is
little consensus on how firms should be managed. The stock market checks whether the manager's view of the
firm's production is a sensible one. For other industries, bank-based financing is preferable. This holds in
particular for industries which face strong information asymmetries. Financing through financial intermediaries
is an effective solution to adverse selection and moral hazard problems that exist between lenders and
borrowers. Banks in particular have developed expertise to distinguish between good and bad borrowers.
Economies that have both well-developed banking sectors and capital markets thus have an advantage.
Furthermore, in times of crisis in either system, the other system can perform the function of the famous spare
wheel.
The financial system is also particularly important in reallocating capital and thus providing the basis for the
continuous restructuring of the economy that is needed to support growth. In countries with a highly developed
financial system, we observe that a greater share of investment is allocated to relatively fast growing sectors.
When we look back more than one century ago, during the Industrial Revolution, we see that England's
financial system did a better job in identifying and funding profitable ventures than other countries in the mid-
1800s. This helped England enjoy comparatively greater economic success. The banker and former editor of
"The Economist" Walter Bagehot expressed this in 1873 as follows. "In England, however, ... capital runs as
surely and instantly where it is most wanted, and where there is most to be made of it, as water runs to find its
level".
Nowadays, the lack of a well-developed stock market would be a particularly serious disadvantage for any
economy. Equity is essential for the emergence and growth of innovative firms. Today's young innovative high-
technology firms will be the main drivers of future structural change essential for maintaining a country's long-
term growth potential. The contribution of financial markets in this area is a necessity for maintaining the
competitiveness of an economy today given the strongly increased international competition, rapid
technological progress and the increased role of innovation for growth performance.
In recent years, "new markets", for stocks of young and growing companies, have become a growing market
segment in the euro area. Equity financing is particularly advantageous for these companies and their investors
given the uncertainties of the economic return. As the term "shares" suggests, with equity financing you get
your share of the outcome, whether it is positive or negative. Banks, on the other hand, may be reluctant to
provide loans owing to the risk profile of these firms, and the greater exposure to a negative result in a loan
contract.
Total market capitalisation of the new markets in five euro area countries grew from EUR 7 billion at the
beginning of 1998 to EUR 167 billion in December 2000. While some of this increase can be attributed to the
overall rise in share prices during this period, it is important to note that the number of listed companies
continued to increase in almost every month. The total number of companies listed on these new markets in the
euro area increased from 63 at the beginning of January 1998 to 564 at the end of 2000. Developments over the
last year have admittedly been dismal. However, it is the nature of new markets, given the uncertainties attached
to future developments for the companies listed on these markets, to exhibit more volatility than established
markets.
Bank-based finance has a special role to play for many companies in need of funds, and thus helps to ensure a
well-balanced growth process. The economic literature on "relationship banking" has demonstrated that banks
can contribute to alleviating the impact of sudden economic shocks on their clients. Banks stand ready to
provide many customers with funds even in adverse circumstances, e.g. when the liquidity of financial markets
dries up.
The banking sector also has an essential role to play with respect to the allocation of funds to the most profitable
investment opportunities. Banks are, as mentioned before, financial intermediaries that by nature add cost to the
allocation of capital. Thus in order for banks to survive in a market economy they need to provide added
benefits. It is difficult to compete with the debt securities market, if a bank loan is of a size where the fixed
costs of accessing debt markets become negligible. However, securities markets are not always sufficiently
liquid and some, especially small and medium, enterprises cannot cover their liquidity needs via securities
markets owing to significant fixed costs of access. An additional benefit of bank-based finance relates to the
intrinsic nature of the banking business: some projects cannot be financed directly by the market on account of
significant information asymmetries between the borrowers and potential lenders. Banks can bridge this gap
thanks to their comparative advantages in the assessment and monitoring of investment projects, which
contributes to overcoming information asymmetries.
The financial system of the euro area after two years with the euro
Let me now turn to the major changes of the financial system in the euro area after two years with the euro.
Financial market integration
The launch of the euro on 1 January 1999 was a historic event. Eleven national currencies were converted into
one single currency overnight. Greece became the twelfth EU Member State to adopt the single currency on 1
January 2001. The newly created currency area of the twelve participating European Union Member States has
a considerable weight in the world economy. It accounts for around 20% of world GDP and world exports. The
successful launch of the euro, which is a key element in the creation of a stable and prosperous Europe, has
boosted the integration of financial markets in the euro area. This process of integration in European financial
markets coincided with the trends towards globalisation and securitisation. Other factors, among a wide range,
which shape the financial system are historically determined characteristics, technological innovations,
monetary and fiscal policies and specific legal and accounting systems that differ from country to country.
Evidence of integration can be found, to varying degrees, in all parts of the financial system. The euro area
money market is among the most integrated parts of the financial system. The conduct of one common
monetary policy in the euro area brought about immediate integration of the unsecured segments of the money
market, mainly the interbank market and the short-term derivatives market. The secured segments of the money
market, that is the repo market and the markets for short-term securities, are also increasingly integrated, but
they still suffer from underlying problems with the management of collateral. Nonetheless, the outlook is
promising. The euro area bond market has also developed rapidly. Notably, the private segments of the euro
area bond market have flourished since the introduction of the euro. The amount outstanding of long-term debt
securities issued by the private sector was 22% higher at the end of 2000 compared with the end of 1998.
Probably the most significant development has been the rapid growth in the euro-denominated corporate bond
market, which has increased several-fold in size since the launch of the euro and is now characterised by issues
of above EUR 1 billion. EMU has also stimulated integration in the stock markets in the euro area, where
structural developments have been dominated by a series of high-profile mergers and attempted mergers.
Regulatory framework
The rapid growth achieved by European securities markets has taken place notwithstanding remaining
regulatory obstacles to their integration. The European authorities are fully aware of the need to address this
problem. Several obstacles have been identified in the recent Report of the Committee of Wise Men, chaired by
Alexandre Lamfalussy. The Committee proposes to speed up the removal of impediments through the
institutionalisation of two new regulatory committees for securities markets, which should allow for an
increased harmonisation of securities regulation and less burdensome procedures for adapting Community rules
to rapidly changing financial markets.
Another essential European initiative was the adoption by the Commission, in May 1999, of a programme for
the completion of the Single Market for financial services. This programme, the Financial Services Action Plan,
lists a series of measures with indicative priorities and timetables. The project considered as a whole and its
inherent philosophy are capable of enhancing economic growth. In this perspective, a handful of specific
initiatives deserve a particular mention. A first initiative is the adoption of the European Company Statutes,
which is essential to enhance the level-playing field between European firms and to provide a suitable legal
framework for transnational conglomerates. A second important aspect is the Risk Capital Action Plan, which
would help redirect financial flows towards fast-growing small and medium-sized enterprises. Let me also
mention the last four initiatives, namely the e-commerce policy for financial services; the harmonisation of rules
on the accounting requirements for European companies; the takeover bids Directive; and finally the removal of
accounting, legal and fiscal discrepancies hindering the cross-border use of collateral. A European Directive on
this subject should be adopted in 2003.
Many of these initiatives may appear to be unimportant and somewhat "esoteric" regulatory changes. However,
they can provide a real boost to the smooth operation of markets and, therefore, to economic growth. For
example, obstacles to the cross-border use of collateral prevent the further cross-border integration and
consolidation of clearing and settlement infrastructures, thus hindering the integration of European money, bond
and equity markets. A smooth electronic integration of trading, clearing and settlement operations would help
reduce transaction costs substantially. The gradual dismantling of regulatory obstacles to remaining market
integration in Europe will contribute to enhancing their depth and efficiency, in turn contributing to an
improved allocation of funds to the most profitable investment opportunities, and thus supporting economic
growth.
What is the role of monetary policy and central banks?
Price stability
The interaction between financial markets, economic growth and monetary policy is by no means a new issue
for central bankers. However, financial market developments have brought the question to the forefront of the
policy debate. The continued integration and deepening of financial markets is a significant issue for policy-
makers, and particularly for central bankers, since smoothly functioning and efficient financial markets are
crucial in ensuring a smooth transmission of monetary impulses.
The best contribution that monetary policy can make to the smooth functioning and integration of European
financial markets and to economic growth is to maintain a steady medium-term price stability orientation. Such
a policy will be beneficial, as it will minimise the adverse effects of inflation and high inflation uncertainty. As
we all know, price stability is beneficial in numerous ways. It not only creates a climate for higher economic
activity over the medium term, but also reduces the economic and social inequalities caused by the asymmetric
distribution of the costs of inflation among the various economic agents. In addition, in an environment of low
inflationary expectations, inflation risk premia become relatively less important as a determinant of financial
prices. As a result, other factors such as credit risk can play a larger role in the price formation mechanism.
Ultimately, this results in a more efficient allocation of financial resources.
The approach of focusing on price stability is by now the conventional wisdom in industrialised countries. In
the case of Europe, this consensus on the contribution of price stability in the medium term to promoting long-
term growth is explicitly enshrined in the Statute of the ESCB, which states unambiguously that "the primary
objective of the ESCB shall be to maintain price stability in the medium term." The ECB is convinced that by
rigorously fulfilling this mandate, monetary policy is making its most effective contribution to the realisation of
strong output growth and satisfactory employment prospects.
Financial stability and the role of central banks in banking supervision
Also the design of prudential regulation plays an important role from a growth perspective. Supervision is the
guardian of financial stability, which in turn crucially determines the capability of the financial system to
allocate resources efficiently and absorb liquidity shocks. Financial crises can have a deep and protracted
impact on economic growth, as illustrated by several episodes of financial instability that occurred in many
countries. The contribution of prudential supervision to economic growth proceeds along two dimensions. From
a preventive perspective, supervision has to ensure a continuous and comprehensive monitoring of all the
potential threats to financial stability. The role of supervision is also crucial after the emergence of a crisis, in
order to provide for a swift and ordered resolution. Supervisors can only be effective in these two respects if
they are able to pay sufficient attention to systemic issues, namely the risk of contagion effects. In order to
address this issue in an effective way, they should be able to bridge the gap between information of a micro-
prudential nature, namely information on the safety and soundness of individual institutions, and macro-
prudential analysis, which encompasses all activities aimed at monitoring the exposure to systemic risk and at
identifying potential threats to financial stability arising from macroeconomic or financial developments.
This line of argument would support a large role for central banks in supervision, since they have traditionally
played a large role in macro-prudential analysis and the preservation of financial stability and they have
acquired a strong expertise in this field. Furthermore, smooth access of central banks to micro-prudential
information would also be profitable from the perspective of another traditional central banking task, namely
the oversight of payment systems.
In spite of these arguments supporting a large role of central banks in supervision, the debate has remained
broadly inconclusive in the economic literature so far, owing to the existence of opposite considerations. The
first important argument against a large role for central banks is the so-called "conglomeration argument",
which crucially relies on the idea of a blurring of distinction between banking, insurance and securities firms. In
order to preserve the level-playing field, all segments of the financial industry would have to be supervised
under the aegis of a common supervisor. According to this line of reasoning, this "umbrella" could not be the
central bank, since the latter is traditionally in charge of supervising monetary organisations. I will not embark
upon a thorough analysis of this issue now. Let me just say that I am convinced that this argument has lost
relevance in the current context characterised by a more market-based conduct of supervision - which alleviates
the level-playing field concern - and by an increased relevance of systemic risk issues.
The second major argument against a large involvement of central banks in supervision is the alleged conflict of
interest between monetary policy and prudential supervision. Many authors have argued that the institution in
charge of monetary policy cannot be entrusted with supervision, because the monetary policy stance would be
"contaminated" by supervisory issues, for instance the need to safeguard the liquidity of individual banks.
The advent of the euro, however, has shifted the balance of arguments decisively in favour of a large
involvement of national central banks (NCBs) in supervision, for two main reasons. First, the argument of a
conflict of interest between monetary policy and prudential supervision becomes irrelevant within the euro area,
where supervisory responsibilities are at the national level. Since the geographical jurisdictions of monetary
policy and prudential supervision no longer coincide, NCBs in charge of prudential supervision are shielded
from the traditional conflict of interest.
The second key factor is the increased relevance of systemic risk since the advent of the euro. The nature and
scope of systemic risk have changed in a decisive way. A first decisive evolution is the growing integration of
European financial markets in the euro area. As I have already mentioned, the interbank market, especially the
unsecured segment, is already fully unified across the area owing to the disappearance of the currency risk and
the connection of national real-time gross settlement systems via TARGET, the large-value cross-border
payment system of the Eurosystem. A second key evolution from the perspective of systemic risk is the growing
merger and acquisition activity and the trend towards the emergence of financial conglomerates in
Europe, which has, for instance, been identified in a recent G10 report on consolidation in the financial sector.
In this new environment, financial institutions are increasingly involved in intricate networks of counterparties
in the interbank market and via payment and settlement systems, and the impact an unwinding of their positions
could have on asset prices becomes even more ambiguous. These interrelations have a more international
character than before the advent of the euro, which implies that supervision has to pay much more attention to
euro area-wide developments. The national central banks of the euro area have a comparative advantage in this
field owing to their responsibilities over payment and settlement systems, their traditional focus on systemic
risk and their role as components of the Eurosystem.
My conclusion is that the successful pursuance of financial stability in Europe, which is a prerequisite for
economic growth, could benefit considerably if NCBs maintain and even reinforce their role in prudential
supervision. The debate on the organisation of banking supervision seems to be taking a different course for the
moment at least in a few euro area countries. Institutional arrangements based on a single supervisory authority
for the financial systems as a whole seem to have gained momentum over the past months in some euro area
countries like Ireland and Finland, and also in your country, Austria, where a single supervisor for banking,
insurance, securities and staff pension funds (Pensionskassen) should be established early 2002 according to the
recent draft Financial Market Supervisory Authority Act ("Finanzmarktaufsichtgesetz").
At first sight, this evolution runs counter to the need for a larger involvement of NCBs in prudential
supervision. However, in this field implementation details are crucial. In particular, it is crucial that effective
provisions for a close co-operation and a smooth exchange of information between the separate supervisory
authority and the NCB are laid down. NCBs should in any case be entrusted with the task of safeguarding
financial stability of the system as a whole and endowed with the instruments needed to pursue such an
objective effectively. In this respect, an extensive operational involvement of NCBs in the conduct of prudential
supervision is a key factor.
Conclusions
In concluding, I believe it is fair to say that EMU has already had a profound impact on the process of EU
financial integration. The impact of the introduction of the euro as a single currency of twelve Member States
has created the potential for large, deep and liquid euro-denominated financial markets, which should help to
deliver high rates of output and employment growth in the euro area economy. This transformation in the
financial and economic landscape entails certain potential risks, but it will provide many opportunities for
enhanced efficiency and growth in the financial markets and economies in the euro area. I am convinced that
the latter will prevail.
Thank you very much for your kind attention
Role of Finance in the development of an economy
Date
Oct 24, 2017
Posted By
Sakshi
Category

 Financial Risk Management

The functioning of an economy depends on the financial system of a country. The financial system includes
banks as a central entity along with other financial services providers. The financial system of a country is
deeply entrenched in the society and provides employment to a large population. According to Baily and Elliott,
there are three major functions of the financial system:
Credit Provision – Credit supports economic activity. Governments can invest in infrastructure projects by
reducing the cycles of tax revenues and correcting spends, businesses can invest more than the cash they have
and individuals can purchase homes and other utilities without having to save the entire amount in advance.
Banks and other financial service providers give this credit facility to all stakeholders.
Liquidity provision – Banks and other financial providers protect businesses and individuals against sudden
cash needs. Banks provide the facility of demand deposits which the business or individual can withdraw at any
time. Similarly, they provide credit and overdraft facility to businesses. Moreover, banks and financial
institutions offer to buy or sell securities as per need and often in large volumes to fulfil sudden cash
requirements of the stakeholders.
Risk management services – Finance provides risk management from the risks of financial markets and
commodity prices by pooling risks. Derivative transactions enable banks to provide this risk management.
These services are extremely valuable even though they receive a lot of flak due to excesses during financial
crisis.

Savings-investment relationship
The above three major functions are important for the running and development activities of any economy.
Apart from these functions, an economy’s growth is boosted by the savings-investment relationship. When there
are sufficient savings, only then can there be sizeable investment and production activity. This savings facility is
provided by financial institutions through attractive interest schemes. The money saved by the public is used by
the financial institutions for lending to businesses at substantial interest rates. These funds allow businesses to
increase their production and distribution activities.

Growth of capital markets

Another important work of finance is to boost growth of capital markets. Businesses need two types of capital –
fixed and working. Fixed capital refers to the money needed to invest in infrastructure such as building, plant
and machinery. Working capital refers to the money needed to run the business on a day-to-day basis. This may
refer to the ongoing purchase of raw materials, cost of finishing goods and transport of finished goods to stores
or customers. The financial system helps in raising capital in the following ways:
Fixed capital – Businesses issue shares and debentures to raise fixed capital. Financial service providers, both
public and private, invest in these shares and debentures to make profits with minimal risk.
Working capital – Businesses issue bills, promissory notes etc. to raise short term loans. These credit
instruments are valid in the money markets that exist for this purpose.

Foreign exchange markets

In order to support the export and import businessmen, there are foreign exchange markets whereby businesses
can receive and transmit funds to other countries and in other currencies. These foreign exchange markets also
enable banks and other financial institutions to borrow or lend sums in other currencies. Moreover, financial
institutions can invest and reap profits from their short term idle money by investing in foreign exchange
markets. Governments also meet their foreign exchange requirements through these markets. Hence, foreign
exchange markets impact the growth and goodwill of an economy in the international markets.

Government securities
Governments use the financial system to raise funds for both short term and long term fund requirements.
Governments issue bonds and bills at attractive interest rates and also provide tax concessions. Budget gaps are
taken care of by government securities. Thus, capital markets, foreign exchange markets and government
securities markets are essential for helping businesses, industries and governments to carry out development and
growth activities of the economy.

Infrastructure and growth

The economic growth depends on the growth of infrastructural facilities of the country. Key industries such as
power, coal, oil determine the growth of other industries. These infrastructure industries are funded by the
finance system of the country. The capital requirement for infrastructure industries is huge. Raising such a huge
amount is difficult for private players and hence, traditionally, governments have taken care of infrastructure
projects solely. However, the economic liberalization policy led to the private sector participation in
infrastructure industries. Development and Merchant banks such as IDBI in India help fund these activities for
the private sector.

Trade development
Trade is the most important economic activity. Both, domestic and international trade are supported by the
financial system. Traders need finance which is provided by the financial institutions. Financial markets on the
other hand help discount financial instruments such as promissory notes and bills. Commercial banks finance
international trade through pre and post-shipment funding. Letters of credit are issued for importers, thereby
helping the country to earn important foreign exchange.

Employment growth
Financial system plays a key role in employment growth in an economy. Businesses and industries are financed
by the financial systems which lead to growth in employment and in turn increases economic activity and
domestic trade. Increase in trade leads to increase in competition which leads to activities such as sales and
marketing which further increases employment in these sectors.

Venture capital
Increase in venture capital or investment in ventures will boost growth in economy. Currently, the extent of
venture capital in India is less. It is difficult for individual companies to invest in ventures directly due to the
risk involved. It is mostly the financial institutions that fund ventures. An increase in the number of financial
institutions supporting ventures will boost this segment.

Balances economic growth

The growth of different sectors of an economy is balanced through the financial system. There are primary,
secondary and tertiary sector industries and all need sufficient funds for growth. The financial system of the
country funds these sectors and provides sufficient funds for each sector – industrial, agricultural and services.
Thus, finance plays a key role in the development of any economy and no economy can run successfully
without a sound financial system.
Please explain how financial markets may affect economic performance.

January 2005
Great question. The simple response is that well-developed, smoothly operating financial markets play an
important role in contributing to the health and efficiency of an economy. There is a strong positive relationship
between financial market development and economic growth. For example, in Chapter 1 of their 2001 book,
Financial Structure and Economic Growth, editors Demirgüç-Kunt and Levine concluded:
In particular, researchers have provided additional findings on the finance-growth nexus and have offered a
much bolder appraisal of the causal relationship; firm-level, industry-level, and cross-country studies all
suggest that the level of financial development exerts a large, positive impact on economic growth.
Financial markets help to efficiently direct the flow of savings and investment in the economy in ways that
facilitate the accumulation of capital and the production of goods and services. The combination of well-
developed financial markets and institutions, as well as a diverse array of financial products and instruments,
suits the needs of borrowers and lenders and therefore the overall economy.
What are financial markets and institutions?
Financial markets (such as those that trade stocks or bonds), instruments (from bank CDs to futures and
derivatives), and institutions (from banks to insurance companies to mutual funds and pension funds) provide
opportunities for investors to specialize in particular markets or services, diversify risks, or both. As noted by
Demirgüç-Kunt and Levine, together financial markets and financial institutions contribute to economic growth;
the relative mix of the two does not appear to be an important factor in growth.
Large financial markets with lots of trading activity provide more liquidity for market participants than thinner
markets with few available securities and participants and thus limited trading opportunities. The U.S. financial
system is generally considered to be the most well developed in the world. Daily transactions in the financial
markets—both the money (short term, a year or less) and capital (over a year) markets—are huge. Many
financial assets are liquid; some may have secondary markets to facilitate the transfer of existing financial assets
at a low cost. Table I provides a list of several well-known U.S. financial markets, ranked by outstanding assets
or liabilities as of 2004.
The U.S. also has a well-developed financial services industry. It includes such familiar types of financial
institutions as banks, pension funds, mutual funds, and insurance companies. Table II provides a list of several
categories of U.S. financial institutions, ranked by outstanding assets as of 2004.
Economic growth is a goal that every country strives to achieve. Even developed countries need to grow and
increase their Gross Domestic product. Financial markets are the engine that drives this vehicle to economic
growth. This paper discusses the role of financial institution in economic growth in Malawi. As a small
landlocked country, Malawi needs a strong financial system to help its stunting economy to grow. The paper
looks at the seven roles of financial markets which are were (1) Resource Mobilisation, (2)credit creation, (3)
provision of wealth (4) solution to liquidity problems, (5) payments function (6) risk and protection and (7)
policy formulation. These roles have great impacts on investment, government spending, the RBM policies
which focus on expansionary and contractionary policies and how financial markets help the institution to make
such decisions. The paper also discusses the financial institutions that help to run the financial markets in
Malawi. These institutions are the Reserve Bank of Malawi, the Malawi stock exchange, depository institutions,
foreign exchange bureaus, finance companies, investment companies, contractual saving intermediaries and
securities firms.
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5. What is The Role Of Capital Market in Economic Development?
What is The Role Of Capital Market in Economic Development?
July 3, 2019
An effective financial sector is vital for economic growth in a modern new-age digitized economy. It pools
together the domestic savings to mobilize and provide capital for productive growth-related projects and
industries. In the absence of such a system, most industries would never be able to grow and would fail for want
of funds and thus growth and development would be directly affected and impacted.
The basic channels connecting the economy to the capital market discussed in any Capital market Course is
thus also connected to the economic growth, growth, and development of industries or facilities and economy
measures for funding such growth.
Such financing methods are:
Direct financing: Here the agents facing a money deficit interact and deal with those agents with a monetary
surplus without intermediaries.
Indirect financing: In this method intermediaries function between the two agents and ensure the fund’s needs
are catered to. Such intermediaries could take the form of banks, insurance companies, investment funds,
NBFCs, pension funds and such. They not only provide funds but also securitize investments and purchase of
assets in a major move to better capital demands.
Any capital market course should begin with answering questions related to what the Debt CM actually is.
Most companies prefer to turn to DCM markets when they need funds for expansion but do not want to trade in
their private ownership tag.
The DCM market is ideal since they deal with the sale of units called bonds. For the investors in bonds, this is a
fixed-income investment where on redemption they get their money back along with attractive interest. The
investment is low-risk and earns a fixed interest rate. Such funds are a short-term boon for firms needing funds
for expansion without the dilution of ownership. It’s a win-win deal for both.
The different types of bonds:
The bond types are risk-of-default related and can be categorized as
 The government bonds are at low-risk for default.
 The companies issued investment bonds also fairly safe from default.
 The bonds that are high-yield susceptible to risk and hence offering a better rate of returns.
The DCM also handles debt-equity issuances for several purposes. At times on reaching debt-maturity bonds
are refinanced or reissued. At other times the expanding company may be looking to reduce cost-to-company
capital.
Role of the capital markets as economic growth drivers:
The capital market is an effective tool to drive economic development and growth.
Here’s why…?
The capital market effectively transfers monetary purchase power from surplus funds of investors to
those with deficits for a fixed period in exchange for greater future purchasing power. They play a major role
in recapitalizing and privatization of large infrastructure projects and industries. The privatization of banks,
insurance companies, real-estate sector, etc is a good example of this strategy.
Capital market channelizes and increases long-term savings to fulfill the monetary demands of companies
with deficit funds to form long-term investments like pension funds, funeral expense covers, individual fixed
investments, etc. This is especially useful for companies who wish to avail funds for a small price without going
in for a change in ownership rights from private holding to equity holding etc.
Capital markets help provide equity for infrastructure development needs which tremendously impacts and
provides for water and sewer systems, development of roads, energy, housing, telecommunications, socio-
economic benefits provisions, public transport and many more. Governmental bonds are the present means of
financing such needs and provide the investors with low-risk appetites a guaranteed pay-back after the fixed
term with an attractive interest rate.
Empowers the government strategy of social inclusion and economic growth through providing platforms
and thrust areas wherein industries can compete globally, forge private-public partnerships, use capital
efficiently, increase domestic productivity and spur growth, global integration, and better economic
development.
The capital market mechanism provides for regulating the markets, covering risks according to appetites,
ensures good investor returns and prevents complete decay of stock market policies.
Conclusion:
The DCM and ECM offer various job roles in the banking sector for capital markets. The capital market course
at Imarticus Learning is specially designed to help you hit the ground running.
It has modules for resume building, personality development and interview facing techniques besides a robust
financial Capital Market Tutorial curriculum. You will need classroom training, mentorship, certification and
experience to help you stand out from the many IB career aspirants. Enroll immediately at Imarticus today.
For more details, in brief, you can also contact us through the Live Chat Support system or can visit one of our
training centers based in – Mumbai, Thane, Pune, Chennai, Hyderabad, Delhi, Gurgaon, and Ahmedabad.
Capital and money markets
Capital and money markets are the platform where governments and numerous corporations raise money from
stakeholders in return for the promise of future revenues.
Buy These Notes in PDF Format
1. Capital market: Capital market is the market where investment instruments like bonds, equities and
mortgages are traded. It is a market which deals in long-term loans. It supplies industry with fixed and working
capital and finances medium-term and long-term borrowings of the central, state and local governments. Major
function of this market is to make investment from stockholders who have excess funds to the ones who are
running a scarcity. The capital market provides both long term and overnight funds.
In financial literature, bulk of economists elaborated the term, capital market. Gold Smith described "the
capital market of a modern economy has two basic functions; first the allocation of savings among users and
investments; second the facilitation of the transfer of the existing assets, tangible and intangible among
individual economic units." According to Grant, Capital market in a broad sense as "a series of channels
through which the savings of the community are made available for industrial and commercial enterprises and
for public authorities. It embraces not only the system by which the public takes up long term securities directly
or through intermediary but also the elaborate network of institutions responsible for short term and medium
term lending."
Such explanation indicate that capital market as the market for long term funds. The capital market provides
long term debt and equity finance for the government and the corporate sector. The capital market also enables
the dispersion of business ownership and reallocation of financial resources among corporate and industries.
Various types of financial instruments that are traded in the capital markets are as under:
o Equity instruments
o Credit market instruments
o Insurance instruments
o Foreign exchange instruments
o Hybrid instruments
o Derivative instruments
There are two types of capital market which include Primary market and Secondary market
Primary Market: Primary Market is that market in which shares, debentures and other securities are sold for
the first time to collect long-term capital. This market is concerned with new issues. Therefore, the primary
market is also called new issue market. In this market, the flow of funds is from savers to borrowers
(industries), therefore, it helps directly in the capital formation of the country. The money collected from this
market is normally used by the companies to improve the plant, machinery and buildings, for extending
business, and for establishing new business unit.

Features of Primary Market:

 1. The first characteristic of the primary market is that it is related with the new issues. Whenever a
company issues new shares or debentures, it is known as Initial Public Offer.
2. Primary market is not the name of any particular place but the activity of bringing in new issues.
3. It has several Methods of Floating Capital. Methods of raising capital in the primary market are as
follows.
Public Issue: In this technique, the company issues a prospectus and invites the general public to
purchase shares or debentures.
Offer for Sale: Under this process, initially the new securities are offered to an intermediary (generally
firms of stock brokers) at a fixed price. They further resell the same to the general public. The benefit of
this method is that the issuing company feels free from the tedious work of making a public issue.
Private Placement: This process entails that the company sells securities to the institutional investors or
brokers instead of selling them to the general public. They, in turn, sell these securities to the selected
clients at a higher price. This method is considered as it is a cheaper method to raise funds as compared
to a public issue.
Right Issue: This technique is used by companies who have already issued their shares. When an
existing company issues new shares, first of all it invites its existing shareholders. This issue is called
the right issue. In this case, the shareholder has the right either to accept the offer for himself or assign a
part or all of his right in favour of another person.
Electronic Initial Public Issue (e-IPOs): Under this process, companies issue their securities through the
electronic medium (i.e. internet). The company issuing securities through this medium enters into a
contract with a Stock Exchange.
4. It Comes before Secondary Market: The transactions are first made in the primary market. The turn of
the secondary market comes later.
Benefits of Primary Market:
1. Manipulation of price is smaller so investment in primary market is safer.
2. No need to time the market the investors get the share at the same price.
3. It is secure because of primary research data is collected directly by the organization that deploys the
research
4. The company receives the money and issues new security certificates to the investors.
Actions in the Primary Market:
1. Appointment of merchant bankers
2. Pricing of securities being issued
3. Communication/ Marketing of the issue
4. Information on credit risk
5. Making public issues
6. Collection of money
7. Minimum subscription
8. Listing on the stock exchange(s)
 9. Allotment of securities in demat / physical mode
10. Record keeping
Secondary market: The secondary market is that market in which the buying and selling of the formerly issued
securities is done. The transactions of the secondary market are usually done through the medium of stock
exchange. The main aim of the secondary market is to create liquidity in securities.
Features of Secondary Market:
o It Creates Liquidity
o It Comes After Primary Market
o It Has A Particular Place
o It Boosts New Investments
Benefits of Secondary Market:
1. The investors can recover their investments to a certain extent, provided their economic status undergoes
a change.
2. In such cases the investors may refrain from making long term investments.
3. Investor can get large interest by invest for a longer period of time.
Activities in the Secondary Market:
1. Trading of securities
2. Risk management
3. Clearing and settlement of trades
4. Delivery of securities and funds
Significance of capital market:
The capital market has significant role in mobilising saving and contribute into productive investments for the
development of commerce and industry. The capital market helps in capital formation and economic
development of the country.
Economists stated that the capital market acts as a strong link between savers and investors. The savers are
lenders of funds while investors are borrowers of funds. The savers who do not spend all their income are
called. �Surplus units� and the borrowers are known as �deficit units�. The capital market is the
transmission device between surplus units and deficit units. It is a channel through which surplus units lend
their surplus funds to deficit units.
Funds flow into the capital market from individuals and financial mediators which are absorbed by business,
industry and government. It allows the movement of stream of capital to be used more effectively and
profitability to boost the national income.
The capital market provides incentives to savers in the form of interest or dividend and transfers funds to
investors. Thus it leads to capital formation. Actually, the capital market provides a market tool for those who
have savings and to those who need funds for productive investments. It diverts resources from inefficient and
unproductive channels such as gold, jewellery, real estate, conspicuous consumption to productive investments.
An organized and matured capital market comprising expert banking and non-banking intermediaries brings
strength in the value of stocks and securities. It does so by providing capital to the needy at reasonable interest
rates and helps in reducing speculative activities.
The capital market boosts economic development. The various institutions which operate in the capital market
give quantities and qualitative direction to the flow of funds and bring rational allocation of resources. They do
so by changing financial assets into productive physical assets. This leads to the development of business and
industry through the private and public sector, thereby bringing economic progress.
In an underdeveloped country where capital is limited, the absence of a developed capital market is a greater
interference to capital formation and economic development. Even though the people are poor, yet they do not
have any inducements to save. Others who save, they invest their savings in wasteful and unproductive
channels, such as gold, jewellery, real estate, conspicuous consumption, etc. Such countries can encourage
people to save more by establishing banking and non-banking financial institutions for the existence of a
developed capital market. Such a market can go a long way in providing a link between savers and investors,
thereby leading to capital formation and economic progress.
The capital market in India is a market for securities, where companies and governments can increase long term
funds. The Indian Equity Market is fully controlled by two major stock exchanges -National Stock Exchange of
India Ltd. (NSE) and The Bombay Stock Exchange (BSE). The benchmark indices of the two exchanges - Nifty
of NSE and Sensex of BSE are closely monitored by the investors.
In Indian capital market, there are following members which smoothly operate functions of market:
1. India Capital Markets Pvt. Ltd.- Members NSE, BSE and NSDL,
2. ICM Commodities Pvt Ltd. � Members MCX, NCDEX
3. SEBI Registered PMS

The functions of the Indian Capital Market: These are as follows:

1. Publicise information efficiently for enabling participants to develop an informed opinion about
investment, disinvestments, reinvestment, or holding a particular financial asset.
2. Allowing quick valuation of financial instruments-both equity and debt.
3. Providing insurance against market risk or price risk through derivative trading and default risk through
investment protection fund.
4. Empower more participation by enhancing the width of the market by encouraging participation through
networking institutions and associating individuals.
5. Provide operational efficiency through:
a. Simplified transaction procedure.
b. Lowering settlement timings.
c. Lowering transaction costs.
6. Develop integration among:
a. Real sector and financial sector.
 b. Equity and debt instruments.
c. Long-term and short-term funds.
d. Long-term and short-term interest costs.
e. Private sector and government sector.
f. Domestic funds and external funds.
7. Direct the flow of funds into efficient channels through investment, disinvestments, and reinvestment.
The capital market boosts economic growth by mobilizing the savings of the economic sectors and directing the
same towards channels of prolific uses. This is enabled through the following:
1. The Industrial Financial Corporation of India (IFC).
2. The Industrial Credit and Investment Corporation of India (ICICI).
3. The Refinance Corporation of India (RFC).
4. The State Financial Development Corporations (SFCs).
5. National Industrial Development Corporation (NIDC).
6. The State Industrial Development Corporation (SIDCs).
7. National Small Industries Corporation (NSIC).
8. Industrial Development Bank of India (IDBI).
9. Life Insurance Corporation of India (LIC).
10. Nationalized Commercial Banks (NCBs).
11. Merchant Banking Institutions (MBIs).
12. National Industrial Reconstruction Corporation of India (NIRC).
13. The Credit Guarantee Corporation of India (CGC).
14. Unit Trust of India (UTI)
Above members are mainly financial institutions which offer the liquidity that is required to push the machinery
of the Capital Market.
2. Money market:
Money market is a tool that manage the lending of short term funds (less than one year). It is a subdivision of
the financial market in which financial instrument with high liquidity and very short maturities are traded. There
are several money market instruments, including treasury bills, commercial paper, bankers' acceptances,
deposits, certificates of deposit, bills of exchange, repurchase agreements, federal funds, and short-lived
mortgage-, and asset-backed securities.
Various institutions and economists defined money market in different ways. According to the RBI, "The
money market is the centre for dealing mainly of short character, in monetary assets; it meets the short term
requirements of borrowers and provides liquidity or cash to the lenders. It is a place where short term surplus
investible funds at the disposal of financial and other institutions and individuals are bid by borrowers, again
comprising institutions and individuals and also by the government." Nadler and Shipman stated that "A money
market is a mechanical device through which short term funds are loaned and borrowed through which a large
part of the financial transactions of a particular country or world are degraded. A money market is distinct from
but supplementary to the commercial banking system." In money market, transactions of huge amount and high
volume take place. It is controlled by few big players. In fact, there are two categories of money market in India
that include organized sector and unorganized sector.
Classification of money market

Unorganized sector include chit funds, money lenders and indigenous banks.
Organized sector include commercial banks in India both public sector and private sector and foreign banks In
money market, main players are Government, RBI, DFHI (Discount and finance House of India) Banks, Mutual
Funds, Corporate Investors, Provident Funds, PSUs (Public Sector Undertakings), NBFCs (Non-Banking
Finance Companies).
Major functions of money market:
1. It furnishes to the short-term financial needs of the economy.
2. It helps the RBI in effective implementation of monetary policy.
3. It provides mechanism to achieve equilibrium between demand and supply of short term funds.
4. It helps in allocation of short term funds through inter-bank transactions and money market Instruments.
5. It also provides funds in non-inflationary way to the government to meet its deficits.
6. It expedites economic growth.
Feature of money market:
o Constituents of Money Market
o Heterogeneous Market
o Dealers of Money Market
o Short-term Loans
o Different from Capital Market
o Association with Big Cities
o Change with Place and Time
Characteristics of A Developed Money Market:
o Existence of Central Bank
o Highly organized commercial Banking System
o Existence of sub-markets
o Integrated structure of money market
o Availability of proper credit instruments
o Adequacy and Elasticity of funds
 o International attraction
o Uniformity of interest rates
o Stability of prices
o Highly developed Industrial system
Importance of Money Market:
There is more significance of money market in financing Industry, financing trade, self-sufficiency of banks and
effective implementation of monetary policy. Money market encourages economic growth and help to
government for proper allocation of resources.
Instrument of Money Market are treasury bills, commercial bills, money at call, promissory notes.
Some new instruments in money market:

Disadvantages of Indian Money Market:

Though the Indian money market is reflected as the progressive money market among developing countries but
it still suffers from several drawbacks. These defects limit the productivity of market.
Absence of Integration: The Indian money market is basically divided into the Organized and Unorganized
Sectors. The organized sector comprises the legal financial institutions backed by the RBI. The unorganized
statement of it includes various institutions such as indigenous bankers, village money lenders, traders. There is
lack of proper incorporation between these two segments.
Multiple rate of interest: In the Indian money market, particularly the banks, there are variable rates of interests.
These rates vary for lending, borrowing, government activities, etc. Many rates of interests create confusion
among the investors.
Inadequate Funds or Resources: The Indian economy with its seasonal structure suffer from frequent shortage
of financial recourse. Lower income, lower savings, and lack of banking habits among people are some of the
reasons for it.
Shortage of Investment Instruments: In the Indian money market, various investment instruments such as
Treasury Bills, Commercial Bills, Certificate of Deposits, Commercial Papers, etc. are used. But taking into
account the size of the population and market these instruments are insufficient.
Shortage of Commercial Bill: It is observed that in Indian money market, as many banks keep large funds for
liquidity purpose, the use of the commercial bills is very limited. Correspondingly since a large number of
transactions are preferred in the cash form, the scope for commercial bills are limited.
Lack of Systematized Banking System: In India, though there is huge network of commercial banks, still the
banking system suffers from major flaws such as the NPA, huge losses, and poor efficiency. The absence of the
organized banking system is major problem for Indian money market.
Less number of Dealers: There are less dealers in the short-term assets who can act as mediators between the
government and the banking system. The less number of dealers leads to the slow contact between the end
lender and end borrowers.
Money market is differentiated from capital market on the grounds of the maturity period, credit instruments
and the institutions.
1. Maturity Period: The money market is involved in the lending and borrowing of short-term finance
whereas the capital market deals in the lending and borrowing of long-term finance.
2. Credit Instruments: The main credit mechanisms of the money market are call money, collateral loans,
acceptances, bills of exchange. In contrast, the main instruments used in the capital market are stocks,
shares, debentures, bonds, securities of the government.
3. Nature of Credit Instruments: The credit instruments allocated in the capital market are more
heterogeneous as compared to money market. Some homogeneity of credit instruments is needed for the
operation of financial markets. Too much diversity creates problems for the investors.
4. Institutions: Important institutions operating in the money market are central banks, commercial banks,
acceptance houses, nonbank financial institutions, and bill brokers. Important institutions of the capital
market are stock exchanges, commercial banks and nonbank institutions, such as insurance companies,
mortgage banks, and building societies.
To summarize, Capital Market is so beneficial to generate wealth through investment or trade in financial
instruments. Here investor can reduce the risk by taking advice or help from any market analyst. Money market
signifies inter-bank market where the banks borrow and lend among themselves to meet the short term credit
and deposit needs of the economy. The money market is a component of financial market which deals in the
borrowing and lending of short term loans generally for a period of less than or equal to 365 days. It is a device
to clear short term financial transactions in an economy.
Money Market vs. Capital Market: What's the Difference?
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BY CHRISTINA MAJASKI

Updated Apr 19, 2019

Money Market vs. Capital Market: An Overview
A financial market brings buyers and sellers together to trade in financial assets such as stocks, bonds,
commodities, derivatives, and currencies. The purpose of a financial market is to set prices for global trade,
raise capital, and transfer liquidity and risk. Although there are many components to a financial market, two of
the most commonly used are money markets and capital markets.
Government and corporate entities use money markets as a means for borrowing and lending in the short
term, usually for assets being held for up to a year. Conversely, capital markets are more frequently used for
long-term assets, which are those with maturities of greater than one year.
Capital markets include the equity (stock) market and debt (bond) market. Together, money markets and capital
markets comprise a large portion of the financial market and are often used together to manage liquidity and
risks for companies, governments, and individuals.
Volume 75%
2:02
Financial Markets: Capital vs. Money Markets
Money Market
The money market is often accessed alongside the capital markets. While investors are willing to take on more
risk and have the patience to invest in capital markets, money markets are a good place to "park" funds that are
needed in a shorter period, usually one year or less. The financial instruments used in capital markets include
stocks and bonds, but the instruments used in the money markets include deposits, collateral loans, acceptances,
and bills of exchange. Institutions operating in money markets are central banks, commercial banks, and
acceptance houses, among others.
Money markets provide a variety of functions for individual, corporate, or government entities. Liquidity is
often the main purpose for accessing money markets. When short-term debt is issued, it's often to cover
operating expenses or working capital for a company or government and not for capital improvements or large-
scale projects. Companies may want to invest funds overnight and look to the money market to accomplish this,
or they may need to cover payroll and look to the money market to help.
The money market plays a key role in assuring companies and governments maintain the appropriate level of
liquidity on a daily basis, without falling short and needing a more expensive loan or without holding excess
funds and missing the opportunity of gaining interest on funds.
Investors, on the other hand, use money markets to invest funds in a safe manner. Unlike capital markets,
money markets are considered low risk; risk-averse investors are willing to access them with the anticipation
that liquidity is readily available. Those individuals living on a fixed income often use money markets because
of the safety associated with these types of investments.

Together, money markets and capital markets are used to manage liquidity and risks for companies,
governments, and individuals.
Capital Markets
Capital markets are perhaps the most widely followed markets. Both the stock and bond markets are closely
followed, and their daily movements are analyzed as proxies for the general economic condition of the world
markets. As a result, the institutions operating in capital markets—stock exchanges, commercial banks, and all
types of corporations, including non-bank institutions such as insurance companies and mortgage banks—are
carefully scrutinized.
The institutions operating in the capital markets access them to raise capital for long-term purposes, such as for
a merger or acquisition, to expand a line of business or enter into a new business, or for other capital
projects. Entities that are raising money for these long-term purposes come to one or more capital markets. In
the bond market, companies may issue debt in the form of corporate bonds, while both local and
federal governments may issue debt in the form of government bonds.
Similarly, companies may decide to raise money by issuing equity on the stock market. Government entities are
typically not publicly held and, therefore, do not usually issue equity. Companies and government entities that
issue equity or debt are considered the sellers in these markets.
The buyers (or the investors) buy the stocks or bonds of the sellers and trade them. If the seller (or issuer) is
placing the securities on the market for the first time, then the market is known as the primary market.
Conversely, if the securities have already been issued and are now being traded among buyers, this is done on
the secondary market. Sellers make money off the sale in the primary market, not in the secondary market,
although they do have a stake in the outcome (pricing) of their securities in the secondary market.
The buyers of securities in the capital market tend to use funds that are targeted for longer-term investment.
Capital markets are risky markets and are not usually used to invest short-term funds. Many investors access the
capital markets to save for retirement or education, as long as the investors have lengthy time horizons.
The Bottom Line
There are both differences and similarities between capital and money markets. From the issuer or seller's
standpoint, both markets provide a necessary business function: maintaining adequate levels of funding. The
goal for which sellers access each market varies depending on their liquidity needs and time horizon.
Similarly, investors or buyers have unique reasons for going to each market: capital markets offer higher-risk
investments, while money markets offer safer assets; money market returns are often low but steady, while
capital markets offer higher returns. The magnitude of capital market returns often has a direct correlation to the
level of risk, but that's not always the case.
Although markets are deemed efficient in the long run, short-term inefficiencies allow investors to capitalize on
anomalies and reap higher rewards that may be out of proportion to the level of risk. Those anomalies are
exactly what investors in capital markets try to uncover. Although money markets are considered safe, they
have occasionally experienced negative returns. Inadvertent risk, although unusual, highlights the risks inherent
in investing—whether putting money to work for the short-term or long-term in money markets or capital
markets.
Role of financial system in economic development of a country

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Role of financial system in economic development of a country
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RELATIONSHIP BETWEEN FINANCIAL SYSTEM AND ECONOMIC DEVELOPMENT
The development of any country depends on the economic growth the country achieves over a period of time.
Economic growth deals about investment and production and also the extent of Gross Domestic Product in a
country. Only when this grows, the people will experience growth in the form of improved standard of living,
namely economic development.
ROLE OF FINANCIAL SYSTEM IN ECONOMIC DEVELOPMENT OF A COUNTRY
The following are the roles of financial system in the economic development of a country.
Savings-investment relationship
To attain economic development, a country needs more investment and production. This can happen only when
there is a facility for savings. As, such savings are channelized to productive resources in the form of
investment. Here, the role of financial institutions is important, since they induce the public to save by offering
attractive interest rates. These savings are channelized by lending to various business concerns which are
involved in production and distribution.
Financial systems help in growth of capital market
Any business requires two types of capital namely, fixed capital and working capital. Fixed capital is used for
investment in fixed assets, like plant and machinery. While working capital is used for the day-to-day running
of business. It is also used for purchase of raw materials and converting them into finished products.
 Fixed capital is raised through capital market by the issue of debentures and shares. Public and other
financial institutions invest in them in order to get a good return with minimized risks.
 For working capital, we have money market, where short-term loans could be raised by the
businessmen through the issue of various credit instruments such as bills, promissory notes, etc.
Foreign exchange market enables exporters and importers to receive and raise funds for settling transactions. It
also enables banks to borrow from and lend to different types of customers in various foreign currencies. The
market also provides opportunities for the banks to invest their short term idle funds to earn profits. Even
governments are benefited as they can meet their foreign exchange requirements through this market.
Government Securities market
Financial system enables the state and central governments to raise both short-term and long-term funds through
the issue of bills and bonds which carry attractive rates of interest along with tax concessions. The budgetary
gap is filled only with the help of government securities market. Thus, the capital market, money market along
with foreign exchange market and government securities market enable businessmen, industrialists as well as
governments to meet their credit requirements. In this way, the development of the economy is ensured by the
financial system.
Financial system helps in Infrastructure and Growth
Economic development of any country depends on the infrastructure facility available in the country. In the
absence of key industries like coal, power and oil, development of other industries will be hampered. It is here
that the financial services play a crucial role by providing funds for the growth of infrastructure industries.
Private sector will find it difficult to raise the huge capital needed for setting up infrastructure industries. For a
long time, infrastructure industries were started only by the government in India. But now, with the policy of
economic liberalization, more private sector industries have come forward to start infrastructure industry. The
Development Banks and the Merchant banks help in raising capital for these industries.
Financial system helps in development of Trade
The financial system helps in the promotion of both domestic and foreign trade. The financial institutions
finance traders and the financial market helps in discounting financial instruments such as bills. Foreign trade is
promoted due to per-shipment and post-shipment finance by commercial banks. They also issue Letter of Credit
in favor of the importer. Thus, the precious foreign exchange is earned by the country because of the presence
of financial system. The best part of the financial system is that the seller or the buyer do not meet each other
and the documents are negotiated through the bank. In this manner, the financial system not only helps the
traders but also various financial institutions. Some of the capital goods are sold through hire purchase and
installment system, both in the domestic and foreign trade. As a result of all these, the growth of the country is
speeded up.
Employment Growth is boosted by financial system
The presence of financial system will generate more employment opportunities in the country. The money
market which is a part of financial system, provides working capital to the businessmen and manufacturers due
to which production increases, resulting in generating more employment opportunities. With competition
picking up in various sectors, the service sector such as sales, marketing, advertisement, etc., also pick up,
leading to more employment opportunities. Various financial services such as leasing, factoring, merchant
banking, etc., will also generate more employment. The growth of trade in the country also induces employment
opportunities. Financing by Venture capital provides additional opportunities for techno-based industries and
employment.
Venture Capital
There are various reasons for lack of growth of venture capital companies in India. The economic development
of a country will be rapid when more ventures are promoted which require modern technology and venture
capital. Venture capital cannot be provided by individual companies as it involves more risks. It is only through
financial system, more financial institutions will contribute a part of their investable funds for the promotion of
new ventures. Thus, financial system enables the creation of venture capital.
Financial system ensures Balanced growth
Economic development requires a balanced growth which means growth in all the sectors simultaneously.
Primary sector, secondary sector and tertiary sector require adequate funds for their growth. The financial
system in the country will be geared up by the authorities in such a way that the available funds will be
distributed to all the sectors in such a manner, that there will be a balanced growth in industries, agriculture and
service sectors.
Financial system helps in fiscal discipline and control of economy
It is through the financial system, that the government can create a congenial business atmosphere so that
neither too much of inflation nor depression is experienced. The industries should be given suitable protection
through the financial system so that their credit requirements will be met even during the difficult period. The
government on its part, can raise adequate resources to meet its financial commitments so that economic
development is not hampered. The government can also regulate the financial system through suitable
legislation so that unwanted or speculative transactions could be avoided. The growth of black money could
also be minimized.
Financial system’s role in Balanced regional development
Through the financial system, backward areas could be developed by providing various concessions or sops.
This ensures a balanced development throughout the country and this will mitigate political or any other kind of
disturbances in the country. It will also check migration of rural population towards towns and cities.
Role of financial system in attracting foreign capital
Financial system promotes capital market. A dynamic capital market is capable of attracting funds both from
domestic and abroad. With more capital, investment will expand and this will speed up the economic
development of a country.
Financial system’s role in Economic Integration
Financial systems of different countries are capable of promoting economic integration. This means that in all
those countries, there will be common economic policies, such as common investment, trade, commerce,
commercial law, employment legislation, old age pension, transport co-ordination, etc. We have a standing
example of European Common Market which has gone to the extent of creating a common currency,
representing several countries in Western Europe.
Role of financial system in Political stability
The political conditions in all the countries with a developed financial system will be stable. Unstable political
environment will not only affect their financial system but also their economic development.
Financial system helps in Uniform interest rates
The financial system is capable of bringing an uniform interest rate throughout the country by which there will
be balanced movement of funds between centres which will ensure availability of capital for all kinds of
industries.
Financial system role in Electronic development:
Due to the development of technology and the introduction of computers in the financial system, the
transactions have increased manifold bringing in changes for the all round development of the country. The
promotion of World Trade Organization (WTO) has further improved international trade and the financial
system in all its member countries.
Money Market
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Money market is basically that particular section of the finance market wherein finance related instruments,
with very brief maturities and high amount of liquidity are adequately traded. The money market is utilized by
the participants for the purpose of lending and borrowing for a brief period, for a number of days to a little less
than a year. The securities of money market incorporates certificates of deposit that are negotiable, U.S.
Treasury related bills, bankers acceptance, commercial paper, federal funds, repurchase agreements and
municipal notes.
The money market is utilized by a variety of participants, including an entity that raises money by selling off
commercial paper in the market as well as an investor buying certificates of deposits as a safe option for
keeping money for a brief period. The reason why the money market is considered to be safe option for putting
money is because of the fact that the short maturities’ as well as securities’ nature is very liquid. However, there
are certain risks involved in the market, which an investor must be careful about and this includes the risk of
securities default. The money market is an ideal place for the government and large organizations for managing
their short-period cash related requirements.
Money Market Functions
The money market plays a significant role in the economy. It serves as a market for indulging in transactions for
a short period. Therefore, it has to offer the facility of adjusting liquidity for the business corporations, banks,
financial institutions and non-banking financial institutions aside to investors. The important functions of
Money market are:
 Maintaining money related equilibrium i.e. to maintain a balance between supply of and demand for
money for transactions that are done for a short period.
 Money market promotes the growth and development of the economy. This is done by making money
available for different units of economy i.e. small-scale industries and agriculture.
 Money market provides assistance to industry and trade. The Money market does this by providing
sufficient funds to trade as well as industry.
 Helps in implementation of monetary policies.
 Money market provides assistance in formation of capital.
 It also offers non-inflationary finance sources to government. This is achieved by issuing treasury
related bills for the purpose of raising short loans.
Organizational goals and shareholder wealth maximization perspective
Effective financial decision making requires an understanding of the goal(s) of the firm. What
objective(s) should guide business decision making that is, what should management try to achieve for the
owners of the firm? The most widely accepted objective of the firm is to maximize the value of the firm for its
owners, that is, to maximize shareholder wealth. Shareholder wealth is represented by the market price of a
firm’s common stock.
Warren Buffett, CEO of Berkshire Hathaway, an outspoken advocate of the shareholder wealth maximization
objective and a premier “value investor, ” says it this way:
Our long-term economic goal . . . is to maximize the average annual rate of gain in intrinsic business value on a
per -share basis.We do not measure the economic significance or performance of Berkshire by its size; we
measure by per-share progress.
Why is Maximizing Shareholder Wealth a Better goal
The shareholder wealth maximization goal states that management should seek to maximize the present value of
the expected future returns to the owners (that is, shareholders) of the firm. These returns can take the form of
periodic dividend payments or proceeds from the sale of the common stock. Present value is defined as the
value today of some future payment or stream of payments, evaluated at an appropriate discount rate.
The discount rate takes into account the returns that are available from alternative investment opportunities
during a specific (future) time period.
The longer it takes to receive a benefit, such as a cash dividend or price appreciation of the firm’s stock, the
lower the value investors place on that benefit. In addition, the greater the risk associated with receiving a
future benefit, the lower the value investors place on that benefit. Stock prices, the measure of shareholder
wealth, reflect the magnitude, timing, and risk associated with future benefits expected to be received by
stockholders.
Shareholder wealth is measured by the market value of the shareholders’ common stock holdings. Market
value is defined as the price at which the stock trades in the market place, such as on the New York Stock
Exchange. Thus, total shareholder wealth equals the number of shares outstanding times the market price per
share.
The objective of shareholder wealth maximization has a number of distinct advantages. First, this objective
explicitly considers the timing and the risk of the benefits expected to be received from stock ownership.
Similarly, managers must consider the elements of timing and risk as they make important financial decisions,
such as capital expenditures. In this way, managers can make decisions that will contribute to increasing
shareholder wealth.
Second, it is conceptually possible to determine whether a particular financial decision is consistent with this
objective. If a decision made by a firm has the effect of increasing the market price of the firm’s stock, it is a
good decision. If it appears that an action will not achieve this result, the action should not be taken (at least not
voluntarily).
Third, shareholder wealth maximization is an impersonal objective. Stockholders who object to a firm’s policies
are free to sell their shares under more favorable terms (that is, at a higher price) than are available under any
other strategy and invest their funds elsewhere. If an investor has a consumption pattern or risk preference that
is not accommodated by the investment, financing, and dividend decisions of that firm, the investor will be able
to sell his or her shares in that firm at the best price, and purchase shares in companies that more closely meet
the investor’s needs.
For these reasons, the shareholder wealth maximization objective is the primary goal in financial management.
However, concerns for the social responsibilities of business, the existence of other objectives pursued by some
managers, and problems that arise from agency relationships may cause some departures from pure wealth-
maximizing behavior by owners and managers. (These problems are discussed later.) Nevertheless, the
shareholder wealth maximization goal provides the standard against which actual decisions can be judged and,
as such, is the objective assumed in financial management analysis.
Social Responsibility Concerns
Most firms now recognize the importance of the interests of all their constituent groups,
or stakeholders customers, employees, suppliers, and the communities in which they operate and not just the
interests of stockholders. For example, Tucson Electric Power Company (now part of UniSource Energy
Corporation) the public utility providing electric service to the Tucson, Arizona area recognizes responsibilities
to its various constituencies:
 To sustain an optimum return on investment for stockholders
 To be perceived by customers as a provider of quality service
 To demonstrate that employees are our most valuable resource
 To provide corporate leadership to the community
 To operate compatibly with environmental standards and initiate programs that are sensitive to
environmental issues [community]
Tucson Electric Power sees no conflict between being a good citizen and running a successful business.
A wide diversity of opinion exists as to what corporate social responsibility actually entails. The concept is
somewhat subjective and is neither perceived nor applied uniformly by all firms. As yet, no satisfactory
mechanism has been suggested that specifies how these social responsibility commitments can be balanced with
the interests of the owners of the firm. However, in most instances, a manager who takes an appropriate long-
term perspective in decision making, rather than focusing only on short -term accounting profits, will recognize
responsibility to all of a firm’s constituencies and will help lead the company to the maximization of value for
shareholders.
Divergent Objectives
The goal of shareholder wealth maximization specifies how financial decisions should be made. In practice,
however, not all management decisions are consistent with this objective. For example, Joel Stern and Bennett
Stewart have developed an index of managerial performance that measures the success of managers in
achieving a goal of shareholder wealth maximization.9 Their performance measure, called Economic Value
Added, is the difference between a firm’s annual after -tax operating profit and its total annual cost of capital.
Many highly regarded major corporations, including Coca-Cola, AT&T, Quaker Oats, Briggs & Stratton, and
CSX, have used the concept. The poor performances of other firms may be due, in part, to a lack of attention to
stockholder interests and the pursuit of goals more in the interests of managers.
In other words, there often may be a divergence between the shareholder wealth maximization goal and
the actual goals pursued by management. The primary reason for this divergence has been attributed
to separation of ownership and control (management) in corporations. Separation of ownership and control has
permitted managers to pursue goals more consistent with their own self -interests as long as they satisfy
shareholders sufficiently to maintain control of the corporation.
Instead of seeking to maximize some objective (such as shareholder wealth), managers “satisfice, ” or seek
acceptable levels of performance, while maximizing their own welfare.
Maximization of their own personal welfare (or utility) may lead managers to be concerned with long-run
survival (job security). The concern for long-run survival may lead managers to minimize (or limit) the amount
of risk incurred by the firm, since unfavorable outcomes can lead to their dismissal or possible bankruptcy for
the firm. Likewise, the desire for job security is cited as one reason why management often opposes takeover
offers (mergers) by other companies. Giving senior managers “golden parachute” contracts to compensate them
if they lose their positions as the result of a merger is one approach designed to ensure that they will act in the
interests of shareholders in merger decisions, rather than in their own interests.
Other firms, such as Panhandle Eastern, International Multifoods, and Ford Motor Company, for example,
expect top managers and directors to have a significant ownership stake in the firm. Panhandle Eastern’s
president was paid entirely in the company’s common shares, 25, 000 per quarter no severance, no retirement
plan, just stock and medical benefits. Ford requires each of its top 80 officers to own common stock in the
company at least equal to their annual salary. As the company’s chairman explained, “I want everyone thinking
about the price of Ford stock when they go to work.”
Agency Problems
The existence of divergent objectives between owners and managers is one example of a class of problems
arising from agency relationships. Agency relationships occur when one or more individuals (the principals)
hire another individual (the agent) to perform a service on behalf of the principals.12 In an agency relationship,
principals often delegate decision-making authority to the agent. In the context of finance, two of the most
important agency relationships are the relationship between stockholders and creditors and the relationship
between stockholders (owners) and managers.
Stockholders and Creditors
A potential agency conflict arises from the relationship between a company’s owners and its creditors. Creditors
have a fixed financial claim on the company’s resources in the form of long -term debt, bank loans, commercial
paper, leases, accounts payable, wages payable, taxes payable, and so on. Because the returns offered to
creditors are fixed whereas the returns to stockholders are variable, conflicts may arise between creditors and
owners.
For example, owners may attempt to increase the riskiness of the company’s investments in hopes of receiving
greater returns. When this occurs, bondholders suffer because they do not have an opportunity to share in these
higher returns. For example, when RJR Nabisco (RJR) was acquired by KKR, the debt of RJR increased from
38 percent of total capital to nearly 90 percent of total capital. This unexpected increase in financial risk caused
the value of RJR’s bonds to decline by nearly 20 percent.
In response to this loss of value, Metropolitan Life Insurance Company and other large bondholders sued RJR
for violating the bondholders’ rights and protections under the bond covenants. In 1991, RJR and Metropolitan
settled the suit to the benefit of Metropolitan. The issue of bondholder rights remains controversial, however. In
order to protect their interests, creditors often insist on certain protective covenants in a company’s bond
indentures.These covenants take many forms, such as limitations on dividend payments, limitations on the type
of investments (and divestitures) the company can undertake, poison puts, 14 and limitations on the issuance of
new debt.
The constraints on the owner-managers may reduce the potential market value of the firm. In addition to these
constraints, bondholders may also demand a higher fixed return to compensate for risks not adequately covered
by bond indenture restrictions.
Stockholders and Managers
Inefficiencies that arise because of agency relationships have been called agency problems. These problems
occur because each party to a transaction is assumed to act in a manner consistent with maximizing his or her
own utility (welfare). The example cited earlier the concern by management for long-run survival (job security)
rather than shareholder wealth maximization is an agency problem. Another example is the consumption of on -
the -job perquisites (such as the use of company airplanes, limousines, and luxurious offices) by managers who
have no (or only a partial) ownership interest in the firm. Shirking by managers is also an agency-related
problem.
In October 2001, Enron Corporation took a $1.01 billion charge related to losses on investments it had made
that went bad. In 1991, the board of Enron permitted its CFO, Andrew Fastow, to set up and run partnerships
that purchased assets from and helped to manage the risk of Enron. Fastow stood to make millions personally.
This conflict-ofinterest arrangement between the board and Enron’s CFO caused the losses cited here and helps
to explain how the company’s stock could decline from a high of nearly $85 in October 2000 to $11 in October
2001. By late November, Enron’s stock traded below $1 per share and in early December, Enron filed for
Chapter 11 bankruptcy protection.
In Enron’s case, the agency conflict between owners and managers was handled poorly. These agency problems
give rise to a number of agency costs, which are incurred by shareholders to minimize agency problems.
Examples of agency costs include
1. Expenditures to structure the organization in such a way as to minimize the incentives for management
to take actions contrary to shareholder interests.
2. Expenditures to monitor management’s actions, such as paying for audits of managerial performance
and internal audits of the firm’s expenditures.
3. Bonding expenditures to protect the owners from managerial dishonesty.
 4. The opportunity cost of lost profits arising from complex organizational structures that prevent
management from making timely responses to opportunities.
A number of different mechanisms are available to reduce the agency conflicts between shareholders and
managers. These include corporate governance, managerial compensation, and the threat of take overs.
Corporate Governance
As a result of recent accounting scandals and perceived excessive executive compensation (relative to company
performance), the Securities and Exchange Commission (SEC), the securities exchanges (NYSE, AMEX,
NASDAQ), The Conference Board (a business research organization), and other experts have made various
proposals concerning how best to deal with the issues of corporate governance.
First, the board of directors of a corporation should have a majority of independent directors. Independent
directors are individuals who are not current or former employees of the company and who have no significant
business ties to the company. Additionally, the committee responsible for nominating members of the board of
directors must be composed only of independent directors.
Further more, the post of chairman of the board of directors should be split from the CEO position or,
alternatively, an independent lead, or presiding, director should chair board meetings. Also, all members of the
audit and compensation committees, must be independent directors. Finally, the company must disclose whether
it has adopted a code of ethics for the CEO and senior financial officers and, if not, explain why it has not done
so.
Many of these proposals have been or are in the process of being implemented by public companies. In addition
to these proposed changes in how corporations govern themselves, the Sarbanes Oxley Act, passed by Congress
in 2002, mandated various changes in the processes used by corporations to report their financial results.
Managerial Compensation
Properly designed compensation contracts can help to align shareholder management conflicts. For example,
providing part of the compensation in the form of stock or options to purchase stock can reduce agency
conflicts. Stock options granted to managers entitle them to buy shares of the company at a particular price
(exercise price). Typically, the options are set at an exercise price greater than the price of the stock at the time
options are granted and can be exercised only after a certain period of time has elapsed.
These conditions are imposed so that managers won’t be tempted to cash in their options immediately and leave
the company. More important to stock value, this is an attempt to align their interests more closely with those of
the shareholders. Many firms, including Disney and Oracle, provide key executives with significant stock
options that increase in value with improvements in the firm’s stock price. Two of the largest payoffs from the
exercise of options were the $706 million received in 2001 by Lawrence Ellison, chairman and CEO of Oracle,
and the $570 million paid in 1998 to Michael Eisner, chairman and CEO of Disney.
Some critics have argued that stock options tend to distort executive decisions by emphasizing short -term
performance and giving them incentives to engage in accounting tricks to inflate the company’s stock price. As
a result, some firms have adopted alternative incentive compensation policies. One plan is to offer “restricted
stock” to company executives. Such stock cannot be sold unless the manager remains with the company for a
stated period of time. Microsoft, for example, stopped issuing stock options in 2003 and instead began offering
restricted stock to its executives (and all other employees). For Microsoft managers, the restricted shares vest,
or can be sold, over a 5 -year period. Another approach is to offer executives “performance shares”, that is,
stock grants based on the company meeting specific performance targets. For example, in 2003 General Electric
(GE) stopped issuing stock options to its CEO and instead offered 250, 000 performance share units.
Each performance share unit was equal to one share of common stock. Half of the performance share units will
vest in 5 years if GE’s cash flow increases at an average rate of 10 percent or more per year. The other half of
the performance share units will vest in 5 years if GE’s shareholder return meets or exceeds the cumulative 5-
year return of companies in the Standard & Poor’s 500 Stock Price Index.15 The potential value of these
performance share units at the time of issue was approximately $7.5 million, which was more than half of the
CEO’s total compensation package.
Threat of Takeovers
Takeovers also can serve as an important deterrent to shareholdermanagement conflicts. The argument goes as
follows: If managers act in their self -interest then share values will be depressed, providing an incentive for
someone to take over the company at a depressed level. The acquirer can then benefit from instituting policies
that are consistent with shareholder wealth maximization, such as eliminating underperforming units and cutting
overhead.
In addition to these mechanisms, we will learn in later chapters that certain corporate financial policies, such as
dividends and capital structure, can also serve to control agency conflicts. Remaining agency problems give rise
to costs that show up as a reduction in the value of the firm’s shares in the marketplace.
The Goals of Shareholder Wealth Maximization
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Twenty Dollar Bills Are Printed At The Bureau of Engraving and Printing
•••
BY ROSEMARY PEAVLER Updated December 24, 2018
Who owns a corporation? Shareholders do. These are the individuals, businesses, and institutions that have an
ownership interest in a company after purchasing shares of that company's stock. Even if your business is a one-
person shop, you are the shareholder because of your invested interest in your company. Because shareholders
own the firm, they are entitled to the profits of the firm.

Shareholder wealth is the appropriate goal of a business firm in a capitalist society. In a capitalist society, there
is private ownership of goods and services by individuals. Those individuals own the means of production to
make money. The profits from the businesses in the economy accrue to the individuals.

Shareholder Wealth Maximization 101

When business managers try to maximize the wealth of their firm, they are actually trying to increase the
company's stock price. As the stock price increases, the value of the firm increases, as well as the shareholders'
wealth.

The Managers of the Firm

People often think that the managers of a firm are the owners. In the case of a small business or partnership, that
might be true (e.g., one owner who also the manager). In a larger business, there may be many levels of
management and staff, and they do not necessarily own the firm. Aside from their salaries and benefits, do they
profit from the business? Only if they own shares of stock in the company. When employees are also
shareholders, they tend to have a greater sense of responsibility to the firm.

Consequently, many companies encourage employees to become shareholders. In fact, some businesses offer
shares of stock to their employees at a discount through an Employee Stock Purchase Plan (ESPP).

Conflicts Between Owners and Managers

Because the managers of a firm are directed and guided by a Board of Directors, and because they do not profit
directly from the firm's goal to maximize shareholder wealth (unless they are also shareholders), conflict can
sometimes arise between stockholders and managers. This conflict is called the agency problem.

Managers serve as agents of the shareholders. If there is an agency problem, it is imperative to find a resolution
as soon as possible to prevent problems within the business that can impede performance.

Social Responsibility
Can a business firm that is trying to maximize the wealth of their shareholders also be socially responsible?
Absolutely! Will they really care about the welfare of society as they try to increase their stock price? Again,
the answer is yes.

Consider the 2008 Great Recession and one of its main causes - the subprime mortgage crisis. Were the banks
that issued those mortgages being socially responsible? Many people answer with a resounding "no"; it appears
that they were worried about their investment portfolios instead of properly loaning money to customers, which
is their charge. Those investment portfolios were filled with toxic assets, which eventually compromised the
operations of many financial institutions and caused the failure of several big banks.

As a result, their share prices fell right along with them. One can surmise to say that they were not socially
responsible.

On the other hand, consider General Motors. After almost failing in the Great Recession, GM turned itself
around, repaid its debt, and developed "greener" vehicles. As a result, it realized an increase in its share price.
Why? GM was taking on the mantle of social responsibility rather than exploiting for financial gain. Business
firms cannot exist and profit in the long run without being socially responsible.

Profit Maximization
Why are business firms not seeking profit rather than an increase in share price? One reason is that profit
maximization does not take the concepts of risk and reward into account as shareholder maximization does. The
goal of profit maximization is, at best, a short-term goal of financial management.
Wealth Maximization
Wealth maximization is a modern approach to financial management. Maximization of profit used to be the
main aim of a business and financial management till the concept of wealth maximization came into being. It is
a superior goal compared to profit maximization as it takes broader arena into consideration. Wealth or Value of
a business is defined as the market price of the capital invested by shareholders.
Table of Contents [show]
THE CONCEPT OF WEALTH MAXIMIZATION DEFINED AS FOLLOWS
It simply means maximization of shareholder’s wealth. It is a combination of two words viz. wealth and
maximization. A wealth of a shareholder maximizes when the net worth of a company maximizes. To be even
more meticulous, a shareholder holds share in the company/business and his wealth will improve if the share
price in the market increases which in turn is a function of net worth. This is because wealth maximization is
also known as net worth maximization.

Finance managers are the agents of shareholders and their job is to look after the interest of the shareholders.
The objective of any shareholder or investor would be a good return on their capital and safety of their capital.
Both these objectives are well served by wealth maximization as a decision criterion for business.
HOW TO CALCULATE WEALTH?
Wealth is said to be generated by any financial decision if the present value of future cash flows relevant to that
decision is greater than the costs incurred to undertake that activity. Increase in wealth is equal to the present
value of all future cash flows less the cost/investment. In essence, it is the net present value (NPV) of a financial
decision.
Increase in Wealth = Present Value of cash inflows – Cost.
Where,

CF1 CF1 CFn

Present Value of Cash Inflows = ——— + ——— +……….+ ———

(1 + K)1 (1 + K)2 (1 + K)n

ADVANTAGES OF WEALTH MAXIMIZATION MODEL

Wealth maximization model is a superior model because it obviates all the drawbacks of profit maximization as
a goal of a financial decision.
 Firstly, the wealth maximization is based on cash flows and not on profits. Unlike the profits, cash flows
are exact and definite and therefore avoid any ambiguity associated with accounting profits. Profit can
easily be manipulative, if there is a change in accounting assumption/policy, there is a change in profit.
There is a change in method of depreciation, there is a change in profit. It is not the case in case of
Cashflows.
 Secondly, profit maximization presents a shorter term view as compared to wealth maximization.
Short-term profit maximization can be achieved by the managers at the cost of long-term sustainability
of the business.
 Thirdly, wealth maximization considers the time value of money. It is important as we all know that a
dollar today and a dollar one-year latter do not have the same value. In wealth maximization, the future
cash flows are discounted at an appropriate discounted rate to represent their present value. Suppose
there are two projects A and B, project A is more profitable however it is going to generate profit over a
long period of time, while project B is less profitable however it is able to generate return in a shorter
period. In a situation of an uncertainty, project B may be preferable. So, timing of returns is ignored by
profit maximization, it is considered in wealth maximization.
 Fourthly, the wealth-maximization criterion considers the risk and uncertainty factor while
considering the discounting rate. The discounting rate reflects both time and risk. Higher the uncertainty,
the discounting rate is higher and vice-versa.
ECONOMIC VALUE ADDED
In the light of modern and improved approach to wealth maximization, a new initiative called “Economic
Value Added (EVA)” is implemented and presented in the annual reports of the companies. Positive and higher
EVA would increase the wealth of the shareholders and thereby create value.
Economic Value Added
= Net Operating Profits after tax – Capital Employed x Weighted Average Cost of Capital.
In summary, the wealth maximization as an objective to financial management and other business decisions
enables the shareholders to achieve their objectives and therefore is superior to profit maximization. For
financial managers, it is a decision criterion being used for all the decisions. For more clarity, refer Profit
Maximization vs. Wealth Maximization.
HOW TO MAXIMIZE SHAREHOLDER’S WEALTH?
Capital investment decisions of a firm have a direct relation with wealth maximization. All capital investment
projects with an internal rate of return (IRR) greater than cost of capital or having positive NPV or creates value
for the firm. These projects earn more than the ‘required rate of return’ of the firm. In other words, these
projects maximize the wealth of the shareholders because they are earning more than what they can earn by
investing themselves.
By analyzing the projects with the methods of capital budgeting, we come to know whether wealth will or
won’t be created in a particular project. But, what is the real source of wealth creation? What is that
characteristic of the project which becomes the root cause of value creation?
SOURCE OF WEALTH CREATION
Normally, two types of environment are faced by us – one is external and other is internal. If both the conditions
support an organization, it tastes the success. A most important external factor which creates value is industry
attractiveness and a similar internal factor is the competitive advantage of the firm.
Two main sources of wealth creation or value creations are the industry attractiveness and competitive
advantage of the firm. Let us discuss them in little more details.
INDUSTRY ATTRACTIVENESS
One of the most important factors for a firm to make profits is its industry attractiveness. Explained by Michael
Porter, there are five forces of industry attractiveness which are as follows:
1. Barriers to Competitor’s Entry: Higher the entry barrier, higher is the chances for a firm to sustain for a
long term.
2. Substitutes: Lower the substitutes, lesser are the chances of consumers switching the products.
3. Bargaining Power of Buyers: Lesser the bargaining power of buyers, the firm becomes in a better
position to dominate terms.
4. Bargaining Power of Suppliers: Lesser the bargaining power of suppliers and buyers, the firm becomes
in a better position to dominate terms.
5. Competition among Competitors: It emphasizes the degree of competition which exists between the
current competitors of the industry. Amicable conditions among the competitors would make the firms
enjoy the better position.
COMPETITIVE ADVANTAGE
There are two elements of competitive advantage as per Michael Porter which are cost advantage and
differentiation advantage.
1. Cost advantage means the cost at which a firm producing the goods cannot be produced by the
competing firms at that cost. Due to this advantage, the firm can sell products at a lower price than the
competitors and still earn profit out of that. Customers are cost conscious and therefore they are attracted
towards the firm’s products. The firm enjoys good sales which lead to more profits and better cash flows
and therefore achieve wealth creation.
2. Differentiation advantage means the product offered by the firm can be easily differentiated from other
competitor’s products. The customers are convinced with a different product which is available only
with the firm under concern. In such cases where the product is unique, firms enjoy higher price and
therefore this becomes the real source of value creation for those firms.
Zubair Ahmad Khan1, Irem Hussanie2 1,2Department of Management Studies, University of Kashmir
ABSTRACT From the various objectives proposed for a business concern, shareholders’ wealth maximization
is considered the most appropriate and sustainable objective for a business concern. Shareholders wealth
maximization criterion proposes that a business concern should only consider the decisions that maximize the
market value of the share or the shareholders’ wealth. The market value of share is treated as an indicator of
efficiency and effectiveness of the firm. Finance theory asserts that shareholders’ wealth maximization is the
single substitute for shareholders’ utility. When the firm maximizes the shareholders’ wealth, the individual
shareholder can use this wealth to maximize his individual utility. It means that by maximizing shareholders’
wealth the firm is consistently operating towards maximizing shareholders’ utility. Although this criterion has
proved superior to objectives proposed earlier, yet it does not find significant use in the industry primarily due
to its complexity in understanding, calculation and application. The article does not recommend any new
conceptual model or framework but provides an elementary base for an imminent exhaustive exploration of
the said objective in present business context, as the shareholders’ wealth maximization is intensely an
interdisciplinary and multidisciplinary concept in its philosophical underpinnings. Key words: Financial
Management, NPV, Return. Risk Shareholders, Wealth INTRODUCTION The modern finance theory
operates on the assumption that the only objective of a business concern should be to maximize the market
value of the share or shareholders’ wealth. Shareholders’ wealth is expressed by the relation; SW (Shareholders’
Wealth) = n x MV (Number of Shares held x Market Value Per Share). It is clear from the expression that
given the number of shares held, the shareholders’ wealth can be maximized by maximizing the market value
per share. Hence conferring to this objective, every business decision should ultimately lead to maximization of
the market value of the share. According to the shareholders’ wealth maximization (SWM) criterion a business
concern should undertake only those projects whose Net Present Value (NPV) is positive i.e. present value of
cash inflows should be greater than present value of cash outflows. Hence, SWM is often translated as
maximizing the Net Present Value (NPV) of a course of action to shareholders. The projected net cash flows;
EBDAT (Earnings before depreciation and after tax) are converted to their respective present values by
discounting them with an appropriate discount rate (K). As per the contemporary finance theory, the best rate
to discount the cash flows of a firm is the Opportunity Cost of Capital (K). The Opportunity Cost of
Capital (K) is the rate of return on alternative investments of equivalent risk or the rate of return on the next best
alternative investment. The expected cash flows of risky investments are discounted at a higher rate while that
of a safer investment are discounted at lower rate. Projects or investments whose NPV is positive are
recommended as they increase the market value of the shares, hence increasing the shareholders’
wealth, while investments with negative NPV reduces the shareholders’ wealth and hence should be rejected.
A firm would be indifferent regarding projects with zero NPV as they keep the shareholders’ wealth
unchanged.
 International Journal of Enhanced Research in Management & Computer Applications ISSN: 2319-7471,
Volume 7 Issue 3, March-2018, Impact Factor: 3.578 Page | 740 Figure I Further, in accordance with SWM
criterion, in all the financial decisions; investment, financing and dividend, the risk relationship must be
optimized (Risk-Return Trade-off) i.e. maximizing return while minimizing risk, as presented in Figure II. For
instance new or innovative investments can fetch above average returns for a firm but they also expose the firm
to higher risk while safer investments can only fetch average profits for the firm while reducing risk exposure.
Hence, a financial manager has to ensure best returns for an investment while minimizing the risk exposure. If a
firm employs financial leverage for financing its investments, it will be able to retain its control and minimize
its overall cost of capital on account of lower cost of debt and interest tax shield, but it is simultaneously
exposed to greater financial risk. Financial risk in this case is created due to the fact that the obligations of debt-
holders or creditors are legal. Creditors have priority claims on income and assets of a firm. If their claims in
terms of payment of interest or principal are not met, they may enforce the firm to liquidate its assets. Equity
financing on the other hand does not expose the firm to financial risk as shareholders will not liquidate a firm
due to their residual claims on income and assets and due to their priority claims on ownership of the business
concern. But due to high cost and the tax burden associated with it, equity financing increases the overall cost of
capital of the firm. Further it dilutes the ownership of a business concern. Keeping in view the risk and
return associated with financing decision, here the manager has to ensure an optimal capital structure i.e. best
mix of debt and equity funds which minimizes the overall cost of capital and maximizes the market value of
share. Similarly, in dividend decision a firm faces the risk and return trade-off. In dividend decision, the
financial manager has to strike a balance between pay-out and retention of dividend and also the issue of bonus
shares. A higher dividend pay-out may convince the shareholders of a concern but due to external financing its
cost of capital will increase hence reducing the profitability. As an alternative, if the concern retains the
dividend and reinvests it, the cost of capital will significantly reduce while increasing the profitability. But such
a decision will increase the risk for the firm so far as the shareholders are concerned. Hence in dividend
decision a manager has to ensure optimum pay-out and retention ratio in consideration with the risk and return
associated with them. Finally, in the short term investment or liquidity or working capital management
decision also risk return trade-off exists. Here this trade-off is expressed in terms of the relation between
liquidity and profitability. If a business concern keeps higher liquidity level i.e. increases the level of cash and
cash equivalents, it will be timely able to cover its liabilities thus reducing risk, but due to increased idle funds
it will lose profitable opportunities. Now if the liquidity level is decreased, funds will be mobilized from
savings to investment which will increase the returns for the concern, but due to decreased level of cash and
cash equivalents the firm is exposed to higher degree of risk. Hence, there is wedge between liquidity and
profitability in terms of risk and return which must be optimized in terms of an optimum level of cash and cash
equivalents.
International Journal of Enhanced Research in Management & Computer Applications ISSN: 2319-7471,
Volume 7 Issue 3, March-2018, Impact Factor: 3.578 Page | 741 Figure II: Working logic of wealth
maximization objective (risk-return trade off) Thus by optimizing the risk and return relationship in all
financial decisions viz. investment (short term and long term), financing and dividend, a firm would be able to
maximize the market value of its shares and hence maximizes the shareholders’ wealth. This is the operating
logic and backbone of Shareholders Wealth Maximization. Although the efficiency of this criterion remains
unchallenged, yet it does not find the application as expected. This is primarily due to the complexity in its
understanding and calculations and also carries time and cost constraints. Further due to the availability of
convenient alternative approaches like profit maximization, the use and significance of this approach is
undermined (Khan, Z.A., 2017). REFERENCES [1] Anthony, R. N. (1960). The trouble with profit
maximization. Harvard Business Review, 38(6), 127-134. [2] Pandey, I. M. (1995). Essentials of Financial
Management, 4th Edtion. Vikas publishing house. [3] Gupta Shasi, K., & Sharma, R. K. Financial Management
Theory and Practice. Kalyani publication,. [4] Khan, Z. A. (2017). Profit Maximization as an objective of a
firm: A Robust Perspective. [5] NS Tung, V Kamboj, A Bhardwaj, “Unit commitment dynamics-an
introduction”, International Journal of Computer Science & Information Technology Research Excellence,
Volume 2, Issue 1, Pages 70-74, 2012. [6] International Journal of Research in Finance and Marketing,7(6),
217-219. [7] Van Horne, J. C., & Wachowicz, J. M. (2008). Fundamentals of financial management. Pearson
Education
SHAREHOLDER'S WEALTH MAXIMAZATION, CORPORATE MANAGEMENT & AGENCY
PROBLEMS.pdf

Ali JILIOW

Financial management has long been related the concept of proper management of funds within an
organization; investing projects that would possible generate a reasonable returns to the investors, so the
responsibility of every financial manager is obviously to maximize shareholder's wealth, and in order for
managers to reach that end point managers on behalf of the share holders are required to work with the best
interest of the owners of the firm. Nevertheless, this paper answers four essential questions.
1.What should be the goal of the financial manager of a corporation and why?
2. What are the financial activities of the company that you are expected to perform as a financial manager and
how are you going to achieve the objective of those activities?
3.Is it possible for the risk premium to be negative before an investment is undertaken? Can the risk premium be
negative after an investment is undertaken? and finally a number of publicly traded firms pay no dividends yet
investors are willing to buy shares in these firms. How is this possible? Does this violate our basic principle of
stock valuation?
Goals of Financial Management
Valuation
Valuation, a goal of financial management, often relies on fundamental analysis of financial statements.
LEARNING OBJECTIVES
Describe the valuation process
KEY TAKEAWAYS
Key Points
 In finance, valuation is the process of estimating what something is worth. Valuation is used to for a
variety of purposes: the purchase or sale of a business, appraisal to resolve disputes, managerial
decisions of how to allocate business resources, and many other business and legal purposes.
 Valuation often relies on fundamental financial statement analysis using tools such as discounted cash
flow or net present value. As such, an accurate valuation, especially of privately owned companies,
largely depends on the reliability of the firm’s historic financial information.
  Not only do managers want to keep reliable financial statements so that they can know the value of their
own businesses, but they also want to manage finances well to enhance the value of their businesses to
potential buyers, creditors, or investors.
Key Terms
 valuation: The process of estimating the market value of a financial asset or liability.
 fundamental analysis: An analysis of a business with the goal of financial projections in terms of
income statement, financial statements and health, management and competitive advantages, and
competitors and markets.
 financial statement: A formal record of all relevant financial information of a business, person, or other
entity, presented in a structured and standardized manner to allow easy understanding.
Introduction
Financial management focuses on the practical significance of financial numbers. It asks: what do the figures
mean? Sound financial management creates value and organizational agility through the allocation of scarce
resources among competing business opportunities. It is an aid to the implementation and monitoring of
business strategies and helps achieve business objectives. There are several goals of financial management, one
of which is valuation.

Valuation: Valuation is, for some, one of the goals of financial management.
Valuation
In finance, valuation is the process of estimating what something is worth. Valuation often relies on
fundamental analysis (of financial statements) of the project, business, or firm, using tools such as discounted
cash flow or net present value. As such, an accurate valuation, especially of privately owned companies, largely
depends on the reliability of the firm’s historic financial information. Items that are usually valued are a
financial asset or liability. Valuations can be done on assets (for example, investments in marketable securities
such as stocks, options, business enterprises, or intangible assets such as patents and trademarks) or on
liabilities (e.g., bonds issued by a company).
Valuation is used to determine the price financial market participants are willing to pay or receive to buy or sell
a business. In addition to estimating the selling price of a business, the same valuation tools are often used by
business appraisers to resolve disputes related to estate and gift taxation, divorce litigation, allocate business
purchase price among business assets, establishing a formula for estimating the value of partners’ ownership
interest for buy-sell agreements, and many other business and legal purposes. Therefore, not only do managers
want to keep reliable financial statements so that they can know the value of their own businesses, but they also
want to manage finances well to enhance the value of their businesses to potential buyers, creditors, or
investors.
Maximizing Shareholder and Market Value
A goal of financial management can be to maximize shareholder wealth by paying dividends and/or causing the
market value to increase.
LEARNING OBJECTIVES
Describe the relationship between shareholder value and market value
KEY TAKEAWAYS
Key Points
 One interpretation of proper financial management is that the agents are oriented toward the benefit of
the principals, shareholders, and in increasing their wealth by paying dividends and/or causing the stock
price or market value to increase.
 The idea of maximizing market value is related to the idea of maximizing shareholder value, as market
value is the price at which an asset would trade in a competitive auction setting; for example, returning
value to the shareholders if they decide to sell shares or if the firm decides to sell.
 There are many different models of corporate governance around the world. These differ according to
the variety of capitalism in which they are embedded. The Anglo-American (US and UK) “model” tends
to emphasize the interests of shareholders.
 The sole concentration on shareholder value has been criticized, for concern that a management decision
can maximize shareholder value while lowering the welfare of other stakeholders. Additionally, short-
term focus on shareholder value can be detrimental to long-term shareholder value.
Key Terms
 market value: The total value of the company as traded in the market. Calculated by multiplying the
number of shares outstanding by the price per share.
 principal: One who directs another (the agent) to act on one′s behalf.
 shareholder: One who owns shares of stock.
Introduction
Financial management is concerned with financial matters for the practical significance of the numbers, asking:
what do the figures mean? There are several goals of financial management, one of which is maximizing
shareholder and market value.
Money to Shareholders: Maximizing shareholder and market value is, for some, one of the goals of financial
management.
Maximizing Shareholder Value
The idea of maximizing shareholder value comes from interpretations of the role of corporate governance.
Corporate governance involves regulatory and market mechanisms and the roles and relationships between a
company’s management, its board, its shareholders, other stakeholders, and the goals by which the corporation
is governed.
In large firms where there is a separation of ownership and management and no controlling shareholder, the
principal–agent issue arises between upper-management (the “agent”) and shareholders (the “principals”). The
danger arises that, rather than overseeing management on behalf of shareholders, the board of directors may
become insulated from shareholders and beholden to management.
Thus, one interpretation of proper financial management is that the agents are oriented toward the benefit of the
principals – shareholders – in increasing their wealth by paying dividends and/or causing the stock price or
market value to increase.
Maximizing Market Value
The idea of maximizing market value is related to the idea of maximizing shareholder value, as market value is
the price at which an asset would trade in a competitive auction setting; for example, returning value to the
shareholders if they decide to sell shares or if the firm decides to sell.
There are many different models of corporate governance around the world. These differ according to the
variety of capitalism in which they are embedded. The Anglo-American (US and UK) “model” tends to
emphasize the interests of shareholders.
The sole concentration on shareholder value has been widely criticized, particularly after the late-2000s
financial crisis, where attention has risen to the concern that a management decision can maximize shareholder
value while lowering the welfare of other stakeholders. Additionally, short-term focus on shareholder value can
be detrimental to long-term shareholder value.
Maximizing Value Without Harming Stakeholders
A goal of financial management can be to maximize value without harming stakeholders, the diverse set of
parties affected by the business.
LEARNING OBJECTIVES
Explain how maximizing value for shareholders can harm the business’s other stakeholders
KEY TAKEAWAYS
Key Points
 Stakeholders are those who are affected by an organization’s activities. The stakeholders can be internal
or external to the firm and some will be involved directly in economic transactions with the business,
while others will not.
 Owners, employees, customers, suppliers, trade unions, the government, local communities, and the
environment can be considered stakeholders. Because of the potential breadth of the term, there are
different views on whom to include in stakeholder considerations.
 Debate is ongoing about whether firms should be managed for shareholder value maximization or also
with stakeholders in mind. While the Anglo-American “model” tends to emphasize shareholders, some
European countries formally recognize other stakeholders in corporate governance decisions.
 Some proponents of stakeholder considerations argue that attention to other stakeholders is intimitely
intertwined with market value and can enhance outcomes for all stakeholders. Others argue that value
should be maximized without harming stakeholders.
Key Terms
 stakeholder: A person or organisation with a legitimate interest in a given situation, action or enterprise.
 market value: The total value of the company as traded in the market. Calculated by multiplying the
number of shares outstanding by the price per share.
Introduction
Professionals in financial management are concerned with the practical significance of the numbers that appear
in financial documents. Given a set of information about certain financial behavior, they ask, what do the
figures mean? There are several goals of financial management, one of which is maximizing value without
harming shareholders.
The Stakeholder Concept
The stakeholder concept is associated with the concept of corporate governance. Corporate governance involves
regulatory and market mechanisms and the relationships that exist between a company’s management, its board,
its shareholders, other stakeholders, and the goals for which the corporation is governed. Stakeholders are those
who are affected by an organization’s activities. The stakeholders can be internal, like owners or employees.
They can also be external, like customers, suppliers, the government, local communities, and the environment.
Some stakeholders are involved directly in economic transactions with the business. Others are either affected
by, or able to affect, an organization’s actions without directly engaging in an economic exchange with the
business (for example, trade unions, communities, activist groups, etc). Because of the breadth of the term
stakeholder, there are different views as to whom should be included in stakeholder considerations.

Environment as stakeholder: The environment can be seen as a stakeholder. Maximizing value without
harming stakeholders is, for some, one of the goals of financial management.
Stakeholders vs. Shareholders
In the field of corporate governance and corporate responsibility, a major debate is currently occurring about
whether a firm or company should make decisions chiefly to maximize value for shareholders, or if a company
has obligations to other types of stakeholders. This increased after the financial crisis of the late 2000s, when
concerns deepened about the potential of companies to lower the welfare of other stakeholders while
maximizing their shareholder value. While the Anglo-American (US and UK) business “model” tends to
emphasize the interests of shareholders over other implicated parties, some European countries formally
recognize other stakeholders in corporate governance decisions.
Some people who argue that businesses should consider other stakeholders, like the government or the
environment, argue that an attention to these types of stakeholders is intimately intwined with market value.
They also argue that a holistic view can enhance general outcomes for all the stakeholders that are involved.
Still others argue that stakeholders, even if they are not considered in business decisions, should at the very least
not suffer harm, and that businesses should maximize value only if they can do so without generating harm.
Why Shareholder Wealth Maximization Despite Other Objectives
Posted by S.P. Kothari (MIT Sloan School of Management), on
Wednesday, May 23, 2018

Comments Offon Why Shareholder Wealth Maximization Despite Other Objectives Print E-Mail
Agency costs, Compliance & ethics, Corporate Social Responsibility, Market efficiency, Shareholder
primacy, Shareholder value
More from: Luo Zuo, Richard Frankel, S.P. Kothari
S.P. Kothari is the Gordon Y. Billard Professor of Accounting and Finance at MIT Sloan School of
Management. This post is based on a recent paper authored by Professor Kothari; Richard Frankel, Beverly &
James Hance Professor of Accounting at Washington University in Saint Louis Olin Business School; and Luo
Zuo, Associate Professor of Accounting at Cornell University SC Johnson College of Business.
The view that firms (managers) behave as if their goal is to increase shareholder wealth is the shareholder-
wealth-maximization principle. While many might agree this principle governs managerial behavior, it
continues to arouse intense scrutiny, adoration, and condemnation. We begin by summarizing the economic
rationale behind and the welfare consequences of managers pursuing this principle. Numerous writings
articulate the principle, including the influential Friedman (1970) and Jensen (2001). Friedman (1970)
encapsulates the principle by imploring managers as shareholders’ agents to “conduct the business in
accordance with their desires, which will generally be to make as much money as possible while conforming to
the basic rules of the society, both those embodied in law and those embodied in ethical custom.”
The argument that managers should seek to increase shareholder wealth begins with the premise that the
society’s resources are scarce. Judicious use of scarce resources implies that resources should be directed
toward higher net-value activities. If prices measure opportunity costs and benefits, the net value of an activity
can be determined by subtracting the price of resources devoted to an activity from the sales revenues generated
by the activity. Because a given activity might involve a multi-period commitment, employing resources that
can be used for multiple periods (e.g., plant, property, and equipment), a net present value calculation is often
necessary to compare cash inflows and outflows occurring in different periods. This net present value
corresponds to the effect of the project on its owner’s wealth. These arguments render the following
proposition: Judicious use of society’s resources implies each project’s owners maximize the value of their
projects.
Many individuals with wealth do not have attractive projects of their own. These individuals will seek projects
that promise higher returns, placing their wealth in the hands of project managers. In doing so, the wealth owner
must add the cost of the project managers’ effort and expertise to the calculation. Manager effort and expertise
are simply another of the society’s scarce resources. Thus, separating the owner of wealth from the wealth
managers does not alter the conclusion that judicious use of society’s resources requires wealth owners to seek
higher value projects. If we view firm managers as the project managers and shareholders as the wealth owners,
our logic implies that firm managers judiciously employ a society’s resources when they seek to increase
shareholder wealth.
Notwithstanding this argument, the shareholder-wealth-maximization principle has been the subject of criticism
from many economists, social activists, prominent business executives, and politicians. We divide this objection
into four more specific criticisms:
i. Shareholders might wish to pursue objectives other than or in addition to wealth maximization,
e.g., concern for the environment. This is a two-part criticism: (a) Managers are reluctant to pursue
other objectives because those run afoul of wealth maximization; and (b) Pursuit of the other objectives
is a means to increase shareholder wealth, but managers do not fully appreciate it. We explain that the
political realm might be a better path to the pursuit of the objectives contrary to wealth maximization,
because competition undermines firms seeking other, unrelated objectives and managers face an
intractable problem when trying to consolidate competing objectives into a distinct target. As for the
objectives consistent with maximization of shareholder wealth (e.g., sensitivity to worker happiness),
managers would and should gladly embrace these subject to the constraints of competition, law and
ethical custom.
ii. Firms might plunder other stakeholders. This idea, perhaps originating in the theory that labor creates
all value, was given graphic voice by Marx, e.g., “Capital is dead labor which, vampire-like, lives only
 by sucking living labor, and lives the more, the more labor it sucks.” We explain that competition and
constraints imposed by law and ethical standards minimize, if not eliminate, the exploitation of (or theft
from) other stakeholders as a means to increase shareholder wealth. Competitive product, labor, and
capital markets counter the pull of incentives to maximize shareholder wealth at the expense of other
stakeholders.
iii. Managers are shareholders’ agents and they will pursue their own objectives. This well-known
incentive (agency) conflict is hardly unique to shareholder-wealth-maximizing organizations. Any
organization, regardless of the objective one wishes its managers to pursue, encounters incentive
conflicts. For example, incentive problems exist in non-profits and government.
iv. Managers and shareholders might suffer from behavioral biases. We explain that such biases would
also hamper organizations seeking alternative goals.
Before we delve into each of the aforementioned four criticisms, we begin by assuming that investors in
corporate organizations seek to maximize the value of their investment. Therefore, we expect to observe firms
and management teams adopt the goal of shareholder wealth maximization and expect them to compete to
devise the most efficient means of achieving this goal. We describe the economic consequences of pursuing the
objective of wealth creation and implications for social welfare under a set of assumptions (a “positive”
approach). The merits of pursuing other objectives is a normative question. All we can argue is that societies are
(predicted to be) poorer as a result.
What then to make of the alternative objectives that are the passion of many individuals, who might also be
shareholders? Forming a consensus might be impossible (Arrow, 1951; Gibbard, 1973; Satterthwait, 1975).
Still, competing objectives espoused by shareholders and members of society, in our opinion, become the
purview of politics. We recognize that politics and law are imperfect avenues to convert these competing
shareholder objectives into restraints on firm actions. Politics is fraught with challenges encountered in getting
the electorate energized about an issue, acting on it either directly or through elected representatives, and thus
bringing about a change that reflects the collective (majority) objective. However, we explain below that the
political route dominates the alternative of expecting managers to embrace a multiplicity of objectives.
While we champion shareholder wealth maximization, to be clear, our position is not that society’s goal should
be unconstrained shareholder-wealth maximization. Hyman Roth is one Hollywood avatar of this position.
When discussing the murder of Moe Green with Michael Corleone, he says, “This is the business we’ve chosen.
I didn’t ask who gave the order, because it had nothing to do with business.” (The Godfather Part II, 1974).
Rule of law is necessary to prevent coercion and fraud. Laws and ethics, as well as competition, constrain the
scope of actions of a corporation. Examples of legal constraints include laws against bribery, child labor, and
forced labor. Ethical principles, such as honesty, keeping firmly to one’s word, and the sanctity of human
beings, constrain individual behavior in situations ill-suited for the state’s heavy hand. Still shareholder wealth
maximization remains the objective subject to these constraints and future constraints as the society’s
objectives evolve and morph into new laws and ethical customs.
Perhaps, criticism of shareholder wealth maximization arises because of a distaste for the concept as a
normative proposition despite the fact that the proposition predicts firm behavior. That is, we face a
disagreement about values masquerading as a disagreement about facts. We explain shareholder wealth
maximization is an efficient means to maximize societal wealth. We do not argue that society’s goal should be
to maximize wealth. The end of a kinder, finer, freer, more just and peaceful society is unlikely to be reached
solely by increasing a society’s wealth. Advocates of other objectives for social ends and the means to achieve
those ends have worthy arguments.
We maintain that managers seeking to increase wealth are not acting immorally, per se. Therefore, we take
issue with those demonizing managers for taking steps to increase shareholder wealth while staying within law
and operating in a competitive economy. We observe that a competitive environment reduces the chances that
the firm will flourish if it pursues other objectives. In addition, managers do not have the means to distill the
varied preferences of present and future shareholders into an objective function that could feasibly serve as
guide for decision making. Other objectives then become the purview of the political realm, cultural norms, and
ethical outlook. Individuals advocating other objectives must persuade other citizens to adopt their opinions and
passions. Of course, demonizing managers, companies, and industries solely because they pursue shareholder
wealth maximization might be an effective (though groundless) means of persuasion.
The possibility that CEOs might engage in mercenary behavior is real and therefore checks and balances are
essential to ensure competition in markets and legal (and ethical) behavior on the part of managers. Adam
Smith’s dim view of businessmen suggests, one must distinguish between defending capitalism and apologizing
for capitalists. “People of the same trade seldom meet together, even for merriment and diversion, but the
conversation ends in a conspiracy against the public, or in some contrivance to raise prices” (Smith, 1776, p.
105). Likewise, we recognize the necessity of a moral code and law to set bounds on permissible wealth-
increasing actions. However, the necessity of moral boundaries is not a distinguishing demerit of shareholder
wealth maximization. Any alternative goal is similarly incomplete without these constraints. Moreover, we are
tempted to give our needs the patina of “morality” to forestall consideration of trade-offs necessary to meet
them. After all, the prohibition against the murder of an innocent man is not subject to a cost-benefit analysis.
Moral arguments must be countered with moral arguments. They cannot be refuted by efficiency (or even
practical) arguments. Stakeholders will be inclined to make moral claims to stymie counter arguments.
Mindful of this dubious pull, we seek a method to guide managers in choosing among legally and ethically
permissible actions. Moreover, shareholder wealth maximization is not incompatible with strategies that, for
example, take into account sustainability, the firm’s local community, or, customer and employee satisfaction.
If paying attention to sustainability increases firm value, that is what managers will (and should) do.
Shareholder wealth maximization would be the criterion managers apply in deciding how much to invest in
“socially responsible activities” similar to any other corporate investment decision they make.
The complete paper is available for download here.
In these days, choosing a corporate objective of a firm is extremely important and has a determinant meaning to
the success or failure of a corporation in controlling the market. To gain it, shareholder value maximization and
stakeholders’ interest satisfaction play a key role in creating profit for company. Which governance objective
should a corporation follow, maximizing shareholder value or satisfying stakeholder’s interests or balancing the
interests of shareholders and stakeholders? This is an inextricable problem for each corporation to pursue its
own goal. It’s difficult for the company to bring forward a right choice.
To make this issue clear, it’s necessary for understanding some basic concepts about shareholder, stakeholder,
what is shareholder value maximization? And what are stakeholders’ interests? Shareholder is defined as an
individual or corporation owns one or more shares of stock in a company. They are the owners of the company,
have potential profit if the company does well or potential loss if the company does poorly. Therefore, it’s a
priority for shareholder value maximization which is defined: “Maximizing shareholder wealth means
maximizing the flow of dividends to shareholders through time” (Glen Arnod, 2008). Why does a corporation
maximize shareholder value? Because shareholders are persons sacrificing the immediate consumption to put
their capital also hand over their savings for managers by purchasing the shares of company with the promise of
a flow of cash in the form of dividends in the long run and not necessarily payback in short time. Maximizing
shareholder wealth is often a superior goal of the company, creating profit to increase the dividends paid out for
each common stock. Shareholder wealth is expressed through the higher price of stock traded on the stock
market. An another constituency of contributing to value for company is stakeholder, Freeman defines it:
“Stakeholder is any group or an individual who can affect or is affected by the achievement of an organization’s
purpose”(Freeman, 1984, p.53). Stakeholders here include customers, suppliers, employees, creditors, directors,
communities, environment, government officials… The different stakeholder groups have different interests.
For example, customer’s interest is high quality products with cheap price, creditor’s interest is low risk and
high payment, the society’s interest is social welfare maximization, the charitable organizations’ interest is to
help unhappy people with a part of maintained profit of the company. A corporation following the stakeholders’
interest goal indicates that the manager makes decision based on all interests of stakeholders.
So far, there have been various points of whether a business should prefer value maximization for shareholders
or interests of stakeholders as a governance objective of the company. According to Milton Friedman: “In a free
enterprise, private property system, a corporate executive is an employee of the owners of the business. He has
a direct responsibility to his employers. That responsibility is to conduct the business in accordance with their
desires, which generally will be to make as much money as possible while conforming to the basic rules of
society…In so far as his actions in accord with his social responsibility, reduce return to stockholders, he is
spending their money”(Milton Friedman, 1970). Shareholders are owners of the firm and deserve any surplus
the firm creates. Shareholders spend money to employ the executives with the desire that they will bring much
higher dividend in the long run, act based on the interests of shareholders for the only purpose to maximize
shareholder wealth. Friedman supports completely for creating value of shareholders, directors have the proxy
responsibility to maximize shareholder wealth, any actions besides shareholder’s benefit are violations of this
duty. It’s also supported by his saying “There is one and only one social responsibility of business- to use its
resources and engage in activities designed to increase its profits so long as it stays within the rules of the game,
engages in open and free competition, without deception or fraud”(Milton Friedman, 1970). He stressed on
pursuing the high returns for owners as a main objective of the company and leads the best allocation of
investment capital for society because the scare resource is utilized best for producing the optimum mix of
goods and services. The only one responsibility of directors is to create value for shareholders, advancing
shareholders’ interests above all others. Is it an out-dated theory which considers the company as a thing to be
owned, an entity separated to other constituencies? Does a company do well without care various
constituencies? It’s like a “zero sum game”, it means gain achieved by winner is loss of loser, if adding gain and
loss together, the result is zero. This theory also implies that there is no win-win situation, in a game there has to
be winner and loser.
But whether shareholder value maximization is the only objective of the corporation in market economy in
these days or not, another point answers this question: “NCR is a successful, growing company dedicated to
achieving superior results by assuring that its actions are aligned with stakeholder expectations. Stakeholders
are all constituencies with a stake in the fortunes of the company. NCR’s primary mission is to create value for
our stakeholders.”(NCR 1990 Annual Report: 2). The fact proves that one company is still successful in
pursuing stakeholders’ interest goal to maximize its value. It indicates that managers should make decisions
based on the interests of stakeholders, especially in a competitive environment as nowadays, satisfying
stakeholders’ interests is very important. Stakeholders are persons indirectly creating a considerable value for
the firm. It requires the company suitable policies for stakeholders’ needs. One survey of directors proved that
NCR is not alone in this view: “.. board of directors no longer believe that shareholders is the only constituent to
whom they are responsible”. (Wang, Jia and Dewhirst, H. Dudley, 1992). Explicitly, shareholder value
maximization is not the only goal of the company, a company can’t do well without caring the interests of
customers, suppliers, employees, or government environment.. Stakeholders are constituencies who play an
important role in the fortunes of the company. Their primary mission is to create value for stakeholders. But one
problem arises for stakeholder theory expressed in Michael Jensen’s writings below, and the corporation should
consider related factors carefully before making decision of their choice.
Michael Jensen says: “Stakeholder theory effectively leaves managers and directors unaccountable for their
stewardship of the firm’s resources…plays into the hands of managers by allowing them to pursue their own
interest at the expense of the firm’s financial claimants and society at large. It allows managers and directors to
devote the firm’s resources to their own favorite causes- the environment, arts, cities, medical research-without
being held accountable…it is not surprising that stakeholder theory receives substantial support from them”
(Jensen, 2001). Jensen attacks the stakeholder approach. He points out a company which acts in the
stakeholder’s interests tends to make the executives in the firm to earn profits for themselves. Because there is
separation of the ownership and control between the owners and managers, which makes managers to pursue
objectives attractive to them. With characteristic of management, directors have the tendency to be lack of
diligence, taking advantage of their position to raise their perks or participate in poor, less risky projects.. So,
it’s not surprising when directors support stakeholder theory. One difficulty for directors to define the main goal
of the firm is to satisfy interests of all stakeholders. In a real life, no one can serve both masters.. stakeholder
theory directs the corporate managers to serve many masters. It is not clear, personal and causes directors
confused in making decision. Besides stakeholder theory’s disadvantage, Jensen still states that the company
can’t maximize the shareholder wealth if it ignores the rest constituencies. No company can create great value
for its shareholders without stable growth of revenue, which comes from the relationship with customers,
suppliers, bankers or government and so on.
Over some arguments above, we can see different points on corporate governance. Should a company go into
the direction of creating value for shareholders over stakeholder’s interests? In my opinion, pursuing only one
objective: shareholder value maximization or stakeholders’ interests is not optimal approach. I agree with the
view of Michael Jensen. Shareholder value maximization’s still prior than stakeholders’ interests with an
effective and clear strategy. Cola-cola company is typical example for making much money by maintaining a
powerful brand name and manufacturing an enjoyable beverage for consumers, a form of maximization of
shareholder value based on its brand name and product. Moreover, maximizing shareholder value also needs
satisfaction of stakeholder’s interests because stakeholders are people who contribute indirectly in creating the
value for the firm. To me, customer satisfaction is very significant in the business perspective nowadays. Any
strategy which increases the investment of the company’s resource to increase customer satisfaction is aimed to
increase the shareholder’s value if the economic return overtime exceeds the company’s cost of capital. The
manager can set the price of each product or service no higher than the perceived price of the customer(the
ceiling price) and no lower than the cost of capital (floor price), concurrently give many promotion programs
such as buy one give one, reducing the product price for the increase in customer satisfaction. Moreover, the
price of the product is not only reasonable for customers, suppliers, but also to the market situation, and
importantly securing the profit for company, guaranteeing for shareholder value. There is no conflict between
maximizing shareholder value and customer satisfaction in this case. However, it’s sometimes difficult for
directors to choose between short-term and long-term goals. Because if the manager wants high price for short-
term goal to raise the year’s profit but in the long run, with competition, the customers will transfer to consume
the products of other firms with cheaper price, the failure in customer satisfaction will reduce shareholder value
aimed to the long-term goal. I think it’s good for managers to note short-term and long-term goals. Because the
goal of shareholder wealth maximization is a long term goal achieved by many short-term decisions to maintain
or exceed the expected value of shareholders. So managers with desire to maximize value for shareholder need
to consider both short-term and long-term impact on their decisions so as to increase the market stock price.
One reality, many firms nowadays choose the direction of satisfying stakeholder’s interest. I can’t say “right” or
“wrong” here, it’s up to the corporation’s specific objectives to different perspectives. But I think the purpose of
stakeholders’ interests shouldn’t conflict with the shareholder value maximization. Because serving the interests
of stakeholders can create profit for the firm, create value for shareholders. The main goal of the company is
shareholder value maximization but not ignore the stakeholder’s interests. For example, to suppliers, the
company can pay for them with the market price, make payment on time, has preferential policies for excellent
suppliers, builds good relationship with suppliers to increase volumes purchased, to improve the product’s
quality, coordinating delivery-production schedules to minimize costs, which helps to maximize shareholder
wealth. To employees, shareholder value maximization requires the company to have good human resources
management because the workforce is very significant in creating superior value for company, it’s a competitive
advantage of the company. A company which treats employees badly as pay lower salary than the market’s one
or has no well treatment policy such as: health insurance, social insurance… is unlikely to maximize value
possible for shareholders. Coca-cola, Disney and General Electric have the best human resources management.
Policies with investment on training courses for employees are encouraged, increasing the competitive
advantage of the company over rivals. In the long run, it will create value for shareholders.
In conclusion, the governing objective of the company should be to maximize the value of the company for
shareholders. However, to achieve this purpose, it also requires serving the economic interests of all
stakeholders over time. Maximizing stakeholder’s interests also maximizes shareholder wealth.

 Time Value of Money Cost of money and the factors effecting the cost, Interest rate fundamentals and
determinants of market interest rate, Role of Time value of money in finance, Concept of future value
and present value, Making timelines, Annuities, Perpetuities and mixed stream of cash flows, with and
without growth, Present value and future value of cash flow streams, Compounding Interest; discrete and
continuous, Loan amortization
Time Value of Money

psu.instructure.com

The time value of money (TVM) is the concept that money available at the present time is worth more
than the identical sum in the future due to its potential earning capacity. This core principle of finance
holds that provided money can earn interest, any amount of money is worth more the sooner it is
received.
The time value of money is the greater benefit of receiving money now rather than an identical sum later. It is
founded on time preference.
Cost of money and the factors effecting the cost,
The Fundamental Factors That Affect The Cost Of Money
811 WordsSep 3, 20164 Pages
Weekly Discussion The four fundamental factors that affect the supply of and demand for investment
capital, and hence interest rates, are productive opportunities, time preferences for consumption, risk,
and inflation. Explain how each of these factors affects the cost of money. In your dicussion, explain why
a hospital 's bond rating is important and describe the different levels. (You can use any bond rating
agency for analysis). Productive opportunities is the supply and demand of capital are based on the
businesses profitability. The higher the profits the higher the interest rate. Conversely , the low the
profitability the lower the interest rate. The ability to borrow money is enhance if the lender perceives the
business as profitable and the risk is lower. Time preferences are based on their time for consumption
and solely by personal preferences. This is dependent on the needs of the investor. The basis of this if the
investor wishes to save his money for the future, that investor may accept a low return for future
consumption. An investor who has the need for high consumption (needs money in the short term), will
lend the money only if the interest rate is high. The needs of the investor will play into the ability for a
business to borrow money. If an all investors need long term, future returns, then interest rates would
lower, if the investor needs money in the short term the interest paid to attract the investor and their
capital will need to be higher.
Show More
Concept Of The Cost Of Money And Factors Affecting It
Concept Of The Cost Of Money
The cost of money refers to the price paid for using the money, whether borrowed or owned. Every sum of
money used by corporations bears cost. The interest paid on debt capital and the dividends paid on ownership
capital are examples of the cost of money. The supply of and demand for capital is the factor that affects the
cost of money. In addition, the cost of money is affected by the following factors as below:

Factors Affecting The Cost Of Money

1. Production Opportunities
Production opportunities refer to the profitable opportunities for investment in productive assets. Increase in
production opportunities in an economy increases the cost of money. Higher the production opportunities more
will be the demand for money which leads to higher cost of money.

2. Time Preference For Consumption

Time preference for consumption refers to the preference of consumers for current consumption as opposed to
future consumption. The cost of money also depends on whether the consumers prefer to consume in current
period or in future period. If the consumers prefer to consume in current period, they spend larger portion of
their earnings in current consumption. It leads to the lower saving. Lower saving reduces the supply of money
causing the cost of money increase. Therefore, as much as the consumers give high preference to current
consumption, the cost of money will increase and vice versa.

3. Risk
Risk refers to the chance of loss. In the context of financial markets, risk means the chance that investment
would not produce promised return. The degree of risk perceived by investors and the cost of money has
positive relationship. If an investor perceives high degree of risk from a given investment alternative, he or she
will demand higher rate of return, and hence the cost of money will increase.
4. Inflation
Inflation refers to the tendency of prices to increase over periods. The expected future rate of inflation also
affects the cost of money, because, it affects the purchasing power of investors. Increasing in rate of inflation
results in decline in purchasing power of investors. The investors will demand higher rate of return to
commensurate against decline in purchasing power because of inflation.
Factors Affecting Cost of Capital
Cost of capital is the cost for a business but return for an investor. There are various factors that can affect the
cost of capital. Broadly, factors can be classified as ‘fundamental factors’ and ‘economic and other factors’.
Fundamental factors are market opportunities, capital provider’s preference, risk, and inflation. Other factors
include Federal Reserve policy, federal surplus and deficit, trade activity, foreign trade surpluses and deficits,
country risk and exchange rate risk.
Table of Contents [show]
FUNDAMENTAL FACTORS AFFECTING COST OF CAPITAL
MARKET OPPORTUNITY
Unquestionably, most fundamental price deciding factor for anything in this world is the law of demand-supply.
Cost of capital is also not away from this fundamental law. When the demand for capital increases, the cost of
capital also increases and vice versa. The demand is influenced greatly by the available market opportunities. If
there are a lot of production opportunities in the market, more and more entrepreneurs will explore those
opportunities to create profitable ventures. Entrepreneurs, then, would require capital to implement their
business ideas. So, cost of capital is directly related to the market opportunities available in the market.
CAPITAL PROVIDER’S PREFERENCES
An individual who has some additional funds has two straight choices – save money or consume it. It is
completely a personal choice but to a great extent, it is impacted by the culture of a society. For example,
Japanese people are more bent towards saving compared to the US. Another important factor that determines
the utility of capital is the interest rate or returns available to their funds. Naturally higher returns would enforce
higher savings.
RISK
‘High-risk high-return’ principle works here too. If the venture where investment is required has a high level of
risk, the return required by the investor would also be very high to compensate the risk. On the other hand, the
businessman taking up the venture may not opt for a too high cost of capital because it may put the viability of
the overall project at stake. So, this is how risk plays a key role deciding the capital transactions in the market.
INFLATION
All capital providers try to invest in a manner that maximizes returns. The lower benchmark for investing has
always been the inflation. At the minimum, an investment should beat the inflation and there should be some
real income. Real income is nothing but the actual return less inflation. In simple words, you invested money
which could buy you a particular basket of things a year ago. After a year when your investment is matured and
you receive money, you would at least expect that money should be able to buy that same basket of things. If
the matured money falls short of buying you the same basket, you have diminished the value of your money in
last one year. If the money is more than just buying that basket, you have earned real income on your
investment.
ECONOMIC AND OTHER FACTORS AFFECTING COST OF CAPITAL
FEDERAL RESERVE POLICY
All federal banks have got the power to influence the economy. US Federal Reserve Board simple purchases the
treasury securities, normally held by banks, to boost the economy. Let’s understand how it works. When the
‘Federal Reserve Board’ buys the Treasury securities from the banks, the banks accumulate a lot of loanable
funds with it. Now, the banks with a higher supply of funds would start offering loans at lower interest rates.
This reduction in interest rates will encourage industrialists to start more and more ventures and that, in turn,
will create job opportunities, overall demand in the market etc. Although, there is a flip side of this policy that it
will increase the inflation in the longer run. This is how federal policies have a great impact on the cost of
capital.
FEDERAL BUDGET DEFICIT OR SURPLUS
Federal budget deficit and surplus also have a role to play in deciding the cost of capital in the market. In a
surplus situation, Fed would buy Treasury securities from the market and that will reduce the interest rates. On
the contrary, in a deficit situation, Fed would sell Treasury securities or mint money. Minting money would
increase the money supply in the market along with an expectation of higher inflation and that leads to
increasing the cost of money. Similarly, selling Treasury securities to banks will reduce the loanable funds with
banks and they increase the cost of funds.
TRADE ACTIVITY
Economic boom and recession also play a very important role in determining the cost of capital by impacting
the interest rates in the market.
FOREIGN TRADE SURPLUSES OR DEFICITS
A foreign trade deficit creates a need for borrowing from other countries. Borrower countries will have their
own opportunity cost of capital based on the interest rates available with other countries. Higher the borrowings
and higher will be the interest rates. That will impact the capital market.
COUNTRY RISK
Country risk is the risk associated with political, social, economic environment of a country. To understand with
an example, assume a country has trends of suddenly changing the tax rates, regulations relating to trade and
commerce etc. An international investor would resist investing in that country because their policy can put any
business at stake suddenly. This will reduce the flow of international capital in the country and thereby increase
the cost of capital.
EXCHANGE RATE RISK
Investment in countries other than the home country has a bearing of exchange rate risk on them. The real return
of an investor depends on two factors.
1. The performance of the investment in the foreign country and
2. The performance of the currency of that country in comparison to home currency.
At the time of maturity of the investment, if the home currency weakens, the net realization in home currency
would also be reduced. That can affect an investor’s decision of investing in other countries, especially whose
currency rates fluctuate a lot.
INDIVIDUAL COMPANY FACTORS AFFECTING COST OF CAPITAL
CAPITAL STRUCTURE POLICY
All companies try to optimize their capital structure with a policy that suits their individual situations.
New acquisition of capital will depend a lot on the capital structure policy and therefore the capital structure
policy of the said company will have a bearing on its cost of capital.
DIVIDEND POLICY
A dividend policy of a corporation decides how much percentage of profits it will retain and how much will be
distributed as dividends. If a company retains higher percentage of profits in the business, it is effectively
adding a capital at the cost of equity. Accordingly, the overall cost of capital will be impacted.
INVESTMENT POLICY
A company is nothing but a set of different projects it takes up. It is very important to note that different
projects would have different risk profile. If a company is adding a project with higher risk compared to overall
risk level of the organization, it is effectively increasing the risk of the organization. With this increase in risk,
the required rate of return will also increase. This is how, investment policy impacts the cost of capital
1/8 Factors determining price developments 1. What monetary policy can and cannot do How can monetary
policy influence what we pay for our goods and services, that is to say the price level? This question touches
upon what economists call the “monetary transmission mechanism” (or MTM), i.e. the process through which
actions of the central bank (such as changes in the policy rates) are transmitted through the economy and,
ultimately, to prices. This process is extremely complex, it changes over time, and differs somewhat from one
economy to another. Monetary policy influences the economy as follows: the central bank is the sole issuer of
base money. This takes the form of banknotes and coins in circulation and banks’ holdings of deposits with
their central bank (bank reserves), that is to say, it is the monopolistic supplier of the so-called “monetary base”.
By virtue of this monopoly, the central bank can influence money market conditions and steer short-term
interest rates. What are the basic features of the MTM? In the short run, a change in interest rates made by the
central bank triggers a number of mechanisms. Why? Mainly because this change has an impact on the
spending and saving decisions taken by households and firms. For example, higher interest rates will make it
less attractive for households and firms to borrow money in order to finance their consumption or investment.
Instead, higher rates will make it more attractive for them to save rather than spend. Finally, changes in interest
rates may also affect the supply of credit. These developments, after a delay of one or two years, then influence
developments in real economic variables such as output. The sequence of reactions to a change in the interest
rate outlined above involves a number of different mechanisms and actions taken by various economic agents at
different stages. Furthermore, the size and strength of the different effects can vary according to the state of the
economy. As a result, monetary policy usually takes a considerable time to affect prices. However, in the
economics profession, it is widely accepted that, in the long run, i.e. after all adjustments in the economy have
worked through, a change in the quantity of money supplied by the central bank will only be reflected in a
change in the general level of prices and will not cause permanent changes in real variables such as real output
or unemployment. A permanent change in the quantity of money in circulation brought about by the central
bank is ultimately equivalent to a change in the unit of account (and thereby in the general price level), which
leaves all other variables stable, in much the same way as changing the standard unit used to measure distance
(e.g. switching from kilometres to miles) would not alter the actual distance between two locations. This general
principle, referred to as the “long-run neutrality” of money, underlies all standard macroeconomic thinking and
theoretical frameworks. A monetary policy which credibly maintains price stability has a significant positive
impact on welfare and real activity. Beyond this positive impact of price stability, real income or the level of
employment in the economy are, in the long run, essentially determined by real (supply side) factors, and cannot
be enhanced by expansionary monetary policy.1 These main determinants of long-run employment and real
income are technology, population growth and all aspects of the institutional framework of the economy
(notably, property rights, tax policy, welfare policies and other regulations determining the flexibility of
markets and incentives to supply labour and capital and to invest in human resources). 1 Supply-side factors are
factors driving the supply of goods and services in an economy, in particular the amount and quality of capital
and labour, as well as technological progress and the design of structural policies. Consult our glossary
www.generationeuro.eu/glossary/ecb_en 2/8 Inflation is ultimately a monetary phenomenon. As a number of
empirical studies confirm, prolonged periods of high inflation are typically associated with high monetary
growth (see the chart below). While other factors (such as variations in aggregate demand, technological
changes or commodity price shocks) can influence price developments over shorter horizons, over time their
effects can be offset by some degree of adjustment of monetary policy. In this sense, the longer-term trends of
prices or inflation can be controlled by central banks. Money and Inflation 2. Money and interest rates – how
can monetary policy influence interest rates? A central bank can determine the short-term nominal interest rates
which banks have to pay when they want to borrow from the central bank. And banks need to turn to the central
bank for liquidity when they need banknotes for their clients and need to fulfil minimum reserve requirements
in the form of deposits with the central bank. As central banks are monopolistic suppliers of base money, they
can determine the policy rates, e.g. the short-term nominal interest rates on loans given to the banks. The
expectations regarding the future development of policy rates in turn influence a wide range of longer-term
bank and market interest rates. Why can central banks influence (ex ante) real interest rates? The role of
“sticky” prices Borrowing and investment decisions by households and firms greatly depend on the real interest
rate. For example, the ex ante real interest rate is the real return which a financial asset is expected to deliver. It
is defined as the nominal interest rate minus expected inflation over the maturity for which the interest rate is
fixed. The impact of monetary policy on short-term real interest rates is related to two issues: i) monetary policy
controls the short-term nominal interest rate and ii) prices are sticky in the short run. What is the meaning of
“sticky prices”? Empirical evidence tells us that most prices are fixed for some time; very often firms do not
instantly adjust the prices they charge in response to changes in supply or demand conditions. In reality, some
prices are adjusted very often (e.g. petrol prices), while other prices are adjusted perhaps once a month or once a
year. There can be various reasons for this. First, prices are sometimes set by long-term contracts between firms
and customers to reduce the uncertainties and costs associated with frequent negotiations. Second, firms may
hold prices steady in order not to annoy their regular customers with frequent price changes. Third, some prices
are sticky because of the way markets are structured; once a firm has printed and distributed a catalogue or price
list, it is costly for it to alter prices. Finally, the calculation of new prices is costly as well. In the long run,
however, prices have to adjust to new supply and demand conditions. Put another way, prices are fully flexible
in the long run.2 Now assume that the central bank increases the supply of money. For example, it prints new
money and buys government bonds with it. People are only prepared to hold a higher amount of money and
reduce their holdings of bonds if the return on these bonds, i.e. the interest rate, falls. Thus, if the central bank
increases the supply of money, the nominal interest rate must fall in order to induce people to hold a higher
amount of money. And as prices are sticky in the short run, this implies that short-term inflation expectations
remain largely unchanged. As a consequence, a change in short-term nominal interest rates translates into a
change in the ex ante expected real interest rate. Therefore, monetary policy can influence expected or ex ante
shortterm real interest rates. 2 With the exception of administered prices, which can only be expected to change
very rarely. 3/8 3. How do changes in interest rates affect the expenditure decisions taken by consumers and
firms? From the perspective of an individual household (e.g. a family), a higher real interest rate3 makes it more
attractive to save, since the return on the savings in terms of future consumption is higher. Therefore, higher
real interest rates typically lead to a fall in current consumption and an increase in savings. From a firm’s
standpoint, a higher real interest rate will deter investment, because fewer of the available investment projects
will offer a return sufficient to cover the higher cost of capital. To sum up, an interest rate rise will make current
consumption less desirable for households and discourage current investment by firms. The effects on
individual households and firms show that an increase in real interest rates brought about by monetary policy
will lead to a reduction in current expenditure in the economy as a whole. Economists say that such a policy
change causes a drop in aggregate demand and is thus often referred to as a “tightening” of monetary policy. It
is important to understand that there are time lags in this process. It might easily take months for firms to put a
new investment plan in place; investments involving the construction of new plants or the ordering of special
equipment can even take years. Housing investment also takes some time to respond to changes in interest rates.
Also, many consumers will not immediately change their consumption plans in response to changes in interest
rates. Indeed, it is generally agreed that the monetary transmission mechanism takes time. Monetary policy
cannot, therefore, control the overall demand for goods and services in the short run. Expressed in another way,
there is a significant time lag between a change in monetary policy and its effect on the economy. How do
changes in aggregate demand affect economic activity and price developments? An easy way of illustrating how
changes in aggregate demand affect price developments is to use a simple model focusing on aggregate supply
and demand in the whole economy. The model basically attempts to describe the relationship between the real
quantity of goods and services supplied and demanded in an economy and the aggregate price level. Short-run
equilibrium of aggregate supply and demand The chart below illustrates aggregate supply (AS) and aggregate
demand (AD), with the price level on the vertical axis and real output on the horizontal axis. Aggregate demand
and short-run aggregate supply Aggregate demand and the price level To understand the slope of aggregate
demand, we have to analyse what happens to real expenditure decisions when the price level changes, assuming
all other economic variables remain the same. It can be shown that the aggregate demand curve has a negative
slope. If prices for goods and services increase, people will suffer a decline in their “real income”, which
reflects the amount of goods and services that their incomes will buy. This implies that they can only finance a
lower volume of transactions. Conversely, if the price level falls, their real income will allow for a higher
volume of purchases, meaning that there will be a greater demand for real output. 3 The real interest rate is
defined as the nominal interest rate minus expected inflation over the maturity for which the interest rate is
fixed. 4/8 Aggregate supply and the price level in the short run Aggregate supply deals with the supply of goods
and services produced by firms. We first need to understand how the overall level of prices is related to the
overall level of output in the short run, i.e. assuming that all other factors (production technology, nominal
wages, etc.) remain the same. How does a change in the price level affect the real production or the real output
of firms? In essence, if nominal wages are given, a higher price level will lead to a decline in real wages. With
lower real wages it becomes more profitable for firms to hire more workers and to increase production.
Conversely, if some additional goods and services can be sold at a higher price, this might encourage firms to
hire more workers (even at a higher salary) and expand their supply. The short-run aggregate supply curve,
therefore, is upward sloping. The intersection of the two curves determines what economists call the
“equilibrium”. The concept of equilibrium is crucial in economics. This is because, in such a situation, the
wishes of both market sides coincide and, therefore, there is no tendency for further change. In this case, the
equilibrium determines the price level and the level of real output prevailing in an economy at the same time.
What happens if the economy faces a state of disequilibrium? Suppose the economy is facing a price level
which is higher than the equilibrium level. In such a situation aggregate supply is too high and aggregate
demand too low compared with equilibrium. What happens? If the price level is higher than in equilibrium,
buyers will want to buy less than producers want to sell. Therefore, some suppliers will lower their prices,
which in turn leads to an increase in aggregate demand. At the same time, the lower prices will raise real wages
(as nominal wages are fixed in the short run) and – as real wages represent a cost factor for firms – they will cut
back production and tend to lower aggregate supply. This process will go on until an equilibrium situation is
reached, i.e. a situation where the wishes and plans of buyers and sellers coincide at a certain price and output
level. Aggregate supply in the long run Why do we speak above of the short-run supply curve? The positive
impact of a higher price level on real output will only last as long as nominal, and therefore also real, wages
remain unchanged. In reality, nominal wages are normally fixed for about one year, and in some cases for up to
two years. If workers or unions do not accept the lower real wages caused by higher prices they will use the
next wage negotiations to demand compensation in the form of higher wages. If real wages return to the level
they were at before the increase in the price level (and if production technology is unchanged), firms will no
longer find it profitable to maintain production and employment at the higher level and will thus make cuts. In
other words, if real wages cannot be reduced by higher inflation in the long run, employment and production
will also be independent of price developments in the long run. This means that the long-term aggregate supply
curve will be vertical. The long-run equilibrium Aggregate demand and long-run aggregate supply The
intersection of the aggregate supply (AS) curve with the horizontal axis (see AS* in the chart above) is what
economists call the potential level of output. This level represents the value of final goods and services
produced when the economy’s resources are fully employed, given the current state of technology and structural
features of the economy (such as labour market regulations, welfare and tax systems, etc.). So far we have
discussed movements along the curves, with all other factors but prices and real output remaining unchanged.
We now need to understand what happens if these other factors change. In essence, such changes shift the
curves to the right or the left. 5/8 Factors affecting aggregate supply and aggregate demand According to the
simple model we have been using, the combination of prices and real income that an economy is experiencing is
obviously determined by the interplay of aggregate supply and demand. This raises questions regarding the
factors leading to shifts in the two curves. The factors leading to an increase in aggregate demand (i.e. a shift in
AD outwards or to the right) include an increase in government expenditure, a reduction in taxes, a depreciation
of the home currency, and an increase in real wealth (e.g. higher stock and land prices), which in turn lead to
higher private consumption and investment expenditure. Private consumption and investment may also be
driven by expectations. For example, if firms expect higher future profits, they will tend to increase investment
expenditures. And if households expect higher real income as a result of higher expected labour productivity,
consumer expenditure will increase. For this reason, an improvement in consumer and investor confidence is
normally related to an increase in current aggregate demand. With regard to the impact of monetary policy, we
can observe that a lower policy rate and an increase in money supply will cause aggregate demand to increase,
thus shifting the demand curve to the right.4 If these variables change in the opposite direction, aggregate
demand will fall (i.e. AD will shift to the left). Regarding aggregate supply, we can see that increases in the
prices of production factors, such as wages, or increases in oil prices will lead to a shift to the left in aggregate
supply. On the other hand, technological progress or increases in productivity will shift aggregate supply to the
right, as this allows for more production at the same cost with a given quantity of labour input. This analysis
shows that changes in the general price level can be brought about by shifts in either the supply curve or the
demand curve or in both. For instance, if all other factors remain stable, a decline in aggregate supply (i.e. a
shift of AS to the left) will be accompanied by a short-term fall in real output and an increase in prices, whereas
an increase in demand (i.e. a shift of AD to the right) will manifest itself in higher short-term real activity and
higher prices. The long-run model illustrates that the behaviour of aggregate demand is crucial in determining
the general price level that an economy experiences in the long run. If the aggregate supply curve is vertical,
changes in aggregate demand will affect prices but not output. If, for instance, money supply were to increase,
the aggregate demand curve would shift to the right and the economy would thus, in the long run, shift to a new
equilibrium where real production has remained the same but prices have risen. Shifts in aggregate demand and
long-run aggregate supply Inflation was defined as a general, or broadly-based, increase in the prices of goods
and services. Therefore, a process of lasting inflation can only be brought about by a continuing increase in
aggregate demand over time. This, in turn, is only possible if monetary policy accommodates such a
development by keeping interest rates low and money growth high. 4 Economists note that often a decline in
money demand is associated with an increase in the velocity of money. The latter variable can be defined as the
speed with which money is transferred between different money holders and thus determines how much money
is required for a particular level of transaction. In fact, these two phenomena must be regarded as two sides of
the same coin. If people want to hold less money, the available stock of money will, given a constant money
supply, have to change hands more often and so circulate more. This is equivalent to a higher velocity of
money. 6/8 4. Factors driving price developments over shorter-term horizons Inflation (i.e. a sustained increase
in the price level) can be caused in either one or two ways. Prices in general will rise if, on average, either
aggregate demand increases or supply decreases. To put it differently, inflationary pressures can result if there
are changes (economists often speak of “shocks” if there are unexpected changes in economic developments)
which lead consumers to increase their expenditure or firms to reduce their production. The first instance, where
demand increases, resulting in inflation, is often described as “demand-pull inflation” in the economic literature.
The second instance, where costs increase and supply therefore decreases, thus also resulting in inflation, is
often called “cost-push inflation”. The opposite happens, i.e. deflationary pressures emerge, if aggregate
demand falls or aggregate supply increases. In general, monetary policy often has to respond to such
developments in order to ensure price stability. In cases of inflationary pressure, the central bank would
normally increase (real) interest rates to prevent that pressure from translating into more persistent deviations
from price stability. Examples of potential shocks: a) Energy price shock ■■ demand persistently outpaces the
supply of energy, e.g. as occurs when emerging markets’ demand for energy develops faster than the supply
available ■■ supply declines rapidly, e.g. as a result of geopolitical tensions and, say, an oil blockade b) Food
price shock ■■ demand persistently outpaces supply, e.g. on account of population growth and rising incomes
■■ disruptions occur in the food chain c) Financial turmoil ■■ the stock exchange crashes d) Technological
breakthroughs ■■ productivity goes up, thereby influencing prices e) Structural reforms ■■ product and labour
market flexibility is enhanced, which can have an impact on prices f ) Natural disasters Price increases that arise
because of an increase in aggregate demand may result from any individual factor that increases aggregate
demand, but the most significant of these factors, besides monetary policy (lower interest rate and an increase in
money supply), are increases in government purchases, depreciation of the exchange rate and increased demand
pressures for domestic goods from the rest of the world (exports). Changes in aggregate demand can also be
caused by increased confidence and an improved economic outlook. It is likely, for example, that firms will
invest more if higher profits can be expected in the future. Changes in aggregate demand will normally increase
the price level and, temporarily, aggregate production. What factors are likely to lead to a reduction in aggregate
supply and thus to higher prices in the short run? The main sources of falling aggregate supply are decreases in
productivity, increases in production costs (for instance, increases in real wages and in the prices of raw
materials, notably oil), and higher corporate taxes imposed by governments. If all other factors remain the same,
the higher the cost of production, the smaller the amount produced at the same price. For a given price level, if
wages or the costs of raw materials, such as oil, rise, firms are forced to reduce the number of people they
employ and to cut production. As this is the result of supply-side effects, the resulting inflation is often referred
to as “cost-push inflation”. Various circumstances could cause the price of inputs to rise, for instance, if the
supply of raw materials such as oil falls short of expectations, or if the worldwide demand for raw materials
rises. Increases in real wages (which do not happen to be matched by increased productivity) will also lead to a
decline in aggregate supply and lower employment. Such wage increases may result from a decline in the labour
supply, which in turn may have been caused by a government regulation which has the effect of reducing the
incentives to work (e.g. higher taxes on labour income). An increase in the bargaining power of trade unions
can also result in higher real wages. If the factors described above work in the other direction, we will see an
increase in aggregate supply. For example, an increase in productivity (e.g. based on new technologies) would,
all things being equal, lead to lower prices and higher employment in the short run as it becomes more
profitable to hire labour at given wages. However, if real wages were to increase in line with productivity,
employment would remain unchanged. 7/8 The role of expected inflation When firms and employees negotiate
wages and when firms set their prices, they often consider what the level of inflation may be in the period
ahead, for example, over the following year. Expected inflation matters for current wage settlements as future
price rises will reduce the quantity of goods and services that a given nominal wage can buy. So, if inflation is
expected to be high, employees might demand a higher nominal wage increase during wage negotiations.
Firms’ costs increase if wage settlements are based on these expectations and these costs can be passed on to
customers in the form of higher prices. A similar case can be made for price-setting on the part of firms. As
many individual prices remain fixed for a particular period, firms which had planned to publish a new price list
may increase their individual prices with immediate effect if they anticipate increases in the general price level
or in wages in the future. So if people expect inflation in the future, their behaviour can already cause a rise in
inflation today. This is another reason why it is very important for monetary policy to be credible in its
objective of maintaining price stability – in order to stabilise longer-term inflation expectations at low levels, in
line with price stability. Taken together, a variety of factors and shocks can influence the price level in the short
run. Among them are developments in aggregate demand and its various components, including developments
in fiscal policy. Further changes could relate to changes in input prices, in costs and productivity, in
developments in the exchange rate, and in the global economy. All these factors could affect real activity and
prices over shorter-term horizons. But what about longer-term horizons? This brings us to another important
distinction in economics. Economists generally draw a distinction between the short run and the long run. 5.
Factors driving price developments over longer-term horizons What is the relative importance of these factors
on inflation over longer-term horizons? Or in other words: are they all of equal relevance as regards inflationary
trends? The answer is clearly “no”. We shall see that monetary policy plays a crucial role here. As already
mentioned, there is a time lag of about one to two years between changes in monetary policy and the impact on
prices. This implies that monetary policy cannot prevent unexpected real economic developments or shocks
from having some short-run impact on inflation. However, there is widespread agreement among economists
that monetary policy can control price developments over the longer term and therefore also the “trend” of
inflation, i.e. the change in the price level when the economy has fully incorporated short-term disturbances. In
the long run, prices are more flexible and can respond to lasting changes in demand and supply (think, for
example, of the spread of smartphones and netbooks, whose prices have declined over time). However, as
already mentioned, in the short run many individual prices are sticky and will remain at their current levels for
some time. How does this distinction influence our results? Without going into too much detail, it can be argued
that output does not depend on the price level in the long run. It is determined by the given stock of capital; by
the labour force available and the quality of that labour force; by structural policies which influence incentives
to work and to invest; and by any technological developments in the field of production. In other words, the
long-term level of output depends on a number of real or supply-side factors. These factors determine the exact
position of the aggregate supply curve. The other curve that determines the state of equilibrium of the economy
is the aggregate demand curve. As we have seen, a number of factors can lead to increases in aggregate demand.
Among them are increases in government expenditures, in external demand for exports, and in improved
expectations of future productivity developments which might have an impact on current consumption and
investment. It is obvious, however, that although many of these factors can increase even for a protracted
period, a sustained increase in the general price level can, in the long run, only be driven by a sustained and
ongoing expansionary monetary policy. This point is often made in terms of the famous statement – “inflation is
always and everywhere a monetary phenomenon”. Indeed, a number of empirical studies have provided
evidence in favour of this hypothesis. The ultimate reason for an inflationary process in the longer run is,
therefore, a sustained increase in money supply which is equivalent to a sustained expansionary monetary
policy. In a longer-term perspective, monetary policy actions thus determine whether inflation is allowed to rise
or is kept low. In other words, a central bank that controls the money supply and the short-term interest rate has
ultimate control over the rate of inflation over longer-term horizons. If the central bank keeps short-term interest
rates too low and increases the money supply by too much, the price level will ultimately also increase. This
basic result is illustrated by the fundamental economic concept which addresses in more detail the relationship
between money and prices, namely the quantity theory of money. 8/8 The quantity theory of money According
to an identity which is widely known as the quantity equation, the change in the money stock (ΔM) in an
economy equals the change in nominal transactions (approximated by the change in real activity (ΔYR) plus the
change in the price level (ΔP)), minus the change in velocity (ΔV). The velocity can be defined as the speed
with which money is transferred between different money holders and thus determines how much money is
required to serve a particular level of nominal transactions.5 In short: ΔM = ΔYR + ΔP – ΔV This relationship
is a so-called identity, i.e. a relationship that can obviously not be falsified. It therefore does not provide any
statements about causality. A sense of causality can only be inferred if further assumptions regarding the
determinants of the variables are taken into account. In particular, the following two assumptions allow the
quantity equation to be transformed into the quantity theory. First, output can, in the long run, be regarded as
being determined by real-side factors like the productive opportunities of the community and its tastes and
preferences. Second, in the long run, velocity is regarded as being determined by payment practices, financial
and economic arrangements for effecting transactions and costs of and returns from holding money instead of
other assets. It then follows that the quantity of money supply – which is determined by the decisions taken by
the monetary authorities – is, in the long run, linked to the price level. Put another way, over the longer-term
horizons, the price level is determined directly by changes in the quantity of money and it moves proportionally
to the latter. One implication of this is that the institution which determines the supply of money, namely the
central bank, is ultimately responsible for longer-term trends in inflation. For more on inflation:
http://www.ecb.europa.eu/stats/macroeconomic_and_sectoral/hicp/html/index.en.html For more on euro area
data: http://sdw.ecb.europa.eu/ 6. Summary The central bank, as the sole issuer of banknotes and bank reserves,
can influence money market conditions and steer short-term interest rates. In the short run, a change in money
market interest rates sets in motion a number of mechanisms and actions by economic agents. Ultimately this
change will influence developments in economic variables, such as output or prices. In the long run – after all
adjustments in the economy have worked through – a change in monetary policy will only be reflected in a
change in the general level of prices. All real variables, such as real output or unemployment, will remain
unaffected. These variables are essentially determined by real factors, such as technology, population growth or
the preferences of economic agents. This also means that the effects of changes in the real factors on price
developments in the short run, can, over time, be offset by achange in monetary policy. In this respect, the
longer-term trends of prices or inflation can be controlled by central banks. 5 This reflects the fact that the left-
hand side of the equation sums up the amount of money used, whereas the right-hand side reflects the value of
the transaction.
Interest rate fundamentals
What Is an Interest Rate?
The interest rate is the amount a lender charges for the use of assets expressed as a percentage of the principal.
The interest rate is typically noted on an annual basis known as the annual percentage rate (APR). The assets
borrowed could include cash, consumer goods, or large assets such as a vehicle or building.
Volume 75%

1:47
Interest Rates: Nominal and Real
Understanding Interest Rates
Interest is essentially a rental or leasing charge to the borrower for the use of an asset. In the case of a large
asset, such as a vehicle or building, the lease rate may serve as the interest rate. When the borrower is
considered to be low risk by the lender, the borrower will usually be charged a lower interest rate. If the
borrower is considered high risk, the interest rate that they are charged will be higher.
For loans, the interest rate is applied to the principal, which is the amount of the loan. The interest rate is
the cost of debt for the borrower and the rate of return for the lender.
KEY TAKEAWAYS
 The interest rate is the amount charged on top of the principal by a lender to a borrower for the use of
assets.
  Most mortgages use simple interest. However, some loans use compound interest, which is applied to
the principal but also to the accumulated interest of previous periods.
 A loan that is considered low risk by the lender will have a lower interest rate. A loan that is considered
high risk will have a higher interest rate.
 Consumer loans typically use an APR, which does not use compound interest.
 The APY is the interest rate that is earned at a bank or credit union from a savings account or certificate
of deposit (CD). Savings accounts and CDs use compounded interest.
When Are Interest Rates Applied?
Interest rates apply to most lending or borrowing transactions. Individuals borrow money to purchase homes,
fund projects, launch or fund businesses, or pay for college tuition. Businesses take loans to fund capital
projects and expand their operations by purchasing fixed and long-term assets such as land, buildings, and
machinery. Borrowed money is repaid either in a lump sum by a pre-determined date or in periodic
installments.
The money to be repaid is usually more than the borrowed amount since lenders require compensation for the
loss of use of the money during the loan period. The lender could have invested the funds during that period
instead of providing a loan, which would have generated income from the asset. The difference between the
total repayment sum and the original loan is the interest charged. The interest charged is applied to the principal
amount.
For example, if an individual takes out a $300,000 mortgage from the bank and the loan agreement stipulates
that the interest rate on the loan is 15%, this means that the borrower will have to pay the bank the original loan
amount of $300,000 + (15% x $300,000) = $300,000 + $45,000 = $345,000.
If a company secures a $1.5 million loan from a lending institution that charges it 12%, the company must repay
the principal $1.5 million + (12% x $1.5 million) = $1.5 million + $180,000 = $1.68 million.
Simple Interest Rate
The examples above are calculated based on the annual simple interest formula, which is:
 Simple interest = principal x interest rate x time
The individual that took out a mortgage will have to pay $45,000 in interest at the end of the year, assuming it
was only a one-year lending agreement. If the term of the loan was for 20 years, the interest payment will be:
 Simple interest = $300,000 x 15% x 20 = $900,000
An annual interest rate of 15% translates into an annual interest payment of $45,000. After 20 years, the lender
would have made $45,000 x 20 years = $900,000 in interest payments, which explains how banks make their
money.
Compound Interest Rate
Some lenders prefer the compound interest method, which means that the borrower pays even more in interest.
Compound interest also called interest on interest, is applied to the principal but also on the accumulated
interest of previous periods. The bank assumes that at the end of the first year the borrower owes the principal
plus interest for that year. The bank also assumes that at the end of the second year, the borrower owes the
principal plus the interest for the first year plus the interest on interest for the first year.
The interest owed when compounding is higher than the interest owed using the simple interest method. The
interest is charged monthly on the principal including accrued interest from the previous months. For shorter
time frames, the calculation of interest will be similar for both methods. As the lending time increases, however,
the disparity between the two types of interest calculations grows.
The table below is an illustration of how compound interest works.

At the end of 20 years, the total owed is almost $5 million on a $300,000 loan. A simpler method of calculating
compound interest is to use the following formula:
 Compound interest = principal x [(1 + interest rate)n – 1]
Where:
 n is the number of compounding periods.
When an entity saves money using a savings account, compound interest is favorable. The interest earned on
these accounts is compounded and is compensation to the account holder for allowing the bank to use the
deposited funds. If a business deposits $500,000 into a high-yield savings account, the bank can take $300,000
of these funds to use as a mortgage loan.
To compensate the business, the bank pays 6% interest into the account annually. So, while the bank is taking
15% from the borrower, it is giving 6% to the business account holder, or the bank’s lender, netting it 9% in
interest. In effect, savers lend the bank money, which, in turn, provides funds to borrowers in return for interest.

The snowballing effect of compounding interest rates, even when rates are at rock bottom, can help you build
wealth over time; Investopedia Academy's Personal Finance for Grads course teaches how to grow a nest egg
and make wealth last.
APR vs. APY
Interest rates on consumer loans are typically quoted as the annual percentage rate (APR). This is the rate of
return that lenders demand for the ability to borrow their money. For example, the interest rate on credit cards is
quoted as an APR. In our example above, 15% is the APR for the mortgagor or borrower. The APR does not
consider compounded interest for the year.
The annual percentage yield (APY) is the interest rate that is earned at a bank or credit union from a savings
account or certificate of deposit (CD). This interest rate takes compounding into account.
Borrower's Cost of Debt
While interest rates represent interest income to the lender, they constitute a cost of debt to the borrower.
Companies weigh the cost of borrowing against the cost of equity, such as dividend payments, to determine
which source of funding will be the least expensive. Since most companies fund their capital by either taking on
debt and/or issuing equity, the cost of the capital is evaluated to achieve an optimal capital structure.
Interest Rate Drivers
The interest rate charged by banks is determined by a number of factors such as the state of the economy. A
country’s central bank sets the interest rate. When the central bank sets interest rates at a high level the cost of
debt rises. When the cost of debt is high, thus discouraging people from borrowing and slows consumer
demand. Also, interest rates tend to rise with inflation.
Fast Fact: The current interest rate for a 30-year mortgage is around 4%, according to Bank of America; in
1981, according to The Street, the 30-year fixed mortgage rate was 18.5%.
To combat inflation, banks may set higher reserve requirements, tight money supply ensues, or there is greater
demand for credit. In a high-interest rate economy, people resort to saving their money since they receive more
from the savings rate. The stock market suffers since investors would rather take advantage of the higher rate
from savings than invest in the stock market with lower returns. Businesses also have limited access to capital
funding through debt, which leads to economic contraction.
Economies are often stimulated during periods of low-interest rates because borrowers have access to loans at
inexpensive rates. Since interest rates on savings are low, businesses and individuals are more likely to spend
and purchase riskier investment vehicles such as stocks. This spending fuels the economy and provides an
injection to capital markets leading to economic expansion. While governments prefer lower interest rates, they
eventually lead to market disequilibrium where demand exceeds supply causing inflation. When inflation
occurs, interest rates increase.
Related Terms
How Loans Work and the Types of Loans
A loan is money, property or other material goods given to another party in exchange for future repayment of
the loan value amount with interest. A loan may be for a specific, one-time amount or can be available as an
open-ended line of credit up to a specified limit or ceiling amount.
more
What the Annual Percentage Rate – APR Tells You
An APR is defined as the annual rate charged for borrowing, expressed as a single percentage number that
represents the actual yearly cost over the term of a loan.
more
Compound Interest Definition
Compound interest is the numerical value that is calculated on the initial principal and the accumulated interest
of previous periods of a deposit or loan. Compound interest is common on loans but is less often used with
deposit accounts.
more
How Annual Percentage Yield (APY) Works
The annual percentage yield (APY) is the effective rate of return on an investment for one year taking into
account the effect of compounding interest. The more often the interest is compounded, the greater the return
will be.
more
Interest
Interest is the charge for the privilege of borrowing money, typically expressed as an annual percentage rate.
more
What a Periodic Interest Rate Means for Your Loans and Investments
The periodic interest rate is the rate charged or paid on a loan or realized on an investment over a specified
period of time. Learn how to calculate it.
more
Interest Rates Explained
When you take out a mortgage, apply for college loans, or finance a new car, your lender determines the rate of
interest you’ll be charged for a portion of, or for the duration of your loan. This rate is heavily influenced by the
overall economy’s interest rates. Interest rate futures enable banks to manage the risk of fluctuating interest
rates — so they can loan money to businesses in your community and to people like you.
What is interest rate risk?
When a bank loans you money, it must pay an interest rate back to the Federal Reserve Bank, the central
banking system of the United States. Think of it like this: if the bank is your lender, then the Fed is the bank’s
lender. Since these interest rates move all the time, the bank is constantly exposed to price risks that will shape
how much money it loans out, and at what rate.
risk:
The possibility of losing some or all profits or investment return due to external market factors.
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Mortgage rates rise and fall along with interest rates. When banks use interest rate futures to manage their
interest rate exposure, they are better able to provide you with a competitive mortgage rate because they’ve
already locked in their own short- or long-term interest rate. Managing their risk with interest rate futures
enables them to loan more money to more people and businesses.
Interest rates Fundamentals of Finance Interest rates Jukka Perttunen University of Oulu - Department of
Finance Fall 2018 Jukka Perttunen Fundamentals of Finance Interest rates Short-term interest rates Interest rate
is always quoted in terms of an annual rate, no matter of what is maturity of the rate. With maturities up to one
year, the practice is to always use a simple interest rate. In a simple rate the interest is added in the principal at
the end of the total period. 1000 ✲ 1030 0 0.25 0.50 0.75 1.00 The applying of the three-month rate of 2.124%
to a e1000 principal results 1000 × (1 + 0.02124 × 0.25) = 1005.31. 1000 ✲ 1030 0 0.25 0.50 0.75 1.00 The
applying of the six-month rate of 2.190% to a e1000 principal results 1000 × (1 + 0.02190 × 0.50) = 1010.95.
1000 ✲ 1030 0 0.25 0.50 0.75 1.00 The applying of the twelve-month rate of 2.332% to a e1000 principal
results 1000 × (1 + 0.02332 × 1.00) = 1023.32. Jukka Perttunen Fundamentals of Finance Interest rates Short-
term interest rates – where they come from? Euribor-banks promise to lend e994’718 against receiving back e1
million at the end of a three-month period. The e5’282 provision, the banks require, is 0.531% of the borrowed
e994’718. The banks quote the three-month Euribor-rate in terms of an annual simple rate of 4 × 0.531% =
2.124%. The three-month rate is applicable over an immediate three-month period only. When applying the rate
it has to be multiplied by 0.25: 994’718 × (1 + 0.02124 × 0.25) = 1’000’000. Euribor-banks promise to lend
e989’169 against receiving back e1 million at the end of a six-month period. The e10’831 provision, the banks
require, is 1.095% of the borrowed e989’170. The banks quote the six-month Euribor-rate in terms of an annual
simple rate of 2 × 1.095% = 2.190%. The six-month rate is applicable over an immediate six-month period
only. When applying the rate it has to be multiplied by 0.50: 989’169 × (1 + 0.02190 × 0.50) = 1’000’000.
Euribor-banks promise to lend e977’212 against receiving back e1 million at the end of a twelve-month period.
The e22’788 provision, the banks require, is 2.332% of the borrowed e977’211. The banks quote the twelve-
month Euribor-rate in terms of an annual simple rate of 1 × 2.332% = 2.332%. The twelve-month rate is
applicable over an immediate twelve-month period only: 977’212 × (1 + 0.02332) = 1’000’000. Jukka Perttunen
Fundamentals of Finance Interest rates Long-term interest rates With maturities longer than one year, the
practice is to use a compounded interest rate. In a compounded rate the interest is added in the principal at the
end of each compounding period. Interest is not paid at that time, but the one and only payment takes place at
the end of the total period. 1000 ✲ 1200 0 1 2 3 4 5 The applying of the annually compounded five-year rate of
2.988% to a e1000 principal results 1000 × (1 + 0.02988)5 = 1159. 1000 ✲ 1200 0 1 2 3 4 5 The applying of
the semiannually compounded five-year rate of 2.976% to a e1000 principal results 1000 × (1 + 0.02976 ×
0.50)10 = 1159. 1000 ✲ 1200 0 1 2 3 4 5 The applying of the continuously compounded five-year rate of
2.954% to a e1000 principal results 1000 e 0.02954×5 = 1159. Jukka Perttunen Fundamentals of Finance
Interest rates Compounding in interest rate In the compounding of interest the annual interest rate r is multiplied
by the length ∆t of the compounding period, and the T-year rate is applied over T/∆t compounding periods: (1 +
r∆t) T/∆t In the case of annual compounding (∆t = 1), and maturity of five years (T = 5), it is: (1 + r × 1)5/1 = (1
+ r ) 5 . In the case of semiannual compounding (∆t = 0.5), and maturity of five years (T = 5), it is: (1 + r ×
0.5)5/0.5 = (1 + r × 0.5)10 . In the case of continuous compounding, the length of the compounding period
approaches zero, and we have lim ∆t→0 (1 + rc ∆t) T/∆t . The multiplying of r by ∆t, when ∆t → 0, results the
same as the dividing r by n, when n → ∞: lim ∆t→0 r∆t = lim n→∞ rc n . The dividing of T by ∆t, when ∆t →
0, results the same as the multiplying T by n, when n → ∞: lim ∆t→0 T/∆t = lim n→∞ nT. Jukka Perttunen
Fundamentals of Finance Interest rates Compounding in interest rate We are now able to express the continuous
compounding as lim ∆t→0 (1 + rc ∆t) T/∆t = lim n→∞ 1 + rc n nT . (Natural) exponential function is defined
as e x = lim n→∞ 1 + x n n , where e = lim n→∞ 1 + 1 n n = 2.7182818... Thus continuous compounding
appears as lim ∆t→0 (1 + rc ∆t) T/∆t = lim n→∞ 1 + rc n nT = lim n→∞ "1 + rc n n T # = e rc T .
Continuously compounded interest can be solved in terms of the difference of logarithmic values: S0e rc T = ST
rc = 1 T ln ST − ln S0 . Jukka Perttunen Fundamentals of Finance Interest rates Transforming between the
compounding methods Continuously compounded rate rc can be transformed to the corresponding discretely
compounded rate r: (1 + r∆t) T/∆t = e rc T (1 + r∆t) = e rc ∆t r = 1 ∆t e rc ∆t − 1 . Discretely compounded rate
r can be transformed to the corresponding continuously compounded rate rc : e rc T = (1 + r∆t) T/∆t e rc = (1 +
r∆t) 1/∆t ln e rc = ln (1 + r∆t) 1/∆t rc = 1 ∆t ln 1 + r∆t . Jukka Perttunen Fundamentals of Financ Interest rates
Long-term interest rates – the 5-year rate An average government-issued five-year, 1000-euro face-value zero-
coupon bond trades currently at e862.70. The annual yield provided by the bond is 2.954% in terms of
continuous compounding. rc = 1 T (ln ST − ln S0) = 1 5 (ln 1000 − ln 862.70) = 0.02954 = 2.954%, 862.70 e
0.02954×5 = 1000. The European Central Bank quotes the five-year rate at the level of 2.954%. 1000 ✲ 2500 0
5 10 15 20 1000 e 0.02954×5 = 1159 We may transform the continuously compounded rate to a semiannually
compounded rate: rc = 2.954%, r = 1 0.5 (e 0.02954×0.5 − 1) = 2.976%, 1000(1 + 0.02976 × 0.5)10 = 1159. We
may transform the continuously compounded rate to an annually compounded rate: rc = 2.954%, r = 1 1.0 (e
0.02954×1.0 − 1) = 2.998%, 1000(1 + 0.02998 × 1.0)5 = 1159. Jukka Perttunen Fundamentals of Finance
Interest rates Long-term interest rates – the 10-year rate An average government-issued ten-year, 1000-euro
face-value zero-coupon bond trades currently at e696.56. The annual yield provided by the bond is 3.616% in
terms of continuous compounding. rc = 1 T (ln ST − ln S0) = 1 10 (ln 1000 − ln 696.56) = 0.03616 = 3.616%,
696.56 e 0.03616×10 = 1000. The European Central Bank quotes the ten-year rate at the level of 3.616%. 1000
✲ 2500 0 5 10 15 20 1000 e 0.03616×10 = 1436 We may transform the continuously compounded rate to a
semiannually compounded rate: rc = 3.616%, r = 1 0.5 (e 0.03616×0.5 − 1) = 3.649%, 1000(1 + 0.03649 ×
0.5)20 = 1436. We may transform the continuously compounded rate to an annually compounded rate: rc =
3.616%, r = 1 1.0 (e 0.03616×1.0 − 1) = 3.682%, 1000(1 + 0.03682 × 1.0)10 = 1436. Jukka Perttunen
Fundamentals of Finance Interest rates Long-term interest rates – the 20-year rate An average government-
issued twenty-year, 1000-euro face-value zero-coupon bond trades currently at e436.49. The annual yield
provided by the bond is 4.145% in terms of continuous compounding. rc = 1 T (ln ST − ln S0) = 1 20 (ln 1000 −
ln 436.49) = 0.04145 = 4.145%, 436.49 e 0.04145×20 = 1000. The European Central Bank quotes the twenty-
year rate at the level of 4.145%. 1000 ✲ 2500 0 5 10 15 20 1000 e 0.04145×20 = 2291 We may transform the
continuously compounded rate to a semiannually compounded rate: rc = 4.145%, r = 1 0.5 (e 0.04145×0.5 − 1)
= 4.188%, 1000(1 + 0.04188 × 0.5)40 = 2291. We may transform the continuously compounded rate to an
annually compounded rate: rc = 4.145%, r = 1 1.0 (e 0.04145×1.0 − 1) = 4.232%, 1000(1 + 0.04232 × 1.0)20 =
2291. Jukka Perttunen Fundamentals of Finance Interest rates Summary of interest rates Short-term interest
rates Quoted rate Simple rate Continuously compounded rate 3-month Euribor 6-month Euribor 12-month
Euribor Long-term interest rates 5-year bond yield 10-year bond yield 20-year bond yield 2.124% 2.190%
2.332% 2.124% 2.190% 2.332% 2.954% 3.616% 4.145% 2.954% 3.616% 4.145% The Euribor-system quotes
the short-term money-market rates as simple rates. The European Central Bank provides the long-term
government bond yields as continuously compounded rates. Jukka Perttunen Fundamentals of Finance Interest
rates Continuously compounded short-term rates Short-term interest rates Quoted rate Simple rate Continuously
compounded rate 3-month Euribor 6-month Euribor 12-month Euribor Long-term interest rates 5-year bond
yield 10-year bond yield 20-year bond yield 2.124% 2.190% 2.332% 2.124% 2.190% 2.332% 2.954% 3.616%
4.145% 2.954% 3.616% 4.145% Sometimes we need to apply the short-term rates in terms of continuously
compounded rates: r = 2.124%, rc = 1 ∆t ln 1 + r∆t = 1 0.25 ln 1 + 0.02124 × 0.25 = 2.118%, 2.118% r =
2.190%, rc = 1 ∆t ln 1 + r∆t = 1 0.50 ln 1 + 0.02190 × 0.50 = 2.178%, 2.178% r = 2.332%, rc = 1 ∆t ln 1 + r∆t
= 1 1.00 ln 1 + 0.02332 × 1.00 = 2.305%. 2.305% Jukka Perttunen Fundamentals of F Interest rates Discount
factors Short-term interest rates Quoted rate Simple rate Continuously compounded rate 3-month Euribor 6-
month Euribor 12-month Euribor Long-term interest rates 5-year bond yield 10-year bond yield 20-year bond
yield 2.124% 2.190% 2.332% 2.124% 2.190% 2.332% 2.118% 2.178% 2.305% 2.954% 3.616% 4.145%
2.954% 3.616% 4.145% We may calculate the discount factors of the different maturities: rc = 2.118%, d0.25 =
e −0.02118×0.25 = 0.99472, Discount factor 0.99472 rc = 2.178%, d0.50 = e −0.02178×0.50 = 0.98917,
0.98917 rc = 2.305%, d1.00 = e −0.02305×1.00 = 0.97721, 0.97721 rc = 2.954%, d5 = e −0.02954×5 = 0.86269,
0.86269 rc = 3.616%, d10 = e −0.03616×10 = 0.69656, 0.69656 rc = 4.145%, d20 = e −0.04145×20 = 0.43649,
0.43649 Jukka Perttunen Fundamentals of Finance Interest rates Interest rate as a coupon bond We may
consider an interest rate as a coupon bond, where the rate represents the coupon rate. The three-month Euribor
”bond” pays its only coupon at the end of the three-month period. Time in months Three-month Euribor 0.25
0.50 0.75 1.00 Coupon rate r 2.124% 2.124% rate is paid on e100 principal over a period of 0.25 years. Coupon
period ∆t 0.25 The coupon paid at the end of the three-month period is e0.531. Coupon payment 100 × r∆t
0.531 The principal of e100 is paid back at the same time. Principal payment 100. Thus the total payment is
e100.531. Total payment 100.531 We have determined the discount factor, which enables us to calculate the
present value of the total payment. Discount factor 0.99472 Present value of the total payment The present
value of the total payment equals to the principal value of the bond – the bond sells at par. 100. Jukka Perttunen
Fundamentals of Finance Interest rates Interest rate as a coupon bond In the case of the six-month Euribor, the
coupon of 2.190% is paid at the end of the six-month period. Time in months Six-month Euribor 0.25 0.50 0.75
1.00 Coupon rate r 2.190% The rate is now applied over a period of 0.50 years. Coupon period ∆t 0.50 The
coupon paid at the end of the six-month period is e1.095. Coupon payment 100 × r∆t 1.095 The principal of
e100 is paid back at the same time. Principal payment 100. Thus the total payment is e101.095. Total payment
101.095 The six-month discount factor is available. Discount factor 0.98917 Present value of the total payment
The bond sells at par. 100. Jukka Perttunen Fundamentals of Finance Interest rates Interest rate as a coupon
bond In the case of the twelve-month Euribor, the coupon of 2.332% is paid at the end of the twelve-month
period. Time in months Twelve-month Euribor 0.25 0.50 0.75 1.00 Coupon rate r 2.332% The rate is now
applied over a one-year period. Coupon period ∆t 1.00 The coupon paid at the end of the six-month period is
e2.332. Coupon payment 100 × r∆t 2.332 The principal of e100 is paid back at the same time. Principal
payment 100. The total payment is e102.332. Total payment 102.332 The twelve-month discount factor is
available. Discount factor 0.97721 Present value of the total payment The bond sells at par. 100. Jukka
Perttunen Fundamentals of Finance Interest rates Swap rates Besides short-term Euribor spot rates, the so-called
Euribor swap rates are quoted in the market. Swap rate is a fixed simple rate, which is paid once a year, over a
total period of several years. The swap rate is paid against the receiving of the floating six-month Euribor-rate,
and vice versa. The two-year swap, for instance, pays the fixed two-year swap rate twice: – the first fixed-rate
payment takes place at the end of the first year, – the second fixed-rate payment takes place at the end of the
second year. The two-year swap receives the floating six-month Euribor rate four times, over four subsequent
six-month periods: – the first floating-rate payment takes place at the end of the first six-month period, and is
determined by the current, already known, six-month Euribor-rate. – the remaining three floating-rate payments
are still unknown, and depend on the six-month Euribor-quotation in the beginning of each of the six-month
periods. The fixed swap rate always spans a par-selling bond in the same way as the Euribor spot rates do. The
floating-rate expectations, the six-month forward rates, span a par-selling bond as well. The two legs of rates are
equal in terms of their current values, and thus they insure each other. In the following, we consider the swap
rates as par-selling bonds, and apply them to determine the discount factors of longer maturities, as well as to
determine the forward rates of future periods. Jukka Perttunen Fundamentals of Finance Interest rates Swap
rates Short-term interest rates Quoted rate Simple rate Continuously compounded rate Discount factor 3-month
Euribor 6-month Euribor 12-month Euribor 2.124% 2.190% 2.332% 2.124% 2.190% 2.332% 2.118% 2.178%
2.305% 0.99472 0.98917 0.97721 Swap rates 2y/6m swap rate 3y/6m swap rate 4y/6m swap rate . . . 30y/6m
swap rate 2.587% 2.783% 2.943% . . . 4.050% 2.587% 2.783% 2.943% . . . 4.050% Long-term interest rates 5-
year bond yield 10-year bond yield 20-year bond yield 2.954% 3.616% 4.145% 2.954% 3.616% 4.145%
0.86269 0.69656 0.43649 Jukka Perttunen Fundamentals of Finance Interest rates Two-year swap rate as a
coupon bond The current two-year Euribor swap rate is 2.587%. The two-year ”bond” pays its two coupons at
the ends of the two one-year periods. Time in years Two-year Euribor swap rate 1 2 Coupon rate r 2.587%
2.587% The two e2.587 coupons are paid on e100 principal over one-year periods. Coupon period ∆t 1.00 1.00
Coupon payment 100 × r∆t 2.587 2.587 The principal of e100 is paid back at the end of the two-year period, at
the maturity of the swap. Principal payment 100. The total payment of the first year is the coupon payment
alone, whereas in the second year, we add the principal. Total payment 2.587 102.587 We know the one-year
discount factor, and are able to calculate the present value e2.528 of the first year’s payment. Discount factor
0.97721 Present value of the total payment 2.528 We do not know the two-year discount factor, but we know
that to trade at par, the present value of the second payment of the ”bond” has to be e100 − e2.528 = e97.472.
97.472 | {z } 100 The value of the discount factor has to be 0.95014. 0.95014 ✛ d2 × 102.587 = 97.472 Jukka
Perttunen Fundamentals of Finance Interest rates Three-year swap rate as a coupon bond The current three-year
Euribor swap rate is 2.783%. Time in years Three-year Euribor swap rate 1 2 3 Coupon rate r 2.783% 2.783%
2.783% The three e2.783 coupons are paid on e100 principal over one-year periods. Coupon period ∆t 1.00 1.00
1.00 Coupon payment 100 × r∆t 2.783 2.783 2.783 The principal of e100 is paid back at the end of the three-
year period, at the maturity of the swap. Principal payment 100. The total payments of the two first years are the
coupon payments alone; in the third year, we add the principal. Total payment 2.783 2.783 102.783 The first
two discount factors are available, and we are able to calculate the present values of the payments. Discount
factor 0.97721 0.95014 Present value of the total payment 2.720 2.644 The present value of the third payment
has to be e100 − e2.720 − e2.644 = e94.636. | {z } 100 94.636 The three-year discount factor has to be d3 =
94.636 102.783 = 0.92074. 0.92074 Jukka Perttunen Fundamentals of Finance Interest rates Four-year swap rate
as a coupon bond The current four-year Euribor swap rate is 2.943%. Time in years Four-year Euribor swap rate
1 2 3 4 Coupon rate r 2.943% 2.943% 2.943% 2.943% The four e2.943 coupons are paid on e100 principal over
one-year periods. Coupon period ∆t 1.00 1.00 1.00 1.00 Coupon payment 100 × r∆t 2.943 2.943 2.943 2.943
The principal of e100 is paid back at the end of the four-year period, at the maturity of the swap. Principal
payment 100. The total payments of the three first years are the coupon payments alone; in the fourth year, we
add the principal. Total payment 2.943 2.943 2.943 102.943 The first three discount factors are available, and
we are able to calculate the present values of the payments. Discount factor 0.97721 0.95014 0.92074 Present
value of the total payment 2.876 2.796 2.710 The present value of the third payment has to be e100 − e2.876 −
e2.796 − e2.710 = e91.618. | {z } 100 91.618 The three-year discount factor has to be d4 = 91.618 102.943 =
0.88999. 0.88999 Jukka Perttunen Fundamentals of Finance Interest rates Summary of interest rates Short-term
interest rates Quoted rate Simple rate Continuously compounded rate Discount factor 3-month Euribor 6-month
Euribor 12-month Euribor 2.124% 2.190% 2.332% 2.124% 2.190% 2.332% 2.118% 2.178% 2.305% 0.99472
0.98917 0.97721 Swap rates 2y/6m swap rate 3y/6m swap rate 4y/6m swap rate . . . 30y/6m swap rate 2.587%
2.783% 2.943% . . . 4.050% 2.587% 2.783% 2.943% . . . 4.050% 0.95014 0.92074 0.88999 Long-term interest
rates 5-year bond yield 10-year bond yield 20-year bond yield 2.954% 3.616% 4.145% 2.954% 3.616% 4.145%
0.86269 0.69656 0.43649 Jukka Perttunen Fundamentals of Finance Interest rates Forward rates Short-term
interest rates Quoted rate Simple rate Continuously compounded rate Discount factor 3-month Euribor 6-month
Euribor 12-month Euribor 2.124% 2.190% 2.332% 2.124% 2.190% 2.332% 2.118% 2.178% 2.305% 0.99472
0.98917 0.97721 Swap rates 2y/6m swap rate 3y/6m swap rate 2.587% 2.783% 2.587% 2.783% 0.95014
0.92074 Six-month forward rates 0.5 × 1.0 forward rate 1.0 × 1.5 forward rate 1.5 × 2.0 forward rate 2.0 × 2.5
forward rate 2.5 × 3.0 forward rate 2.447% 2.808% 2.851% 3.143% 3.193% 2.447% 2.808% 2.851% 3.143%
3.193% Forward rates are future-period rates. Jukka Perttunen Fundamentals of Finance Interest rates Forward
rates vs. spot rates 0 0.50 1.00 There is an opportunity to borrow e100 for twelve months, and pay the rate of
2.332%. Borrowing at the twelve-month rate: 1 + 2.332%✲ At the end of the twelve-month period we are to
pay e100(1 + 2.332% × 1) = e102.332. At the same time, there is an opportunity to lend e100.00 for six-months,
and receive the rate of 2.190%. Lending at the six-month rate: 1 + 2.190% × 0.5✲ At the end of the six-month
period, we are to receive e100.00(1 + 2.190% × 0.5) = e101.095. We may contract to lend the received
e101.095 at the forward rate of 2.447% for the latter six-month period. Lending at the six-month forward rate: 1
+ 2.447% × 0.5✲ At the end of the period, we are to receive e101.095(1 + 2.447% × 0.5) = e102.332. The
received e100.00 covers the e100, we need to pay for the loan. Jukka Perttunen Fundamentals of Finance
Interest rates Forward rates vs. swap rate 0 1 2 Behind the first year, the forward rates are spanned by the swap
rates. Borrowing at the two-year swap rate: ✲ There is an opportunity to borrow e100 for two years, and pay
the two-year swap rate of 2.587% for it. At the end of the first year, we are to pay an interest of e100 × 2.587%
= e2.587. 2.587%✲ At the end of the second year, we are to pay e100(1 + 2.587%) = e102.587. 1 + 2.587% In
terms of today’s euros, the payments make 0.97721 × e2.587 + 0.95014 × e102.587 = e100. 0.97721 0.95014
Jukka Perttunen Fundamentals of Finance Interest rates Forward rates vs. swap rate 0 1 2 Borrowing at the two-
year swap rate: 2.587%✲ 1 + 2.587%✲ 0.97721 0.95014 We lend the borrowed e100 for six-months at the rate
of 2.190%. Lending at the six-month rate: 1 + 2.190% × 0.5✲ At the end of the six-month period, we receive
e100.000(1 + 2.190% × 0.5) = e101.095. We contract to lend the e101.095 for the second six-month period at
the forward rate of 2.447%. 1 + 2.447% × 0.5✲ At the end of the second six-month period, we receive
e101.095(1 + 2.447% × 0.5) = e102.332. We contract to lend the e102.332 for the third six-month period at the
forward rate of 2.808%. 1 + 2.808% × 0.5✲ At the end of the third six-month period, we receive e102.332(1 +
2.808% × 0.5) = e103.779. We contract to lend the e103.779 for the fourth six-month period at the forward rate
of 2.851%. 1 + 2.851% × 0.5✲ At the end of the fourth six-month period, we receive e103.779(1 + 2.851% ×
0.5) = e105.258. Jukka Perttunen Fundamentals of Finance Interest rates Forward rates vs. swap rate 0 1 2
Borrowing at the two-year swap rate: 2.587%✲ 1 + 2.587%✲ 0.97721 0.95014 Lending at the six-month rate:
1 + 2.190% × 0.5✲ 1 + 2.447% × 0.5✲ 1 + 2.808% × 0.5✲ 1 + 2.851% × 0.5✲ The chain of six-month
forward rates results the terminal value of e105.258 at the end of the two-year period. e100 ×
(1+2.190%×0.5)(1+2.447%×0.5)(1+2.808%×0.5)(1+2.851%×0.5) = e105.258. In terms of today’s euros, it is
0.95014 × e105.258 = e100. The chain of forward rates results the same – in terms of today’s euros – as the
applying of the swap rate. Forward rates are spanned by the swap rates. Jukka Perttunen Fundamentals of
Finance Interest rates Forward rates vs. three-year swap rate 0 1 2 3 Borrowing at the three-year swap rate:
2.783%✲ 2.783%✲ 1 + 2.783%✲ 0.97721 0.95014 0.92074 Lending at the six-month rate: 1+2.190%×0.✲5
1+2.447%×0.✲5 1+2.808%×0.✲5 1+2.851%×0.✲5 1+3.143%×0.✲5 1+3.193%×0.✲5 The present value of
the swap rate payments is 0.97721 × e100 × 2.783% + 0.95014 × e100 × 2.783% + 0.92074 × e100 × (1 +
2.783%) = e100. The chain of spot/forward rates provides the terminal value of e100 ×
(1+2.190%×0.5)(1+2.447%×0.5)(1+2.808%×0.5) (1+2.851%×0.5)(1+3.143%×0.5)(1+3.193%×0.5) = e108.61.
The present value of the terminal value is 0.92074 × e108.61 = e100. Jukka Perttunen Fundamentals of Finance
Interest rates Forward rates and discount factors 0 1 2 3 Borrowing at the three-year swap rate: 2.783%✲
2.783%✲ 1 + 2.783%✲ 0.97721 0.95014 0.92074 Lending at the six-month rate: 1+2.190%×0.✲5
1+2.447%×0.✲5 1+2.808%×0.✲5 1+2.851%×0.✲5 1+3.143%×0.✲5 1+3.193%×0.✲5 The already determined
discount factors are implicitly in the forward rates: d1×e100×(1+2.190%×0.5)(1+2.447%×0.5) = e100 ⇒ d1 =
0.97721, d2×e100×(1+2.190%×0.5)(1+2.447%×0.5)(1+2.808%×0.5)(1+2.851%×0.5) = e100 ⇒ d2 = 0.95014.
Jukka Perttunen Fundamentals of Finance Interest rates Forward rates and discount factors 0 1 2 3 Borrowing at
the three-year swap rate: 2.783%✲ 2.783%✲ 1 + 2.783%✲ 0.97721 0.95014 0.92074 Lending at the six-month
rate: 1+2.190%×0.✲5 1+2.447%×0.✲5 1+2.808%×0.✲5 1+2.851%×0.✲5 1+3.143%×0.✲5 1+3.193%×0.✲5
The still missing discount factors can be solved by the forward rates:
d1.5×e100×(1+2.190%×0.5)(1+2.447%×0.5)(1+2.808%×0.5) = e100 ⇒ d1.5 = 0.96368,
d2.5×e100×(1+2.190%×0.5)(1+2.447%×0.5) (1+2.808%×0.5)(1+2.851%×0.5) (1+3.143%×0.5) = e100 ⇒ d2.5
= 0.93544. Jukka Perttunen Fundamentals of Finance Interest rates Summary of interest rates Short-term
interest rates Quoted rate Simple rate Continuously compounded rate Discount factor 3-month Euribor 6-month
Euribor 12-month Euribor 2.124% 2.190% 2.332% 2.124% 2.190% 2.332% 2.118% 2.178% 2.305% 0.99472
0.98917 0.97721 Swap rates 2y/6m swap rate 3y/6m swap rate 2.587% 2.783% 2.587% 2.783% 0.95014
0.92074 Six-month forward rates 0.5 × 1.0 forward rate 1.0 × 1.5 forward rate 1.5 × 2.0 forward rate 2.0 × 2.5
forward rate 2.5 × 3.0 forward rate 2.447% 2.808% 2.851% 3.143% 3.193% 2.447% 2.808% 2.851% 3.143%
3.193% 0.97721 0.96368 0.95014 0.93544 0.92074 Jukka Perttunen Fundamentals of Finance Interest rates
Summary of interest rates Short-term interest rates Quoted rate Simple rate Continuously compounded rate
Discount factor 3-month Euribor 6-month Euribor 12-month Euribor 2.124% 2.190% 2.332% 2.124% 2.190%
2.332% 2.118% 2.178% 2.305% 0.99472 0.98917 0.97721 Swap rates 2y/6m swap rate 3y/6m swap rate
2.587% 2.783% 2.587% 2.783% 0.95014 0.92074 Six-month forward rates 0.5 × 1.0 forward rate 1.0 × 1.5
forward rate 1.5 × 2.0 forward rate 2.0 × 2.5 forward rate 2.5 × 3.0 forward rate 2.447% 2.808% 2.851%
3.143% 3.193% 2.447% 2.808% 2.851% 3.143% 3.193% 2.432% 2.788% 2.831% 3.119% 3.168% 0.97721
0.96368 0.95014 0.93544 0.92074 For further purposes, we transform the simple forward rates to continuously
compounded rates. Jukka Perttunen Fundamentals of Finance Interest rates Three-year swap rate as a coupon
bond revisited Time in years Three-year Euribor swap rate 1.0 2.0 3.0 Coupon rate r 2.783% 2.783% 2.783%
The largest financial transaction most homeowners undertake is their home mortgage, yet very few fully
understand how mortgages are priced. The main component of the price is the mortgage interest rate, and it is
the only component borrowers have to pay from the day their loan is disbursed to the day it is fully repaid.
Definition of Interest Rate
An interest rate is the price of money, and a home mortgage interest rate is the price of money loaned against
the security of a specific home. The interest rate is used to calculate the interest payment the borrower owes the
lender.

The rates quoted by lenders are annual rates. On most home mortgages, the interest payment is calculated
monthly. Hence, the rate is divided by 12 before calculating the payment.
Consider a 3% rate on a $100,000 loan. In decimals, 3% is .03, and when divided by 12 it is .0025. Multiply
.0025 times $100,000 and you get $250 as the monthly interest payment.
Interest and Other Loan Charges
Interest is only one component of the cost of a mortgage to the borrower. They also pay two kinds of upfront
fees, one stated in dollars that cover the costs of specific services such as title insurance, and one stated as a
percent of the loan amount which is called “points”. And borrowers with small down payments also must pay a
mortgage insurance premium which is paid over time as a component of the monthly mortgage payment.
Interest Rate and the APR
Whenever you see a mortgage interest rate, you are likely also to see an APR, which is almost always a little
higher than the rate. The APR is the mortgage interest rate adjusted to include all the other loan charges cited in
the paragraph above. The calculation assumes that the other charges are spread evenly over the life of the
mortgage, which imparts a downward bias to the APR on any loan that will be fully repaid before term – which
is most of them.
Monthly Interest Accrual Versus Daily Accrual
The standard mortgage in the US accrues interest monthly, meaning that the amount due the lender is calculated
a month at a time. There are some mortgages, however, on which interest accrues daily. The annual rate, instead
of being divided by 12 to calculate monthly interest is divided by 365 to calculate daily interest. These are
called “simple interest mortgages,” I have discovered that borrowers who have one often do not know they have
one until they discover that their loan balance isn’t declining the way it would on a monthly accrual mortgage.
Simple interest mortgages are the source of a lot of trouble.
Fixed Versus Adjustable Interest Rates
A mortgage on which the interest rate is set for the life of the loan is called a “fixed-rate mortgage” or FRM,
while a mortgage on which the rate can change is an “adjustable rate mortgage” or ARM. ARMs always have a
fixed rate period at the beginning, which can range from 6 months to 10 years. The rate adjustment feature of an
ARM makes it a lot more complicated than an FRM, which is why many borrowers won’t consider an ARM.
The Structure of Mortgage Interest Rates
On any given day, Jones may pay a higher mortgage interest rate than Smith for any of the following reasons:
 Jones paid a smaller origination fee, perhaps receiving a negative fee or rebate.
 Jones had a significantly lower credit score.
 Jones is borrowing on an investment property, Smith on a primary residence.
 Jones’ property has 4 dwelling units whereas Smith’s is single family.
 Jones is taking “cash-out” of a refinance, whereas Smith isn’t.
 Jones needs a 60-day rate lock whereas Smith needs only 30 days.
 Jones waives the obligation to maintain an escrow account, Smith doesn’t.
 Jones allows the loan officer to talk him into a higher rate, while Smith doesn’t.
All but the last item are legitimate in the sense that if you shop on-line at a competitive multi-lender site, such
as mine, the prices will vary in the way indicated. The last item is needed to complete the list because many
borrowers place themselves at the mercy of a single loan officer.
Changes in Mortgage Interest Rates
Most new mortgages are sold in the secondary market soon after being closed, and the prices charged borrowers
are always based on current secondary market prices. The usual practice is to reset all prices every morning
based on the closing prices in the secondary market the night before. Call these the lender’s posted prices.
The posted price applies to potential borrowers who have been cleared to lock, which requires that their loan
applications have been processed, the appraisals ordered, and all required documentation completed. This
typically takes several weeks on a refinance, longer on a house purchase transaction.
To potential borrowers in shopping mode, a lender’s posted price has limited significance, since it is not
available to them and will disappear overnight. Posted prices communicated to shoppers orally by loan officers
are particularly suspect, because some of them understate the price to induce the shopper to return, a practice
called “low-balling.” The only safe way to shop posted prices is on-line at multi-lender web sites such as mine.
Chapter 4 Interest Rate fundamentals
I.
Risk Free Interest Rate
a.
Interest rate demanded if there were no risk
b.
Interest rate on short term Treasuries serves as a proxy for the risk free rate
II.
What determines the Risk Free Rate
a.
Risk free rate is determined b
y the supply and demand for investment money
i.
Supply of Investment Money
1.
Money people don’t plan on spending is available for investment
2.
Quantity supplied positively related to the interest rate
–
figure 4.2
ii.
Demand for Investment Money
1.
Demand depends t
he economic outlook
2.
Quantity demanded inversely related to the interest rate
–
figure
4.2
iii.
Interest rate and the level of investment determined by the interaction of
the demand and supply of investment money
b.
Shifts in the supply of money
–
figure 4.3
i.
Su
pply of money is controlled by the Federal Reserve
1.
Monetary policy
–
FED policy determining the amount and growth
of the money supply
2.
Open Market Operation
a.
Primary way the FED expands or contracts the money
supply
b.
Involves buying and selling US Treasur
ies
i.
Buy bonds
–
inject funds into banking system
–
lower interest rates
ii.
Sell bonds
–
withdraw funds from banking system
–
raise interest rates
ii.
Demand for money depends on overall economic conditions
1.
Expect economic growth
–
demand for investment funds
rises
driving up interest rates
2.
If demand for investment money drops interest rates drop
iii.
If the FED wants supply of money can overwhelm demand for money
III.
Term structure of interest rates
a.
Normally a longer term requires a higher interest rate
i.
People nee
d to be paid more for tying their money up longer
ii.
PSECU is paying 4% on 12 and 18 month CDs
iii.
Why tie your money up for 18 months for same rate as 12 months
b.
Yield curve is a graph of interest rates against time to maturity
c.
Curve does not always behave no
rmally
i.
Flat
–
interest rate the same regardless of term
ii.
Inverted
–
interest rate lower for longer term
d.
Yield Curve Theories
i.
Expectations
1.
Expectation of lower rates in the future may lead to an inverted
yield curve
2.
Presently expect interest rates to b
e lower in the future
ii.
Liquidity Preference Theory
iii.
Market Segmentation Theory
IV.
Risk Premiums
a.
Nominal interest rate = risk free rate + risk premium
b.
Risk Premium
i.
Default risk
1.
Bonds
–
Bond rating
–
table page 86
2.
Equities
a.
Income statement compare debt to
earnings
ii.
Other risks
–
table 4.1
V.
Risk and Return
a.
Only get higher return for taking higher risk
b.
If asked to take higher risk need to receive higher return
c.
Evaluating this relationship is fundamental to finance
VI.
Interest rate sifts
a.
Change in risk free
rate
–
Federal Reserve
i.
Mostly drives interest rate changes
ii.
Figure 4.9
b.
Change in investors tolerance for risk
i.
High profile defaults
ii.
International affairs
determinants of market interest rate
EDUCATION AND EXAMINATION COMMITTEE OF THE SOCIETY OF ACTUARIES
FINANCIAL MATHEMATICS STUDY NOTE DETERMINANTS OF INTEREST RATES by Michael
A. Bean, FSA, CERA FCIA, FCAS, PhD Copyright 2017 by the Society of Actuaries The Education and
Examination Committee provides study notes to persons preparing for the examinations of the Society of
Actuaries. They are intended to acquaint candidates with some of the theoretical and practical
considerations involved in the various subjects. While varying opinions are presented where appropriate,
limits on the length of the material and other considerations sometimes prevent the inclusion of all
possible opinions. These study notes do not, however, represent any official opinion, interpretations or
endorsement of the Society of Actuaries or its Education and Examination Committee. The Society is
grateful to the authors for their contributions in preparing the study notes. FM-26-17 1 Determinants of
Interest Rates Michael A. Bean, FSA, CERA, FCIA, FCAS, PhD November 2, 2016 Contents 1
Introduction............................................................................................................................. 3 2
Background............................................................................................................................. 3 2.1 What is
interest? ............................................................................................................... 3 2.2 Quotation bases for
interest rates..................................................................................... 6 2.2.1 Rates on U.S. Treasury
Bills..................................................................................... 6 2.2.2 Rates on Government of Canada Treasury
Bills....................................................... 7 2.2.3 Effective and Continuously Compounded
Rates...................................................... 7 3 Understanding the Components of the Interest Rate
.............................................................. 8 3.1 Interest rates in a world of no inflation or default
risk..................................................... 9 3.1.1 Interest Rates by
Term.............................................................................................. 9 3.1.2 Yield Curves
........................................................................................................... 11 3.2 Interest rates in a world of no
inflation but in which defaults can occur....................... 12 3.2.1 Default with No Recovery
...................................................................................... 13 3.2.2 Default with Partial
Recovery................................................................................. 15 3.2.3 Compensation for Default Risk
.............................................................................. 16 3.3 Interest rates in a world of known inflation
................................................................... 16 3.4 Interest rates in a world of uncertain inflation
............................................................... 19 3.4.1 Loans with Inflation Protection
.............................................................................. 19 3.4.2 Loans without Inflation Protection
......................................................................... 21 3.4.3 Real and Nominal Interest
Rates............................................................................. 21 3.4.4 Decomposition of the Interest Rate When
Defaults are Possible ........................... 22 4 Retail Savings and Lending Interest Rates
........................................................................... 23 4.1 Banks as intermediaries between borrowers and
savers ................................................ 23 4.2 Savings Interest
rates...................................................................................................... 24 4.3 Lending Interest
rates..................................................................................................... 25 5 Bonds Issued by Governments and
Corporations................................................................. 26 5.1 Zero-coupon
bonds......................................................................................................... 27 2 5.2 U.S. Treasury securities
................................................................................................. 28 5.3 State and local government bonds in the
United States................................................. 32 5.4 Government bonds in Canada
........................................................................................ 32 5.5 Corporate bonds
............................................................................................................. 34 6 The Role of Central
Banks.................................................................................................... 37 6.1 Operation of the payment
system................................................................................... 37 6.2 Lender of last
resort........................................................................................................ 38 6.3 The United States Federal
Reserve Bank System.......................................................... 39 3 1 Introduction Interest rates arise in some
form in virtually every calculation in actuarial science and finance. This study note is intended to provide
an overview of what interest rates represent, how they arise in practice, and the factors that determine
their value. We begin by considering what interest represents from an economic perspective and how
interest rates are expressed in practice. We next consider the effect that defaults, inflation, and other
factors can have on the value of interest rates, and show how an interest rate can be decomposed into
component parts with each component viewed as compensation for a particular risk. We then consider
some situations where interest rates arise in practice, including retail savings and lending products and
bonds issued by governments or corporations; key takeaways from this discussion are that interest rates
can differ greatly from one product or borrower to another and can fluctuate by material amounts over
time. We end with a discussion of the role of central banks and how their actions can influence the
general level of interest rates. 2 Background 2.1 WHAT IS INTEREST? From an economic perspective,
interest can be viewed as either the compensation received for deferring consumption, e.g., putting money
in a savings account rather than spending it, or the cost of consuming when resources are not available,
e.g., using a credit card to make a purchase rather than first saving the money. At any given time, a
person with money has two choices. One is to either spend the money today and the second is to save it
for the future. Likewise, a person without money has two choices. One is to borrow money from someone
to buy something and the second is to decide to postpone the purchase. The decision whether to spend,
save, borrow, or refrain from spending can be a complex one. Some people require a greater incentive to
save, i.e., the reward for deferring consumption needs to be greater, while others require a greater
incentive to borrow, i.e., the cost of borrowing needs to be lower. Consider a group of people, each with
10001 that can either be spent today or lent to someone who will repay the loan with interest in two years.
When the compensation for lending, i.e., the interest received, is low, few people in the group will want to
lend their 1000 and instead will choose to spend it on themselves. However, when the compensation for
lending is high, most people in the group will choose to lend their 1000 and defer their own spending.
When the compensation for lending is between these extremes, some people will choose to spend and
others will choose to lend, depending on their individual preferences to save versus spend. This is
illustrated graphically in Figure 1, which shows the amount of interest required as a fraction of the
population of potential lenders. In economic terms, the graph in Figure 1 represents the 1 The currency
being used (dollars, euros, etc.) is not relevant to the discussions in this note. Hence, no currency symbols
will be attached to monetary amounts. 4 potential supply of money that is available for lending, or more
simply, the supply curve. Note that the supply curve is increasing. Now consider a different group of
people with no money. Each of the people in this group would like to buy an item that costs 1000 but
would need to borrow the money from someone in the first group to do this. When the cost of borrowing,
i.e., the interest to be paid, is high, few people in this group will want to borrow the money and instead
will decide that the item isn’t worth purchasing. However, when the cost of borrowing is low, most people
in this group will choose to borrow the money so that they can purchase the item now. When the cost of
borrowing is between these extremes, some people will choose to borrow and buy the item now and others
will choose not to buy the item at all, depending on their individual willingness to borrow. This is
illustrated in Figure 2, which shows the amount of interest a person in this group is willing to pay as a
fraction of the population of potential borrowers. In economic terms, the graph in Figure 2 represents the
potential demand for money, or more simply, the demand curve. Note that the demand curve is
decreasing. Finally, suppose that the number of potential lenders is exactly equal to the number of
potential borrowers, so that the supply and demand curves can be displayed on the same set of axes, as
shown in Figure 3. Then, since in this example there can only be one lender associated with a given
borrower, the fraction of potential lenders who lend their 1000 must be exactly equal to the fraction of
potential borrowers who borrow 1000. Consider the intersection of the supply and demand curves, which
for this illustration happens to correspond to the fraction 45% and interest amount 115. This point
defines the interest amount for which the supply and demand of money are in balance. 5 To see this, note
that 45% of lenders are willing to lend 1000 if the amount of interest is 115 or more while 45% of
borrowers are willing to borrow 1000 if the amount of interest charged is 115 or less, so if the amount of
interest is 115 then there will be an equal number of willing lenders and borrowers. However, if the
amount of interest paid is less than 115 then fewer than 45% of lenders will be willing to lend but more
than 45% of borrowers will be willing to borrow, which will result in an imbalance between lenders and
borrowers. In this situation, the borrowers willing to pay more interest will get their loans first, the
borrowers unable to get loans will advertise their willingness to pay more, additional lenders enticed by
the higher interest amounts will decide to lend, and this will continue until the number of lenders equals
the number of borrowers, which in this illustration happens when the amount of interest is 115.
Similarly, if the amount of interest paid is greater than 115 then more than 45% of lenders will be willing
to lend but fewer than 45% of borrowers will be willing to borrow, the lenders willing to receive less
interest will be able to lend their 1000 first, the lenders who are not matched with a borrower will
advertise their willingness to receive less interest, additional borrowers enticed by the lower interest
amounts will decide to borrow, and this will continue until the number of borrowers equals the number
of lenders. This example is admittedly very simplistic. In reality, lenders and borrowers typically have
more than the two options assumed here. For example, a potential lender may decide to neither spend
nor lend and instead keep the money in a safe at home. Moreover, a person’s decision whether to spend,
save, or borrow is not solely driven by the amount of interest charged. People may choose to hold on to
their money, e.g., to meet future expenses or pay for the latest electronic gizmo that is expected to hit the
market a year from now, whatever the amount of interest that is payable on loans today. Nevertheless,
this example provides important insights into what interest is and how it is determined. Indeed, from an
economic perspective, interest is the equilibrium price of money 6 and is defined by the intersection of the
supply and demand curves for money. Moreover, this equilibrium price is not static. When there are
shifts in the supply or demand curves for money as may occur, for example, when a new product is
introduced or expected to be introduced to the market, the equilibrium amount of interest and number of
loans will also change. 2.2 QUOTATION BASES FOR INTEREST RATES There are many different
ways in which interest rates can be quoted. Some quotation conventions are primarily historical, dating
from a time when interest calculations had to be done mentally or using pencil and paper; others may be
the result of legal statutes designed to protect consumers against unscrupulous advertising practices.
Because there are many different ways in which interest rates can be quoted, it is important to be aware
of the particular quotation basis that is used in a given application so that the inferences one makes are
meaningful. Here we highlight a few important quotation bases that frequently arise in practice and show
that for a given loan or investment, the interest rates determined using different quotation bases can be
materially different. 2.2.1 RATES ON U.S. TREASURY BILLS As an example, consider a government
Treasury bill, which is a short-term debt security issued by a government for the purpose of meeting
short-term cash flow obligations. It is essentially a loan to the government. By convention, government
Treasury bills have a term less than one year, typically three months or six months, at issue, and a
maturity value that is a fixed, round number such as 10,000, 100,000, 1 million, etc. A U.S. Treasury bill,
commonly referred to as a U.S. T-bill, is quoted using the following formula: 360 Dollar amount of
interest Quoted rate Number of days Maturity value of the Treasury bill   where “Number of days” is
the remaining number of days until maturity. For example, a 90-day T-bill with maturity value 10,000
and price 9800 would have a quoted rate at issue of 8% (= 360/90 × 200/10,000). The quoted rate on a
U.S. T-bill can be quite different from the interest rate defined by the usual compound interest formula 0
(1 )t P P i t    . Substituting 0P  9800 , 10,000 Pt  , and t = 90/365 into the compound interest formula
and solving for 𝑖 we find that i = 8.54% (rounded to two decimal places). The interest rate defined by the
compound interest formula is a more accurate representation of the rate of growth than the quoted rate,
but it can be difficult to calculate quickly without the assistance of a calculator or computer. By contrast,
the quoted rate is very simple to calculate, particularly when the maturity value is a multiple of 10,000; in
fact, the calculation can be done mentally, which was undoubtedly an attractive feature in the 1930s,
1940s and 1950s. 7 2.2.2 RATES ON GOVERNMENT OF CANADA TREASURY BILLS Not all
government Treasury bills follow the same quotation convention as U.S. T-bills. For example, Treasury
bills issued by the Government of Canada are quoted using the following formula: 365 Dollar amount of
interest Quoted rate . Number of days Current price of Treasury bill   In particular, the quoted rate is
calculated with respect to the current price of the T-bill rather than its maturity value and the number of
days in a year is assumed to be 365 rather than 360. With this convention, a Government of Canada T-
bill with maturity value 10,000, current price 9800 and 90 days to maturity would have a quoted rate of
approximately 8.28% (=365/90 × 200/9800). Note that this is materially different from the 8% rate that
would be quoted using the U.S. T-bill convention or the 8.54% rate that would be determined using the
compound interest formula. This example nicely illustrates why it is important to be aware of the
quotation basis used in a given application, particularly when the application involves working with
historical data. Indeed, we see that if one blindly compares the rates on U.S. and Government of Canada
T-bills with identical terms without adjusting for differences in quotation basis, one might conclude that
Government of Canada T-bills pay more interest when in fact the interest paid on both T-bills is the
same. 2.2.3 EFFECTIVE AND CONTINUOUSLY COMPOUNDED RATES To minimize the possibility
of error due to the mixing of quotation bases, it is good practice to convert all the interest rates in a given
problem to a common basis. For this purpose, two quotation bases are particularly noteworthy. The first
defines rates by the compound interest formula mentioned earlier: 0 (1 ) .t P P i t    The interest rate 𝑖
defined by this formula is referred to as the effective interest rate; when 𝑡 is measured in years, it is the
effective per annum interest rate. The second defines rates by the alternative compound interest formula:
0 . rt P P e t   The interest rate 𝑟 defined by this latter formula is referred to as the continuously
compounded rate or the force of interest; when 𝑡 is measured in years, it is the continuously compounded
per annum interest rate. Effective per annum rates are easy to grasp and for this reason most often used
in business applications. For example, in advertisements for car loans, phrases such as “annual
percentage yield (APY)” or “annual percentage rate (APR)” often accompany a quoted rate. Rates such
as 8 these are typically effective per annum rates; however, reading the fine print is always a good idea.
Continuously compounded rates are easier to work with from a mathematical perspective and for this
reason are most often used in economic and actuarial modeling applications. Continuously compounded
rates are additive, whereas effective rates are not. For example, consider an investment that earns a
different rate each year. If the rates are quoted in continuously compounded form, then the accumulation
after 𝑛 years is 1 2 1 2 0 0 , n n r r r r r r P e e e P e        where 1 2 , , , n r r r are the continuously
compounded rates for the respective years. If 𝑟 is the equivalent continuously compounded rate for the
entire 𝑛-year period then 1 2 0 0 n rn r r r P e P e       , which implies that 1 2 ( ) / n r r r r n    
. Similarly, if the rates are quoted in effective form then the equivalent per annum rate for the n year
period is easily seen to be 1/ 1 2 [(1 ) (1 ) (1 )] 1 n n i i i i       . Clearly, the mathematics of
compounding is much simpler when rates are quoted in continuous form. Returning to the example of the
90-day T-bill with maturity value 10,000 and current price 9800, we see from the formula for compound
interest in continuous terms that the interest rate on this T-bill expressed in continuous per annum form
is approximately 8.19%. This rate is lower than the rate in effective per annum form but higher than the
rate using the standard quotation convention for U.S. Treasury bills. These observations are summarized
in Table 1. Table 1: Quoted Rates for a 90-day T-bill with Price 9800 per 10,000 of Maturity Value U.S.
T-bill convention Government of Canada T-bill convention Continuously compounded per annum
Effective per annum 8.00% 8.28% 8.19% 8.54% 3 Understanding the Components of the Interest Rate
In the previous chapter, we saw that from an economic perspective interest is the compensation received
for deferring consumption, or equivalently, the cost of consuming before acquiring the necessary assets,
and interest rates can be viewed as the equilibrium price of money. Hence, an important determinant of
interest rates is the supply and demand of money. In this chapter, we consider additional determinants of
interest rates including the length of time money is lent, the extent to which there is a risk that lent money
is not fully repaid, and the extent to which money loses its purchasing power over time. We will see that
when interest rates are expressed in continuous form, they can be decomposed into a sum with one term
representing compensation for deferring consumption, another compensation for lost purchasing power,
another compensation for the risk of default, and so on. 9 3.1 INTEREST RATES IN A WORLD OF NO
INFLATION OR DEFAULT RISK Let’s begin by considering interest rates in a world in which the
prices of goods and services do not change over time and all loans are fully repaid on time according to
the terms originally agreed upon, i.e., there is no monetary inflation and no risk of default. Such a world
does not exist, of course; prices of goods and services do change, generally increasing over time, and
people do not always repay loans in full or on time. However, for the purposes of discovering additional
determinants of interest rates, this is a useful starting point. 3.1.1 INTEREST RATES BY TERM
Suppose that loans of amount 1000 can be made for one, two, three, four or five years with all interest
paid at the end of the loan term, and that the equilibrium repayment amounts (original loan amount plus
interest) for the various terms are as shown in Table 2.2 For example, the repayment amount for a loan
of three years is 1060, consisting of the original 1000 amount plus total interest of 60, paid at time three.
Table 2 also shows the effective and continuous per annum interest rates corresponding to these
repayment amounts, rounded to two decimal places.3 Table 2: Hypothetical Repayment Amounts &
Interest Rates for a Loan of Amount 1,000 for Various Terms Term (years) 1 2 3 4 5 Repayment amount
1015 1035 1060 1090 1125 Effective per annum rate 1.50% 1.73% 1.96% 2.18% 2.38% Continuous per
annum rate 1.49% 1.72% 1.94% 2.15% 2.36% Notice that the repayment amounts shown in Table 2
increase with loan term. This should always be the case, for a rational lender when given the choice
between loans such that the loan with the shorter term has the larger repayment amount will always
choose the shorter term loan even if that means putting the money repaid from the shorter term loan in a
safe for a while; hence borrowers wishing to borrow money for longer terms will have to pay more to
attract the interest of lenders. The interest rates corresponding to the repayment amounts in Table 2 also
increase with loan term. Some readers may find this surprising since an interest rate is supposed to be a
mechanism for expressing the price of money that takes into account the length of time money is lent as
well as the amount lent and the frequency of interest payments. There are good reasons to expect the
equilibrium interest rates for different loan terms to be different. First of all, the pool of people interested
in borrowing money for five years is likely to 2 As the discussion in this chapter is intended to be generic,
the currency of the loan amounts and interest payments is not specified; however, it is understood that all
amounts are denominated in the same currency. 3 The reader should verify that the interest rate values
in this table are correct using the formulas provided earlier. 10 be different from the pool of people
interested in borrowing money for just one year. A person who borrows money for just one year usually
does so to cover a short-term cash flow shortfall and expects to be able to earn enough money during the
year to repay the loan with interest by year’s end. However, a person who borrows money for five years
generally needs the money for that length of time, e.g., to fund the start up of a new business venture or
purchase some durable good, and expects it will take several years to earn enough money to repay the
loan. Likewise, the pool of people interested in lending money for five years is likely to be different from
the pool of people interested in lending money for just one year. People who lend money for five years or
more are generally saving for some long-term goal such as retirement and don’t mind having their money
tied up for an extended period of time whereas people who lend money for just one year are generally
saving for some shorter term goal and want to be able to access their money within that shorter
timeframe. Since the pools of borrowers and lenders are generally different for different loan terms, it
follows that the supply and demand dynamics of money are also different, and hence the equilibrium
interest rates will differ. This explanation for the difference in interest rates by term is called the market
segmentation theory. Secondly, even if the pool of lenders is not strictly differentiated by term and some
lenders who might otherwise prefer one term could be persuaded to lend for another, there must be some
incentive for them to do so. All things being equal, lenders tend to prefer to lend money for shorter terms
because this gives them the flexibility to take advantage of alternative investment opportunities that may
arise during the course of a longer term. Hence, to persuade lenders to lend money for the longer term,
borrowers generally have to pay a higher rate of interest, not just higher compensation. This explanation
is called the liquidity preference theory or the opportunity cost theory. There are two additional theories
that have been postulated to explain why interest rates differ by term. One is the expectations theory.
According to this theory, the interest rate on a longer term loan provides information on the interest
rates that shorter term loans are expected to have in the future; for example, if the interest rate on a
three-year loan is currently greater than the interest rate on a one-year loan then two years from now,
the rate on a one-year loan will be higher than it is now. The final one is the preferred habitat theory.
Similar to the market segmentation theory, this theory asserts that differences in interest rates are
attributable to differences in the pools of lenders and borrowers; however, lenders and borrowers are not
rigidly segmented by term. Given sufficient incentive to do so, market participants are willing to move to
a term that is different from their preferred one. Although not a frequent occurrence, interest rates can
decrease with term. There are several reasons this could happen. There could be a decrease in the pool of
people interested in lending money for shorter terms because they need the money themselves, e.g., to buy
the latest electronic gizmo or to pay bills during a period of unemployment. In this case, the supply curve
for short-term money shifts upwards and to the left, and the equilibrium interest rate increases (see
Figures 1 and 3 in the previous chapter). At the same time, there could be an increase in the 11 pool of
people interested in borrowing money for shorter terms, e.g., to pay expenses during a period of reduced
cash flow; in this case, the demand curve for short term money shift upwards and to the right, and the
equilibrium interest rate increases once again (see Figures 2 and 3 in the previous chapter). There could
also be a decrease in the pool of people interested in borrowing money for longer terms. This could
happen, for example, if the economy is weaker than normal, the rate of return on long-term investments
is not sufficiently high to justify the cost of borrowing, and/or the risk of entering into a long-term
venture is higher than normal. In this case, the demand curve for long term money shifts downwards and
to the left, and the equilibrium long term interest rate declines. Interest rates can also increase and then
decrease with term. In this case, the cost of medium-term money is greater than the cost of either short-
term or long-term money. The reader is invited to contemplate situations where this could occur. 3.1.2
YIELD CURVES The preceding discussion suggests that interest rates will generally vary by term.
Hence, an interest rate value is only meaningful when associated with a particular term. Now, with the
passage of time, a five-year loan becomes a four-year loan and then a three-, two- and one-year loan, and
having to specify a term length every time a specific interest rate value is mentioned can become
cumbersome, particularly when working with loans of many different terms at the same time. A
convenient alternative is to consider the interest rate values for the different terms as a collection and
specify how that collection evolves over time. When the interest rate values for the different terms are
considered as a collection, this collection is called a yield curve. 0.00% 0.50% 1.00% 1.50% 2.00% 2.50%
1 2 3 4 5 Yield (continuous per annum) Term (years) Figure 4: Normal Yield Curve 0.00% 0.50% 1.00%
1.50% 2.00% 2.50% 1 2 3 4 5 Yield (continuous per annum) Term (years) Figure 5: Inverted Yield Curve
12 The yield curve corresponding to Table 2 is shown in Figure 4. Note that the curve in this case slopes
upwards. This is the expected shape because, as noted earlier, lenders tend to prefer to lend money for
shorter terms and hence generally must be provided an incentive to lend for a longer term. Figure 5
shows a yield curve when interest rates decrease with term and Figure 6 shows one when interest rates
increase and then decrease. Note that the yield curve in Figure 5 slopes downwards and the one in Figure
6 has the shape of a bow, sloping upwards and then downwards. With these observations in mind, we can
define the following terms. A yield curve is said to be normal or upward-sloping if the interest rate values
increase with term; it is said to be inverted or downward-sloping if the interest rate values decrease with
term; and it is said to be bowed if the interest rate values increase and then decrease with term, or
decrease and then increase with term. A yield curve is said to be flat if the interest rate values are the
same for all terms. Figure 7 provides an illustration of a flat yield curve. Flat yield curves rarely arise in
practice. However, many simple models of interest rates and interest rate movements nevertheless
assume that yield curves are flat. For example, the concept of duration, which is widely used in the
management of bond portfolios is based on this assumption. The traditional formulas for mortgage and
annuity mathematics, are also based on this assumption. As long as the user is aware that it is an
approximation, the assumption that yield curves are flat can help to simplify a problem and allow general
insights to be gained. However, it is important to remember that this is an idealized assumption and that
in general yield curves are not flat. 3.2 INTEREST RATES IN A WORLD OF NO INFLATION BUT IN
WHICH DEFAULTS CAN OCCUR Now consider a world in which defaults can occur, i.e., there is a
risk that some borrowers will not fully repay the amount lent on time and with interest at the agreed
upon terms. For simplicity, continue to assume that the prices of goods and services do not change over
time, i.e., there is no monetary inflation. 0.00% 0.50% 1.00% 1.50% 2.00% 2.50% 1 2 3 4 5 Yield
(continuous per annum) Term (years) Figure 6: Bow-Shaped Yield Curve 0.00% 0.50% 1.00% 1.50%
2.00% 2.50% 1 2 3 4 5 Yield (continuous per annum) Term (years) Figure 7: Flat Yield Curve 13 3.2.1
DEFAULT WITH NO RECOVERY Suppose that there are two types of borrowers, those who always
repay loans in full and on time and those for whom defaults though rare are possible. Suppose further
that for borrowers who are certain to repay their loans in full and on time, the equilibrium repayment
amounts and interest rates for a loan of 1000 are the same as given in Table 2 earlier, and for borrowers
for whom defaults are possible, the number of defaults per 1000 borrowers are as given in Table 3. For
example, for a loan with a term of three years, ten out of 1000 borrowers will pay nothing at the end of
three years. What can be said about the repayment amount and interest rate for a loan of 1000 of a
specified term to a borrower for whom default is possible? Table 3: Assumed Number of Defaults Over
Loan Term per 1000 Loans Term (years) 1 2 3 4 5 Number of defaults 2 5 10 16 25 To answer this
question, consider a group of 1000 borrowers each of whom seeks to borrow the amount 1000 for a term
of three years and suppose that out of this group of 1000 borrowers it is known in advance that precisely
ten will default, but not which ten. Let x be the contractual repayment amount at time three. Then, the
total amount received by the lender at time three is (990 · x) + (10 · 0) = 990 · x. Suppose that a lender has
the amount one million to lend for three years and is considering providing a loan of 1000 to each of these
1000 borrowers but also has the option of lending the money to a group of 1000 borrowers, each of whom
is certain to repay the loan amount on time with interest. From Table 2, we know that the equilibrium
repayment amount for a three-year loan for which repayment is certain is 1060, so if the lender chooses
to lend the one million amount to the 1,000 borrowers who are certain to repay, the lender is certain to
receive the amount 1000 · 1060 = 1,060,000 at the end of three years. On the other hand, if the lender
chooses to lend the one million amount to the 1000 borrowers for whom repayment is not certain, the
lender will receive the amount 990 · x at the end of three years. Consequently, for the lender to be willing
to provide loans to the 1000 borrowers for whom repayment is not certain, the following inequality must
be true: 990 1,060,000,  x i.e., x 1070.71. Hence, when repayment is not certain, the repayment amount
on a three-year loan of 1000 must be at least 1070.71 (rounded to two decimal places). This corresponds
to an effective per annum interest rate of 2.30% and a continuous per annum rate of 2.28%. 14 The
minimum required repayment amount and interest rate for loans of terms one, two, four and five years
can be determined in a similar way. Table 4 provides a summary of these minimum required repayment
amounts and interest rates.4 Table 4: Minimum Required Repayment Amounts & Interest Rates on a
Loan of Amount 1000 When Repayment is Not Certain Term (years) 1 2 3 4 5 Number of defaults over
loan term per 1000 loans 2 5 10 16 25 Repayment amount 1017 1040 1071 1108 1154 Effective per annum
rate 1.70% 1.99% 2.30% 2.59% 2.90% Continuous per annum rate 1.69% 1.97% 2.28% 2.56% 2.86%
The preceding discussion assumes that there are just two types of borrowers and that in any group of
1000 borrowers of a particular type, it can be known in advance precisely how many borrowers in the
group will default over the loan term. In reality, there are many different types of borrowers, some more
likely to default than others, and no matter how homogeneous a particular group of borrowers appears
to be, it cannot be known in advance precisely how many borrowers in the group will default. Hence,
lenders must do research on prospective borrowers to ascertain what their likelihood of default is and
identify borrowers that are more or less likely than others to default. This research can be costly and
lenders must be able to recover these costs if they are to be persuaded to lend money to borrowers who
are not certain to repay. Lenders must also receive compensation for assuming the risk that the number
of defaults is higher than anticipated. Consequently, the repayment amounts and interest rates must be
higher than the minimum amounts indicated in Table 4. Different lenders will have different levels of
skill and cost structures for identifying prospective borrowers and different profit requirements for
assuming risk. Hence, for any given loan, the minimum required repayment amount and interest rate will
be different for different lenders. At the same time, different borrowers will have different degrees of
willingness to pay the amounts required by various lenders. These different degrees of willingness to lend
and borrow at specific repayment levels define the supply and demand curves for money when default is
possible. Each loan term and borrower class will have its own set of supply and demand curves, and the
equilibrium repayment amount and interest rate for a loan of a given term to a borrower of a particular
class will be the intersection of the supply and demand curves for that particular loan 4 The reader
should verify that the numbers in this table are correct. 15 term and borrower class. The equilibrium
repayment amounts and interest rates cannot be calculated directly; they can only be observed.
Moreover, they depend on market conditions and can vary from one market to another. We will have
more to say about this later. 3.2.2 DEFAULT WITH PARTIAL RECOVERY In the previous example, it
was assumed that when default occurs, the loss to the lender is total, i.e., there is no partial repayment of
the original loan amount or interest owed. However, in reality, lenders usually recover at least part of the
original amount lent. This is certainly true for loans such as car loans or home equity loans that are
secured by property that can be seized by the lender and sold in the event of default, but it is also true on
loans that are not secured by property or other collateral. Indeed, borrowers who default and are unable
to repay the full amount of an unsecured loan will often agree to provide partial repayment as part of a
resolution arrangement. Let’s consider the previous example again but now assume that when default
occurs, the lender is able to recover 25% of the amount owed. As before, let 𝑥 be the contractual
repayment amount for a loan of term three years. It follows that the amount repaid by the 1000
borrowers in total, assuming precisely ten of them default but pay 25% of the balance due at time three,
is 990 10 (0.25 ) 992.5 .      x x x Arguing as before, 992.5 1,060,000 or 1068.01.    x x Comparing
this to the earlier case of no recovery, we see that when the lender is able to recover 25% on defaulted
loans, the minimum repayment amount on a three-year loan of 1000 is 1068 versus the 1071 amount
determined previously. This corresponds to an effective per annum rate of 2.22% versus the previously
determined rate of 2.30% and a continuous per annum rate of 2.19% versus the previously determined
2.28% rate. Table 5 provides a summary of the minimum required repayment amounts and interest rates
under the assumption of a 25% recovery at the end of the loan term. Now, as noted in the previous
example, a lender has considerable uncertainty with regard to the number of defaults or the propensity
of an individual borrower to default. When partial recoveries are possible, there will also be uncertainty
in the amount that can be recovered. Even if a lender is fairly certain of the amount that can be
recovered, the lender will still generally incur costs realizing the value in these recoveries such as the
costs involved in repossessing property or negotiating modified loan terms or resolution arrangements,
etc. These costs are generally passed through to borrowers in the form of higher required repayment
amounts and interest rates. 16 Table 5: Minimum Required Repayment Amounts & Interest Rates on a
Loan of Amount 1000 When There is 25% Recovery on Defaults Term (years) 1 2 3 4 5 Number of
defaults over loan term per 1000 loans 2 5 10 16 25 Repayment amount 1017 1039 1068 1103 1146
Effective per annum rate 1.65% 1.93% 2.22% 2.49% 2.77% Continuous per annum rate 1.64% 1.91%
2.19% 2.46% 2.73% 3.2.3 COMPENSATION FOR DEFAULT RISK From the preceding discussion, it
should be clear that, all else being equal, the interest rate on a loan with default risk will be greater than
the interest rate on an otherwise identical loan without default risk. The amount by which the rate on a
loan with default risk exceeds the rate on the loan without default risk represents the compensation for
default risk. When interest rates are expressed in continuous per annum form, the interest rate on a loan
with default risk can be decomposed into a sum of the form R = r + s, where R is the rate on the loan with
default risk, r is the rate on a loan of the same term without default risk, and s is the difference between
these two rates. When interest rates are expressed in effective per annum form, the analogous
relationship is R = (1 + r) · (1 + s) – 1 where R and r are as before but expressed in effective rather than
continuous per annum form and s represents the compensation for default risk. Since (1 + r) · (1 + s) – 1
= r + s + r ·s and r · s is generally quite small, the quantity R is sometimes decomposed into the
approximate sum R r s   in this case. The reader is invited to construct examples where the error in the
approximation R r s   cannot necessarily be ignored. 3.3 INTEREST RATES IN A WORLD OF
KNOWN INFLATION From everyday experience, we know that the prices of goods and services do not
stay the same but generally change over time. Some prices, such as those for computer hardware tend to
fall over time as newer, faster and more powerful machines become available while others, such as those
for dental services, seem to invariably rise. However, on balance prices tend to rise most of 17 the time.
The tendency of prices to increase in aggregate over time is referred to as monetary inflation or simply
inflation. Inflation is usually measured by tracking the prices of a specific basket of goods and services
over time, taking improvements in product quality into consideration as appropriate.5 There are a
number of different indexes used to measure inflation, the most well-known being the consumer price
index and the producer price index. A consumer price index (CPI) tracks the prices of a basket of goods
and services that a typical consumer in a particular population or geographic area is assumed to buy
while a producer price index (PPI) tracks the prices of a basket of raw materials that a typical producer
of manufactured products is assumed to use in the manufacturing process. The change in the level of a
price-level index is referred to as the inflation rate for that index. Inflation rates are generally expressed
in compounded per annum form, e.g., an inflation rate of 2% means that after three years, the price-level
index is approximately 3 [(1.02) 1] 100% 6.12%    higher. However, in some circumstances, it may be
more convenient to work with inflation rates in continuous per annum form. An inflation rate of 2% does
not mean that all prices increase by exactly 2% per annum, nor does it mean that all consumers will pay
2% more each year for the items they buy; some consumers may pay more than 2%, others less,
depending on how the basket of items they buy compares to the basket of items used to construct the
particular price index. Inflation rates only provide information on the general tendency for prices to
increase. Inflation is an important consideration in virtually all investment decisions. To see why,
consider a person with an amount 1000, which the person can either use today to buy an item costing
1000 or lend to someone else with repayment of 1035 including interest in two years. Moreover, suppose
that the person will eventually need to buy the item. If the person is confident that the price in two years
will still be 1000, then the decision is effectively whether to buy the item now or wait two years and earn
interest of 35 for waiting. On the other hand, if the person believes prices will increase at 2% per year,
then the item will cost 1040.04 in two years, so rather than pocket 35 for waiting, there will be an extra
cost of 5.04. The person is better off buying the item today. If inflation is 1% per year, there is money to
be made by waiting, but it may be insufficient compensation for the delay. Inflation also affects a
borrower’s ability and willingness to borrow money at specific rates. Indeed, when inflation is present,
wages as well as prices tend to increase over time and so the amount that a borrower can afford to repay
on a loan is greater than when there is no inflation. Continuing with the illustration of the previous
paragraph, consider a person whose current wages are 10,350 and suppose that 10% of the person’s
wages are available for discretionary spending each year. Suppose that the person plans to spend all
available discretionary income this year and next and, in addition, would like to borrow an amount 1000
today with repayment 5 For example, if the price of an entry-level computer is the same this year as last
but its speed is twice as fast, there would an adjustment to this year’s observed price to account for the
improved quality. 18 in two years. If the person’s wages remain unchanged for the next two years then
the maximum the person can afford to repay on a loan of 1000 is 1035 (=10% of 10,350), which implies a
maximum loan rate of 1.73% effective per annum. However, if wage rates are increasing at the rate of
2% per year then the person’s available discretionary income in two years will be 1076.81 (=10% of 2
10,350 1.02  and the person will be able afford to repay as much as 1076.81 (rounded to two decimal
places) on a loan of 1000, which is equivalent to an effective per annum interest rate of 3.77%.6 This
illustration shows that when inflation is present, lenders will generally require borrowers to pay them
more interest than they otherwise would to compensate for the loss in purchasing power over the term of
the loan, but at the same time borrowers will generally have the ability to pay more interest because their
future incomes are likely to be higher than when there is no inflation. Consequently, when inflation is
present, interest rates are likely to be higher. The question is how much higher. In general, the answer to
this question is quite complicated. However, by making some idealized assumptions, we can get an idea
what the answer should be in some very simple situations. Suppose that all wages and the prices of all
goods and services in an economy increase at exactly the same rate, that rate is known in advance with
certainty by all participants in the economy, and all participants in the economy make borrowing,
lending and consumption decisions based on that information. Consider a loan with term 𝑡 years in which
all interest is paid at the end of the loan term. From the earlier discussion, the repayment amount on this
loan in a world of no inflation is 0 Rt P P e t   . Note that R is the equilibrium interest rate (in
continuous per annum form) with deferred spending and the uncertainty of repayment taken into
account. Suppose that the certain rate of inflation (in both wages and prices) is 𝑖 per year, expressed in
continuous form. Then since the borrower was willing (and presumably had the ability) to repay 0 Rt P e
in a world of no inflation, the borrower will have the ability and willingness to repay 0 Rt it P e e   due to
increased wages. Moreover, the lender will require the same adjustment to account for the loss of
purchasing power of the money lent. The equilibrium repayment amount is therefore * * ( ) 0 0 R i t R t P
P e P e t      . Now from the earlier discussion, we have R = r + s where r represents compensation for
deferred consumption and s represents the compensation for default risk. It follows that when rates are
expressed in continuous per annum form, the interest rate in a world of certain inflation is R* = r + s +i.
When rates are expressed in effective per annum form, the analogous relationship 6 1/2 (1.07681 1) 100%
3.77%    19 is * R r s i        (1 ) (1 ) (1 ) 1 where the rates are as before but expressed in effective
rather than continuous per annum form. 3.4 INTEREST RATES IN A WORLD OF UNCERTAIN
INFLATION The preceding discussion considered interest rates in a world of known inflation. In
particular, it was assumed that all wages and the prices of all goods and services in an economy increase
at exactly the same rate, that rate is known in advance with certainty by all participants in the economy,
and all participants in the economy make borrowing, lending and consumption decisions based on that
information. In reality, prices do not increase by identical amounts and inflation rates can only be
observed after the fact, so borrowing, lending and consumption decisions must be made without complete
information. Uncertainty in inflation affects lenders and borrowers differently. Inflation is always
detrimental for lenders because it erodes the purchasing power of amounts that are repaid in the future;
so when there is increased uncertainty in inflation, lenders generally require additional compensation
and the supply curve for money shifts upward. However, borrowers may not be willing to pay the
additional amounts that lenders desire even if their wages are expected to increase, so the demand curve
need not move in the same way as the supply curve. As a result, when inflation is uncertain, the
equilibrium repayment amounts and interest rates can move in ways that are difficult to predict. This
can make the decomposition of interest rates into component parts more challenging. 3.4.1 LOANS
WITH INFLATION PROTECTION One way that a lender can deal with uncertainty in inflation is to
structure a loan so that the amounts repaid by the borrower depend on the actual inflation experienced
over the loan term, where the inflation experienced is defined by a particular reference index of
monetary inflation such as the consumer price index. The loan contract for such a loan specifies a quoted
rate that determines the amounts to be repaid assuming no inflation and defines the reference index that
is to be used to adjust these repayment amounts. The amount that the borrower actually repays is
calculated as the repayment amount assuming no inflation multiplied by the ratio of the reference index
values observed at the beginning and ending of the loan term. To see how this works, consider the
repayment amounts before inflation adjustment indicated in Table 6. As in previous illustrations, assume
that the amount lent is 1000 and all interest is paid at the end of the loan term. For simplicity, assume
that defaults are not possible. 20 Table 6: Repayment Amounts & Interest Rates Before Inflation
Adjustment for a Loan of 1000 with Inflation Protection Term (years) 1 2 3 4 5 Repayment amount
before inflation adjustment 995 998 1005 1010 1015 Effective per annum rate – 0.5000% – 0.1001%
0.1664% 0.2491% 0.2982% Continuous per annum rate – 0.5013% – 0.1001% 0.1663% 0.2488%
0.2978% Suppose that a particular loan contract is for a term of two years and that the reference index
specified in the contract increases 1.5% during the first year of the loan and 2.5% during the second.
Then the amount the borrower must repay at the end of the loan term is 998 · 1.015 · 1.025 = 1039.29. If
instead the reference index increases at a compound rate of 1% per annum over the loan term then the
amount the borrower must repay is 998 · 1.01 · 1.01 = 1018.06. From this, it should be clear that the
amount the borrower must repay depends on the inflation rate that is actually realized and, all else being
equal, the greater the realized rate of inflation, the larger the repayment amount. Note that the interest
rates for terms one and two years in this example are negative before inflation adjustment. This means
that, in the absence of a floor on the amount the borrower must repay, the lender would actually receive
less than the amount lent if the inflation experienced over the term of the loan is 0%. Why would a lender
ever enter into such a lending arrangement? After all, wouldn’t the lender be better off just putting the
money in a safe, assuming there is no cost to doing so? If the lender knew in advance that inflation was
certain to be 0% over the term of the loan, then the lender would definitely be better off just putting the
money in a safe, but in a world of uncertain inflation, this is not necessarily so. Indeed, in a world of
uncertain inflation, the lender may be willing to accept a loss in the dollar amount lent when inflation is
0% in exchange for protection against a potentially greater loss in purchasing power if inflation turns out
to be more than 0%. This loss reflects the fact that there is a cost associated with inflation protection.
These observations suggest that when rates are expressed in continuous per annum form, the quoted rate
on a loan with inflation protection but no default risk can be written as R r c 1   , where r represents
the compensation for deferred consumption and c is the cost of inflation protection. The rate actually
realized in a particular inflation scenario is ( ) 1 a R r c i    a , where a i is the realized, i.e., actual, rate
of inflation. Note that the quantities r and c cannot be observed individually; only the difference r – c can
be observed. The only conclusion that can be drawn 21 from observing that the quoted rate on a loan
with inflation protection is negative is that the cost of inflation protection exceeds the compensation for
deferred consumption. 3.4.2 LOANS WITHOUT INFLATION PROTECTION Loans of the type just
discussed preserve the lender’s purchasing power but introduce uncertainty into the amount the
borrower must ultimately repay. A borrower on a fixed income may not wish to take on this uncertainty
and accordingly may be willing to pay the lender additional interest for the privilege of knowing with
certainty what the repayment amount will be. In this case, the lender assumes the risk that the
purchasing power of the amount lent will not be preserved and sets the repayment amounts at higher
levels. The compensation that the lender receives for assuming the risk of lost purchasing power takes
two forms:  Compensation for the loss in purchasing power that is expected over the term of the loan at
the time the contract is entered into; and  Compensation for the risk that the loss in purchasing power
actually realized is greater than what was expected. This suggests that when rates are expressed in
continuous per annum form, the rate on a loan without inflation protection and with no risk of default
can be written as 2 , R r i i    e u where r represents the compensation for deferred consumption, e i
represents the compensation for expected inflation, and u i represents the compensation for unexpected
inflation. Comparing this formula to the formula * R r s i    in the case of an economy with certain
inflation and noting that s = 0 when there is no risk of default, it is clear that the compensation for
expected inflation 𝑖𝑒 is simply the expected rate of inflation. Moreover, it appears that when inflation
rates are stable, i.e., prices in the economy increase at a steady pace, u i will be fairly small but when they
are volatile, u i could be quite large. 3.4.3 REAL AND NOMINAL INTEREST RATES The quoted
interest rate on a loan with inflation protection is known as the real interest rate. The corresponding
interest rate for a loan without inflation protection is known as the nominal interest rate. From the
preceding discussion, we see that when rates are expressed in continuous per annum form and there is no
risk of default, the real interest rate for a loan of a given term is R r c 1   and the nominal interest rate
is R r i i 2    e u . The actual rate of interest earned on a loan with inflation protection is ( ) 1 a R r c i
   a . None of the quantities r, c, e i , or u i can be observed directly. However, the difference between
the nominal and real interest rates, which is equal to R R i i c 2 1     e u , can be observed. This
difference depends on the expected rate of inflation, the cost of inflation protection and the 22
compensation for unexpected inflation. Financial commentators often say that the difference between
nominal and real interest rates provides an indication of the inflation rate expected by the financial
market. However, from this equation, we see that this is only true when u i c  is small relative to e i ,
which can only happen when inflation rates are relatively stable and not too close to zero. In general, the
difference R R 2 1  overestimates the market’s expectation of future inflation. As noted earlier, real
rates can be negative and when this happens, it means that the cost of inflation protection is greater than
the compensation for deferred consumption. Nominal rates can also be negative, at least in theory, but
the circumstances under which this can occur are somewhat different. From the formula R r i i 2    e
u and assuming that the compensation for unexpected inflation u i can never be negative, at least one of r
or e i must be negative for the nominal rate to be negative. Now 0 e i  means that inflation is expected to
be negative, i.e., prices are expected to fall over the term of the loan. When this happens, the purchasing
power of money increases over time, which means that the money a borrower repays at the end of the
loan term is worth more than it was at the beginning of the term. In theory, the repayment amount under
such circumstances should be adjusted to account for the increased purchasing power; however, this
assumes that the person with money to lend has no other alternative but to lend it to someone. In reality,
the lender could just as easily put the money in safekeeping. Provided that the costs of safekeeping are
not too high, this might be a better alternative. In this situation, there is no compensation for deferred
consumption and the negative nominal interest rate simply represents the cost of safekeeping. 3.4.4
DECOMPOSITION OF THE INTEREST RATE WHEN DEFAULTS ARE POSSIBLE The preceding
discussion assumed no risk of default. In reality, most loans have some default risk associated with them.
In this situation, the interest rate on a loan of a given term can be written as * R r s i i     e u where
all rates are expressed in continuous per annum form and depend on the loan term. The quantity s is
known as the credit spread or alternatively the spread for credit risk. Note that * 2 s R R   . In
practice, credit spreads are determined using this formula, i.e., by calculating the difference between the
observed rate on the loan with default risk and the observed rate on a loan of the same term without
default risk. Credit spreads vary with loan term and the collection of spreads by loan term is known as
the spread curve. Similar to yield curves, spread curves can have a variety of shapes; however, most of
the time, they are upward-sloping, reflecting the fact that the longer the term of the loan, the greater the
risk of default. Unlike the situation in a world of certain inflation, credit spreads can vary with the
inflation environment. When the compensation for inflation is higher than average, credit spreads are 23
often lower. All else being equal, higher inflation makes it easier for borrowers to repay debts, which in
turn means that default is less likely. 4 Retail Savings and Lending Interest Rates The previous two
chapters of this study note considered interest rates from a conceptual perspective and identified
important determinants of interest rates including the supply and demand of money and the extent to
which the purchasing power of money changes over time. In this chapter and the two that follow, we
consider how interest rates arise in practice. The focus of this chapter is on interest rates associated with
retail savings and lending products; rates associated with government and corporate bonds are
considered in the chapter that follows. Our discussion will reveal additional factors that influence the
level of interest rates including the overhead costs associated with financial intermediation, the presence
or absence of embedded options or guarantees, and the liquidity of financial markets. As we will soon see,
interest rates can vary greatly from one product or borrower to another and can fluctuate by material
amounts over time. 4.1 BANKS AS INTERMEDIARIES BETWEEN BORROWERS AND SAVERS
When the concepts of interest and supply and demand curves for money were introduced, it was
implicitly assumed that borrowers and lenders are able to identify each other and enter into transactions
on their own. In reality, it is very difficult for borrowers and lenders to do this without the assistance of
some third party whose business it is to identify potential borrowers and lenders and match them up. The
third parties who perform this function are known as financial intermediaries. In the retail market, the
most important financial intermediaries are banks and savings and loan companies. Banks and savings
and loan companies accept deposits from the general public and in turn extend loans to individuals, small
businesses, and corporations. For banking to work, the interest rates charged on loans must be greater
than the interest rates paid on deposits; further, the difference between these rates must be sufficient to
cover overhead costs and the losses on loans that go into default, as well as provide a reasonable amount
of profit for owners. In most jurisdictions, entities that accept deposits from the general public are
heavily regulated at either the federal or state level to ensure that depositors’ money remains safe and is
ultimately returned when promised. Banks are also regulated because of the important role they play in
the payments system. In developed economies, the vast majority of payments for goods and services are
made by check or using a debit or credit card, and virtually all such payments pass through one or more
banks. Hence, the failure of a bank not only affects depositors of that bank but can also impede others in
the economy from conducting business, particularly if the bank is large and responsible for processing a
significant number of payments. Banks and savings and loan companies are not the only financial
intermediaries operating in the retail market. In recent years, alternative lenders have emerged. These
lenders, many of which 24 operate online platforms only, do not accept deposits from the general public
but instead raise the funds needed for lending directly from investors. Because they do not accept
deposits from the general public, these companies are not regulated as banks; however, the business in
which they are engaged is very similar to banking and, as a result, sometimes referred to as “shadow
banking.” The growing importance of shadow banking and the risks associated with it became apparent
during the financial crisis of 2008-09 when a number of alternative lenders collapsed. Without the
support that comes from being part of the regulated financial system, these lenders found it difficult to
raise the funds needed to continue operations; their collapse reverberated throughout the credit markets
and had a negative impact on the overall economy. Alternative payment providers that operate outside
the traditional banking system have also become more prominent in recent years. Examples include
PayPal, Apple Pay and Bitcoin. Most of these alternative payment providers use smartphones or the
internet to process payments and rely on sophisticated encryption technology to protect a user’s identity
and financial information. These companies are part of a growing number of companies, known
collectively as financial technology companies or “fintech” companies for short, that use new technology
to offer traditional banking services, albeit in a non-traditional way. Whether any of these financial
technology companies will pose an existential threat to traditional banks remains to be seen. However,
whatever form banking takes in the future, the basics of the business model are likely to stay the same:
charge more interest for the loans one extends than it costs to fund them. 4.2 SAVINGS INTEREST
RATES Banks and savings and loan companies offer two basic types of savings products: savings
accounts, which give the customer the flexibility to withdraw any amount up to the full account balance
at any time without penalty, and certificates of deposit or CDs, which require the customer to keep the
money on deposit for a defined period of time (usually with a penalty for early withdrawal). Banks also
offer transaction or checking accounts; however, such accounts typically pay little or no interest and
hence are not considered further. In addition to the general economic factors such as inflation discussed
in the previous chapter, there are additional factors that determine the interest rate that a bank pays on
savings deposits. By far, one of the most significant is the overhead cost of the bank. Full service banks
that operate in many lines of business and have large networks of physical branches have much higher
overhead costs than banks that operate online only and have only one or two lines of business. These
higher costs must be recouped by paying savers less, charging borrowers more, or both. The difference in
interest rates paid by online versus traditional banks can be substantial. The business environment in
which a bank operates also affects the interest it is willing to pay on savings products. When the demand
for loans is high in a particular region of the country, banks operating in that region may be willing to
pay more interest to depositors to attract the additional deposits necessary to fund the loans. This
explains why the interest rates in different regions of a country, e.g., Michigan versus Texas, can
sometimes be different. 25 The business strategy pursued by a bank may also affect the amount of
interest it is willing to pay on savings products. For example, banks seeking to grow the size of their loan
book may need to pay more interest than other banks operating in the same market to attract the
deposits necessary to fund the desired growth. Finally, the credit rating or perceived creditworthiness of
a bank can affect the interest rate it must offer to attract deposits. Although most banks operating in the
U.S. are insured under the FDIC7 , the failure of a bank can still be costly for depositors. For example,
depositors may have limited access to their funds during a wind-up of operations or may have to arrange
for their accounts to be transferred to another bank. Banks that are perceived to be at greater risk of
failure generally have to provide depositors some incentive to keep their money on deposit. That incentive
often comes in the form of a higher rate on deposits, particularly ones that are locked in for a longer
term, but could take other forms as well, such as a free checking account or discounts on selected bank
services. This is by no means a complete list of the factors that determine the interest rates that a bank
pays on deposits, but it captures most of the key ones. 4.3 LENDING INTEREST RATES Banks and
savings and loan companies offer lending products such as credit cards, personal loans, auto loans, and
mortgages. There are three basic types of lending products:  Those such as mortgages, auto loans, or
home equity loans that are secured by property that can be seized by the lender in the event that the
borrower fails to repay the full amount of the loan;  Those such as credit cards that are not secured by
any property; and  Those such as student loans or high-ratio mortgages (mortgages for which the size of
the loan is almost as large as the value of the property and there is little equity in the underlying
property) that are guaranteed by a third party such as the federal government or a mortgage guaranty
insurance company that agrees to cover the lender’s losses up to defined limits in the event that the
borrower defaults. These three types of lending products are known respectively as secured loans,
unsecured loans, and guaranteed loans (or, more descriptively, loans with guaranteed repayment). The
property that is designated as security for a secured loan is known as collateral. In the previous chapter,
we saw that the component of the interest rate that provides compensation for default risk depends on
the likelihood that a borrower defaults and the extent to which recovery is possible in the event of default.
In practical terms, this suggests that, in addition to the economic factors noted in that chapter, the
interest rate on a loan provided by a 7 Federal Deposit Insurance Corporation, the agency of the U.S.
government that insures the deposits of savers against failure of a bank. At the time of writing, the
amount of coverage was 250,000 per person or legal entity per covered bank. 26 bank or savings and loan
company is determined by the creditworthiness of the borrower, whether the loan is secured, unsecured
or has a guarantee, and the quality and extent of any security or guarantee. All else being equal, the rate
on a loan to a higher risk borrower should be higher, and the rate on an unsecured loan such as a credit
card should be greater than the rate on a secured loan such as a mortgage. Similarly, the rate on a loan
without a guarantee should be greater than the rate on a loan with one. Unlike the situation for deposit
products where all customers generally receive the posted rate, 8 the loan rates posted by a bank are only
indicative. The actual rate that a borrower pays on a loan of a given type depends on the creditworthiness
of the borrower as indicated by factors such as borrower income and credit history. All else being equal,
a borrower with a steady paycheck and a history of making payments on time will pay a lower rate than
a borrower whose income is primarily derived from sales commissions and who has been late paying
bills. The exception to this is the rate charged on credit cards. Regulations generally prohibit credit card
companies from charging different customers different rates unless a customer misses a payment on the
credit card account itself, in which case the credit card company is permitted to raise the interest rate
that it charges that particular customer. Of course, credit card companies are still permitted to charge
different rates on different cards and will often design their cards so that higher risk borrowers prefer
one type of card while lower risk ones prefer another; for example, some banks have found that cards
offering cash back rewards are especially attractive to customers who pay their balance in full each
month. A bank’s prime rate is the rate it charges its best and most creditworthy customers. Very few
customers are eligible to borrow money at a bank’s prime rate. However, the prime rate is generally a
benchmark for the bank’s other loan rates and is useful for comparing the rates charged by one bank
versus another. Banks with higher prime rates tend to have higher rates for all lending products, but not
always. By contrast, the mortgage rates posted by banks are typically higher than what a customer with
good credit history and an established relationship with the bank can expect to pay. Most full service
banks are willing to provide their customers discounts on posted mortgage rates in recognition of the fact
that the bank that holds a customer’s mortgage is typically the bank where most of the customer’s other
business is conducted and any discount provided on the mortgage rate can generally be recovered by
selling the customer other high-margin products such as mutual funds or retirement savings accounts. 5
Bonds Issued by Governments and Corporations Like individuals and small businesses, governments and
large corporations borrow money for a variety of reasons, from managing short-term cash flow
shortfalls, e.g., when there is a mismatch 8 Some banks may offer better savings rates to customers with
larger amounts on deposit or as an incentive to transfer new money into the bank. Depending on the
regulatory environment in which it operates, the bank may be required to publicly disclose the offer and
make it available to all customers as well as the general public. 27 in the timing of receipts and
disbursements, to investing in longer-term assets such as roads and bridges, schools and hospitals, or
manufacturing plants. However, the borrowing needs of governments and large corporations are much
greater than those of individuals or small businesses, and can range from hundreds of millions to billions
of dollars. Few if any banks have the capacity or desire to lend amounts of this size to a single borrower.
Hence, governments and large corporations seeking to raise large amounts of money must generally turn
to the public financial markets. The usual way to raise money in the public financial markets is by issuing
securities. There are two basic types of securities: bonds and stocks (also known as shares). Bonds are
similar to the certificates of deposit issued by banks in that interest is paid to the holder of the bond at
regular intervals and the face amount of the bond is repaid on a specific date, known as the maturity
date; however, unlike CDs, bonds can be sold to third parties after issue and there is no guarantee that
the holder of the bond will be fully repaid. By contrast, stocks represent an ownership position in the
entity that issued the security and entitle the holder to a share of the entity’s profits. By issuing securities,
governments and large corporations are able to raise large amounts of money in a fairly efficient way
while spreading the risks associated with providing this money over a large group of investors. For
obvious reasons, governments and non-profit corporations can only issue bonds, whereas profit-seeking
corporations can issue either bonds or stocks. After a bond is issued, it can be purchased or sold through
an investment broker until such time that the bond matures or is redeemed by the issuer. The prices of
bonds change from day to day or more frequently and depend on factors that include the
creditworthiness of the issuer, the liquidity of the market, the currency in which the bond is
denominated, the time until the bond matures, the expected rate of inflation, the tax treatment of interest
payments, and in the case of corporate bonds, the seniority of the bond issue in a company’s capital
structure. These price changes along with the natural tendency of bonds to age and hence bond terms to
shorten as bonds approach maturity result in changes to bond yields. In this chapter, we discuss the
factors that affect bond prices and yields, with a particular focus on the bonds of the U.S. Treasury, state
and local governments, the Government of Canada, and large multinational corporations. 5.1 ZERO-
COUPON BONDS Most bonds with term greater than one year at the time of issue pay interest at
regular intervals prior to maturity. In the U.S. and Canada, the usual convention is to pay interest
(known as a coupon payment or just coupon) once every six months, and accordingly calculate yields
based on semi-annual compounding. However, some bonds with term greater than one year pay no
interest prior to maturity, i.e., the coupon rate is 0% and the holder receives the face amount of the bond
at maturity. These are effectively compound interest bonds with the difference between the face amount
and the price of the bond representing the amount of interest that the bondholder receives at maturity.
Because they have no interest coupons, such bonds are known as zerocoupon bonds. 28 Zero-coupon
bonds are typically created by an investment bank in the following way. The bank will buy a large
quantity of bonds of a particular issue, remove the interest coupons from these bonds, and then sell each
of the interest coupons as well as the original face amount as a separate bond. This process for creating
zero-coupon bonds is sometimes referred to as stripping the coupons from a bond. For this reason, zero-
coupon bonds are also known as strip bonds. Once they are created, the strip bonds associated with a
particular bond issue trade separately. Hence, the yields on strip bonds of different maturities are
generally different from one another; they are also generally different from the yield on the coupon bond
that was used to create them in the first place. Stripping the interest coupons from a coupon bond and
trading each of the resulting strip bonds separately is a straightforward way to determine the yield curve
for an entity that issues bonds infrequently and may only have a few issues outstanding. Provided that
there is sufficient trading in the resulting strip bonds, the observed yields should provide a good
indication of the interest rates that an issuer would have to offer on new bonds of various terms. For a
given issuer, the collection of strip bond yields by term is known as the zero-coupon yield curve for that
issuer. Strip bonds are the most fundamental type of bond there is and zero-coupon yield curves the most
natural type of yield curve to consider. Indeed, after a little reflection, it should be clear that every
coupon bond is really just a portfolio of zero-coupon bonds with each interest coupon and the maturity
amount of the bond representing a different zero-coupon bond. Hence, given the prices of a particular
issuer’s strip bonds, one should be able to determine the price of any bond of this issuer, at least in
theory. With this perspective, one sees that the yield on a coupon bond is a complex weighted average of
the yields on various zero-coupon bonds with the weights determined in part by the relative size of the
interest coupons. When the coupon rate on an interest-paying bond is high, the interest coupons will
represent more of the bond’s total cash flow and receive more weight than the maturity amount; when
the coupon rate is low, the interest coupons will represent less of the bond’s total cash flow and receive
less weight than the maturity amount. Since yields normally increase with term, this means that, all else
being equal, the yield on a bond with a high coupon rate will generally be lower than the yield on a bond
with a low coupon rate. The fact that two coupon-bearing bonds of the same issuer with the same
maturity date can have different yields presents a bit of a challenge when it comes to defining the notion
of yield curve for coupon-bearing bonds. The usual convention is to define the yield for a given term to be
the yield on a bond of this term that is trading at par. 5.2 U.S. TREASURY SECURITIES The most
widely held and traded bonds in the world are the bonds of the federal government of the U.S. These
bonds, which are issued by the Treasury Department of the U.S. government at regular intervals and
collectively known as U.S. Treasury securities, are considered to be among the safest bonds in the world
and are virtually free of default risk. 29 The U.S. Treasury issues two basic types of bonds: Treasury
bills, which have term one year or less at issue, have no interest coupons, and are sold at a discount to
maturity value; and Treasury notes, which have terms ranging from two to 30 years at issue, have semi-
annual interest coupons, and are typically issued at or near par. Treasury bills and notes are initially sold
by auction with designated banks and brokers as participants in the auction; this ensures that the initial
rates offered are reasonably indicative of prevailing market conditions. They are then traded in the
secondary market with the prices and yields at any given time determined by the market conditions
prevailing at the time. Yields on U.S. Treasury bills are quoted using the convention described in Chapter
2 (simple discount with actual/360 day count), while yields on U.S. Treasury notes are quoted based on
semi-annual compounding. There are two types of Treasury notes, those in which the interest payments
and maturity amount are fixed at issue and those in which the interest payments and maturity amount
are indexed to inflation. The first type, known as nominal return bonds, are more common and have a
longer history; the second type, known variously as real return bonds or inflation-indexed bonds, are less
common and have only been issued by the U.S. Treasury since the 1990s. Interest payments and maturity
amounts on real return bonds are calculated in a way similar to that described in the section of Chapter 3
on loans with inflation protection; the precise details of the calculation of course depend on the
particulars of the bond issue. Real return bonds issued by the U.S. Treasury are known as Treasury
Inflation-Protected Securities or TIPS for short. Real return bonds are important because they provide
sponsors of pension plans that have benefits indexed to inflation a mechanism for managing the risk that
long-term inflation turns out to be greater than expected. The U.S. government is well positioned to
assume this risk because its tax receipts are directly linked to inflation rates; indeed, as wages and prices
increase, so too do the income and excise taxes it receives. However, pension plans are less well positioned
to take on this risk. By purchasing real return bonds, pension plans can transfer this risk to the U.S.
Treasury. Real return bonds are also important for individual investors and retirees who are not
members of a pension plan. By investing a portion of their savings in real return bonds, income-seeking
investors or retirees can protect at least some of their income against the ravages of inflation, which can
be substantial over time. Indeed, with only a 2% per annum inflation rate, an item that costs 100 today
will cost almost 150 in 20 years, a 50% increase or equivalently a one-third loss in the purchasing power
of money. Yield information on U.S. Treasury bonds traded in the secondary market is published each
business day by the U.S. Federal Reserve and is available at the website
http://www.federalreserve.gov/releases/h15/. Yields are published for specified terms. Table 7 shows the
actual yields published for May 10, 2016. Note that the one-year T-bill yield is slightly lower than the one-
year Treasury constant maturity nominal yield; this is due to the differences 30 in the quotation bases
used for T-bills and Treasury notes.9 Note also that the yields on five- and seven-year TIPS are negative;
this shows that negative real yields are not just a theoretical possibility. Based on comments in Chapter 3,
the negative five- and seven-year TIPS yields can be interpreted as meaning that the cost of inflation
protection is greater than the compensation for deferred consumption over these terms. Table 7: Yields
on Selected U.S. Government Securities as of May 10, 2016 Term 1 mo 3 mo 6 mo 1 yr 2 yr 3 yr 5 yr 7 yr
10 yr 20 yr 30 yr Treasury bills (secondary market) 0.25 0.24 0.35 0.50 Treasury constant maturities
Nominal 0.25 0.24 0.36 0.52 0.72 0.88 1.20 1.52 1.77 2.18 2.61 Inflationindexed – 0.33 – 0.16 0.15 0.58 0.84
The yields published by the Federal Reserve are determined by observing the yields on actively traded
coupon bonds with prices at or near par and then using interpolation to obtain a yield curve. Hence, the
yield published for a particular term need not represent the yield of a bond that was actually traded on
that day; it could be that there were no Treasury bonds of that term available and the published yield is
just an interpolated value. However, the published yield generally provides a good indication of what the
yield would have been if a par bond of that term had been available and actively traded. The yields on the
nominal return bonds of the U.S. Treasury are often referred to as risk-free rates. The reason is the rate
of return on such bonds is virtually certain, provided that the bond is held to maturity. However, this
does not mean that the nominal return bonds of the U.S. Treasury are without risk. Indeed, although the
dollar amount of return on a nominal return bond may be certain, the purchasing power of that return is
not. Nevertheless, the concept of risk-free rate is a useful one. The Federal Reserve Bank of St. Louis
maintains a large database of historical statistics, including historical yields on U.S. Treasury bonds. This
data is available for download at the website https://research.stlouisfed.org/fred2/. Using historical yield
information from this database, yields on U.S. Treasury bonds can be tracked over time. Figure 8 shows
the nominal yields for one-, five- and ten-year Treasury bonds from 1955 to 2015 inclusive.10 9 Although
the U.S. Treasury does not issue one-year coupon-bearing bonds, there will be a number of such bonds
trading in the secondary market, e.g., two-year notes that were issued a year ago or ten-year notes that
were issued nine years ago. 10 This illustration uses the monthly time series. 31 From this graph, it is
clear that yields on U.S. Treasury bonds have been quite volatile over the 60-year period 1955-2015,
increasing from a range of 2%–4% in the 1950s to highs of 15%–17% in the early 1980s and then
decreasing to multi-decade lows of 0%–2% in recent times. To anyone not familiar with this history, the
yields of the early to mid-1980s will seem astonishingly high, as will the rapid rate of increase in the yields
from 1978 to 1981. Also, with the exception of the 2010s, yields have tended to move in cycles of about
four or five years, steadily increasing and then decreasing, sometimes quite quickly. Most of the time
shortterm yields are less than long-term ones, often by material amounts, i.e., the yield curve is upward-
sloping with a fairly steep slope, but at cycle peaks, short-term yields are typically greater than long-term
ones though not by much, i.e., the yield curve is inverted. Historically, these yield cycles have been closely
linked to expansion and contraction cycles in the US economy; indeed, for many forecasters, an inverted
yield curve was considered a sure sign that the economy would soon be in recession or at the very least a
pronounced slowdown. However, since 2010, that link has been less apparent. Historical yield
information is also available for periods prior to 1955 but with less granularity, e.g., time series are
generally only available for Treasury bills and long-term Treasury bonds. Looking at yields from these
earlier periods, one discovers that yields on Treasury bills and bonds were low throughout the 1930s, not
unlike the 2010s. This suggests that, when considered 32 in the context of a longer historical period, the
yield environment of the 2010s may not be as unusual as it at first appears from the graph in Figure 8. 5.3
STATE AND LOCAL GOVERNMENT BONDS IN THE UNITED STATES The federal government of
the U.S. is not the only level of government that issues bonds in the U.S. State and local governments also
issue bonds, although the extent to which a particular state or municipality may do so is sometimes
limited by the state’s constitution or laws; for example, a state may have in place a balanced budget law,
which is a type of law that requires the state government to balance its budget each fiscal year and
severely limits its ability to borrow money to meet current expenditures. One of the main reasons that
state and local governments issue bonds is to finance the construction and maintenance of long-term
infrastructure such as municipal water systems, schools and hospitals, and roads and bridges. There are
two basic types of bonds issued by state and local governments: revenue bonds and general obligation
bonds. Revenue bonds are bonds that are backed by revenues generated from a dedicated source such as
the tolls levied on drivers using a particular road or bridge, or the charges levied on homeowners for
municipal water service. General obligation bonds are bonds that are backed by the general taxing
authority of the state or local government. Unlike the bonds of the U.S. Treasury, the bonds of state and
local governments are not free of default risk. Indeed, the governments of some states and municipalities
have gotten into financial difficulty in the past and in some cases even gone bankrupt; notable examples
include New York City in the 1970s, Orange County, California in the 1990s, and more recently, the city
of Detroit. Hence, all else being equal, the yields on state and local government bonds should be higher
than the yields on US Treasury bonds of the same term, with the yield premium being greater for less
creditworthy issuers. However, state and local government bonds have a feature that can result in their
yields being lower than they otherwise would be. Provided that a number of conditions are met, the
interest paid on certain types of bonds issued by state or local governments in the U.S. can be tax free or
taxable at a preferred rate. In this context, tax free means that the person or entity receiving the interest
payments does not have to pay income tax on the interest received, while taxable at a preferred rate
means that the tax rate is lower than it would be for other types of income such as wages. The tax-free or
tax-preferred status of these bonds make them attractive for income-seeking investors such as retirees.
State and local governments are aware of this and typically set the coupon rate for these bonds at a level
that is lower than would otherwise be required by investors. 5.4 GOVERNMENT BONDS IN CANADA
Up until now, we have considered interest rates without reference to the currency in which the particular
savings or lending product or bond is denominated, or as in the discussion of U.S. 33 Treasury securities,
tacitly assumed that the underlying currency is U.S. dollars. However, as we broaden the scope of our
discussion to include bonds issued outside the U.S., it becomes necessary to consider currency more
explicitly. Outside the U.S., financial transactions including transactions involving the borrowing or
lending of money are typically conducted in the currency of the country where the transaction takes
place. For example, transactions that take place in Great Britain are typically conducted in British
pounds (also known as pound sterling) and transactions that take place in Canada are typically
conducted in Canadian dollars. Like the U.S. government, the Government of Canada issues bonds of
various terms, ranging from Treasury bills with a duration of 91 days at issue to long-term Treasury
bonds with a maturity of 30 years at issue. Most of these bonds are issued in Canadian dollars, but some
are issued in U.S. dollars, mainly to meet the needs of U.S. and other international investors who are
interested in buying the bonds of the Government of Canada but do not wish to be exposed to fluctuation
in the value of the Canadian dollar. The Canadian dollar, like the currencies of most other industrialized
nations with well-developed economies, is a floating currency, which means that its value against the U.S.
dollar and other currencies continually changes based on the supply and demand for Canadian dollars in
international currency markets. When demand for Canadian dollars is high as generally occurs when
there is a lot of demand for Canadian assets or the goods and services produced by companies located in
Canada, the Canadian dollar increases in value. When demand is low, the Canadian dollar decreases in
value. Currency fluctuation is an important consideration for international investors because their return
on an investment depends not only on the return in the local currency but also on the extent to which the
value of the local currency changes over the life of the investment compared to the investor’s own
currency. The Government of Canada has issued bonds for over a century and has an unbroken record
of repayment. To U.S. investors, Government of Canada bonds are almost as safe as U.S. Treasuries.
Hence, the yields on Government of Canada bonds that are denominated in U.S. dollars tend to be very
similar to the yields on U.S. Treasury bonds; the slight differences that do exist are attributable to the
fact that bonds issued by the Government of Canada trade less frequently and in lower volumes than U.S.
Treasuries. However, the yields on Government of Canada bonds denominated in Canadian dollars can
be quite different. The reason is that the yields on bonds denominated in Canadian dollars are primarily
determined by the level of economic activity in Canada, including the overall supply and demand for
Canadian dollars, while the yields on bonds denominated in U.S. dollars are primarily determined by the
state of the U.S. economy. For an investor based in Canada, the yields on the (nominal return) bonds of
the Government of Canada are considered to be the risk-free rates, in the same way that the yields on the
nominal return bonds of the U.S. Treasury are considered the risk-free rates for U.S.-based investors.
Provided that the bonds of the Government of Canada are held to maturity, the rates of return on 34
these bonds, measured in local currency, are virtually certain. Hence, the notion of risk-free rate depends
on both the term of the investment and the currency in which it is denominated. Similar to the U.S., the
governments of Canadian provinces and municipalities also issue bonds; however, these bonds are not
free of default risk. Hence, the yields on the bonds of Canadian provinces and municipalities are higher
than the yields on bonds of the Government of Canada. 5.5 CORPORATE BONDS Corporations issue
bonds for reasons similar to governments, e.g., from managing short-term cash flow shortfalls to
investing in longer term assets such as manufacturing plants, mines and oil wells. However, the frequency
with which corporations issue bonds and the extent to which these bonds are traded in the secondary
market is much different than it is for governments. In general, the bonds of corporations trade much
less frequently than the bonds of governments. In fact, for some issues of corporate bonds, there may be
little or no trading at all. Investment brokers maintain inventories of the more actively traded corporate
issues for purchase or sale. An example of the type of information that an investment broker would make
available to clients is provided in Table 8. Table 8: Selected Corporate Bond Offerings as of May 17, 2016
Coupon Maturity Offer Quantity (1000s) Bid Yield Bid Price per 100 Ask Price per 100 Ask Yield Type
Rating ABC Grocery 6.65% 11/08/2027 44 3.7073% 127.285 129.882 3.4691% Corp BBBm 6.45%
02/09/2028 1000 3.7571% 125.337 127.943 3.5195% Corp BBBm 6.50% 01/22/2029 1000 3.9047% 125.743
128.445 3.6720% Corp BBBm 6.54% 02/17/2033 1000 4.3327% 126.083 129.142 4.1140% Corp BBBm
BCD Telecom 0.00% 02/26/2028 430 63.956 3.8330% Corp Al 6.55% 05/01/2029 88 3.8535% 127.284
130.035 3.6231% Corp Al 4.35% 12/18/2045 1000 4.4275% 98.725 102.183 4.2199% Corp Al EFG
Pipeline 0.00% 07/24/2029 260 52.756 4.9120% Corp BBBh 7.20% 06/18/2032 393 4.9254% 125.056
127.965 4.7014% Corp BBBh 5.75% 09/02/2039 17 4.9203% 111.417 115.424 4.6572% Corp BBBh PIP
Pipeline 4.75% 04/30/2043 107 5.3239% 91.834 94.848 5.1038% Corp BBBl ZAP Electric 6.93%
06/01/2032 305 3.5192% 141.519 144.800 3.3071% Corp Ah 6.59% 04/22/2043 1000 3.7093% 148.786
153.185 3.5174% Corp Ah 4.00% 12/22/2051 785 3.7618% 104.648 108.719 3.5655% Corp Ah 35 Note
that the bid price of a bond is the price that the investment broker is willing to pay to buy the bond from
the customer while the ask price is the price at which the investment broker is willing to sell the bond to
the customer; for obvious reasons, the bid price should always be lower than the ask price. The bid yield
is the yield that corresponds to the bid price and the ask yield is the yield that corresponds to the ask
price. Since the bid price is always lower than the ask price, the bid yield will always be greater than the
ask yield. The difference between the bid and ask yields for a particular bond issue is known as the bid-
ask spread and is a measure of the liquidity of the issue. Liquidity refers to the ease with which it is
possible to buy or sell a particular bond and the costs associated with doing so. When a bond is
purchased and sold less frequently, brokers who maintain an inventory of the bond issue generally
require customers to pay more to purchase it and they offer less to buy it back from them. Doing so
protects the broker against sudden changes in the overall market, in particular, a sudden drop in the
prices of all bonds. Hence, when a bond is purchased and sold less frequently, the bid yield is generally
higher, the offer yield lower, and the bid-ask spread greater. From Table 8, note that the bid-ask spread
for the ZAP Electric bond maturing on April 22, 2043 is 0.19% while for the PIP Pipeline bond maturing
on April 30, 2043 (eight days later), it is 0.22%, which suggests that the ZAP Electric bond is slightly
more liquid than the PIP Pipeline bond. The bid-ask spread for a typical U.S. Treasury or Government
of Canada bond would be even lower. The rating associated with a bond issue provides an indication of
the likelihood of issuer default and the recovery one can expect in the event of default. All else being
equal, the higher the rating, the lower the likelihood of default and the higher the likely recovery in the
event of default; hence, higher rated bonds typically have lower yields. Ratings are generally assigned
using letters of the alphabet, where A represents a higher rating than B, AA a higher rating than A, and
so on; these rating classes are often subdivided by affixing a suffix such as l, m, h (low, medium, high) or
simply +/-. The ratings provided by investment brokers generally come from an independent credit
rating agency that specializes in rating bond issues. Different rating agencies use different rating criteria
and alphabetical schemes, but the ratings assigned by different agencies tend to be quite similar.
Recovery on a bond in the event of default is determined in part by the seniority of the bond in the
issuer’s capital structure. Seniority refers to the order in which the holders of a corporation’s securities
would be paid in the event of liquidation; holders of the more senior issues are paid first while holders of
common equity are paid last. Corporations frequently issue bonds with different seniorities. Some bond
issues will be secured by specific assets; others will be unsecured but senior to all other unsecured debt;
and still others will be subordinated, i.e., lower than other debt but still higher than common equity or
preferred shares. All else being equal, the price of a corporation’s more senior debt should be higher and
the yield lower than the corporation’s less senior debt. A bond’s seniority is often taken into
consideration when a credit 36 rating is assigned to a bond issue, but not always; the issuer’s overall
creditworthiness is still usually the dominant factor. Finally, many corporate bonds have provisions that
give the issuer or the holder the right to redeem the bond before maturity subject to particular conditions
being met. These provisions can be quite valuable to either the issuer or the holder of the bond and
accordingly will affect the bond’s price and yield. There are two basic types of early redemption
provisions: calls and puts. A call provision is a provision that allows the bond’s issuer to redeem (“call”)
the bond before maturity at a particular price, usually above par, that is defined at the time of issue. A
put provision is a provision that allows the bond’s holder to sell (“put”) the bond back to the issuer
before maturity at a particular price, usually below par, that is defined at the time of issue. Call
provisions are valuable to bond issuers because they enable issuers to redeem their outstanding bonds
when interest rates drop below particular levels and then issue new bonds at the lower rates prevailing at
that time. Indeed, as interest rates drop, bond prices generally rise, all else being equal, and so when
interest rates drop to the level where a bond’s price reaches the price at which it can be redeemed by the
issuer, the issuer is generally better off redeeming the bond and issuing a new one than continuing to
make interest payments on the existing bond. Early redemption enables the issuer to save on future
interest costs but has an adverse effect on the bondholder, who will not receive the higher interest
payments that would have otherwise been made. Bond purchasers must be compensated for this
possibility by paying a lower price or, equivalently, receiving a higher yield. Hence, all else being equal, a
bond with a call provision should have a higher yield than a bond without the call provision. Put
provisions are valuable to bondholders but potentially costly to issuers. Indeed, when interest rates are
rising and bond prices falling, a put provision enables the bondholder to redeem the bond and purchase a
new bond at a higher rate; however, if the bondholder elects to do this, the issuer must have the funds
available to repay the bondholder or else issue a new bond and pay higher interest costs going forward.
Hence, all else being equal, a bond with a put provision should have a lower yield and higher price than a
bond without the put provision. In addition to liquidity, issuer creditworthiness, seniority, and the
presence or absence of call or put provisions, the prices and yields on corporate bonds are determined by
the same factors that affect the prices and yields of risk-free government bonds, e.g., currency, term and
inflation. Like governments, corporations frequently issue bonds in more than one currency. Although
corporations that are based in a single country generally issue bonds in the currency of that country,
corporations whose revenues are linked to the currency of a specific country will often issue bonds in that
currency instead; examples include multinational corporations and commodity producers such as oil and
gas exploration and refining companies and mining companies whose products are priced in U.S. dollars
regardless of where the company’s operations happen to be located. Finally, it is worth noting that in
spite of what was suggested in Chapter 3, the spread between a corporate bond and a risk-free
government bond of the same term and currency may or may not 37 provide a good indication of the
incremental compensation for credit risk for that term and currency. For a bond without any embedded
options, e.g., put or call provisions, the spread probably provides a reasonable estimate of the
compensation for credit risk; however, for a bond with one or more embedded options or one that is
denominated in a currency that is different from the investor’s preferred currency, this need not be so. In
the latter case, the spread is a combination of the compensation for credit risk, the compensation or cost
of embedded options, and if appropriate, the compensation for assuming currency risk. 6 The Role of
Central Banks We conclude this study note with a brief discussion of the role of central banks and how
their actions can influence the general level of a country’s interest rates. A central bank is a special type
of bank that acts as a banker to the commercial banks that are authorized to conduct business in a given
country and facilitates the movement of money throughout that country’s financial system. Today,
virtually all industrialized countries with well-developed economies have a central bank; however, this
was not always the case. The form, mandate and activities of a country’s central bank vary from one
country to another. In some countries, the central bank has broad responsibilities, including management
of the economy, control of the currency and supervision of the banks; in other countries, the central
bank’s role is more limited and may not even include issuance of the country’s currency. The two core
functions of any central bank are to facilitate the operation of a country’s payment system and act as a
lender of last resort for banks that are authorized to do business in the country. 6.1 OPERATION OF
THE PAYMENT SYSTEM In modern well-developed economies, the payment system works so well that
most people take it for granted and in fact may not even be aware that it is there. One goes to the grocery
store, uses one’s debit card to make payment, and automatically assumes that the payment will be
accepted as long as there are sufficient funds in the bank account linked to the card. One hires a
landscaper, writes the landscaper a check, and automatically assumes that the landscaper’s bank will
deposit the check to the landscaper’s bank account even if the landscaper deals with a different bank.
One goes to work, does one’s job, and automatically assumes that come payday, one’s paycheck will be
deposited to one’s bank account even if the bank one deals with is different from one’s employer. Each of
these seemingly simple transactions involves a number of different and unrelated parties. For example, in
the case of the grocery store transaction, there is your bank, the grocery store’s bank, the bank that
operates the debit terminals used by the grocery store, a national credit card issuer like Visa or
MasterCard if the credit card issuer’s logo appears on the debit card, and possibly a number of other
intermediaries. For the transaction to be successful and completed in real time, each of the parties
involved needs some assurance that the parties they happen to be 38 dealing with will be able to fulfill
their obligations when all accounts are settled at the end of the day (or whenever the accounts are
ultimately settled). The central bank provides this assurance by being available to step in and make good
on the obligations of the banks acting as intermediaries in the transaction in the unlikely event that one
or more of them is unable to do so. The central bank is able to do this because, as part of the privilege of
being granted the authority to operate a bank, banks must maintain a specified amount of money on
deposit with the central bank at all times. The amount of money that a given bank must maintain on
deposit at the central bank is known as the bank’s reserve requirement. In general, each bank has a
different reserve requirement and this reserve requirement changes from one day to the next depending
on factors such as the amount of money customers have on deposit at the bank, the volume of
transactions processed by the bank in a typical day, and the importance of the bank in the overall
payment system. The actual amount of money that a bank has on deposit at the central bank, which
necessarily will be greater than the bank’s reserve requirement, is known simply as the reserve. The
reserve amounts on deposit at the central bank provide the central bank the means to make good on a
bank’s obligation. In the unlikely event that a bank is unable to fulfill its obligations under a particular
transaction, the central bank can simply withdraw the money from the bank’s reserve account and
complete the transaction in place of the bank. The reserve accounts also provide an efficient way of
moving money from one bank to another. Rather than each bank having to maintain an account with
every other bank operating in the country, banks can simply transfer money back and forth between
reserve accounts at the central bank. The actual functioning of the payment system is more complicated
than what this suggests. However, this description should still give one an appreciation of the important
role central banks play in facilitating payments. 6.2 LENDER OF LAST RESORT The other core
function of a central bank is to act as a lender of last resort for banks that are authorized to do business
in the particular jurisdiction. This function is critical to maintaining confidence in the financial system.
The public has become accustomed to thinking that the money they have on deposit in checking and
savings accounts can be withdrawn at any time and, in the ordinary course of business, a bank should
have little difficulty fulfilling a customer’s wishes in this regard. However, if every customer of the bank
decided to withdraw the money they had on deposit at the bank and if all these requests came at the same
time, the bank would be unable to honor them all for the simple reason that, at any given time, most of
the money on deposit with the bank is lent to other customers and hence not immediately available. If all
the money deposited with the bank were available all of the time, the bank would have no way of
generating the income needed to pay interest on savings accounts or even cover the overhead associated
with operating a bank, and would then have to charge customers for the privilege of keeping their money
on deposit. 39 The central bank provides a backstop to banks that are experiencing higher than normal
withdrawals and in so doing ensures that the public’s confidence in the bank’s ability to honor
withdrawal requests from its customers is maintained. The central bank does this by lending the bank
whatever it needs to meet customer withdrawal requests and using the loans on the bank’s balance sheet
as security. Provided that the loans on the bank’s balance sheet are of good quality, the central bank will
be reasonably confident in the bank’s ability to repay the amounts lent when the period of higher than
normal withdrawals passes and should have no hesitation lending the bank the funds it needs. Of course,
a bank experiencing higher than normal withdrawals could turn to its peers for assistance rather than
the central bank and, in practice, this is what often happens. However, the difference between the central
bank and the bank’s peers is that the central bank is always willing and able to perform this function,
even when the bank’s peers are not. It is for this reason that the central bank is referred to as the lender
of last resort. One may wonder where the central bank gets the money to lend to banks that are
experiencing higher than normal withdrawals. There are two main sources. The first is the reserve
accounts that all banks are required to maintain with the central bank. The money in these accounts is
effectively cash. All the money in all the reserve accounts is available to support a bank that is
experiencing higher than normal withdrawals. The second is currency that the central bank issues itself.
Provided that the central bank has the authority to issue currency, it can issue whatever amount of cash
is needed to support a bank that is experiencing higher than normal withdrawals. Of course, if the
central bank does not have the authority to issue currency and a large number of banks experience
higher than normal withdrawals at the same time, then the central bank may only be able to provide
limited support. In such circumstances, limits are likely to be imposed on the amount each customer can
withdraw over a given period of time. 6.3 THE UNITED STATES FEDERAL RESERVE BANK
SYSTEM11 The central bank of the U.S. has a tripartite structure, which consists of a Board of
Governors, 12 regional reserve banks, and a committee, known as the Federal Open Market Committee,
that sets policy with respect to the central bank’s capital market activities such as the purchase or sale of
bonds issued by the U.S. Treasury. Hence, the central bank of the U.S. is really a system of banks and
accordingly is called the Federal Reserve System. The Federal Open Market Committee, also known as
the FOMC, is responsible for setting policy with respect to the central bank’s capital market activities.
The most visible way it does this is through setting a target for what is known as the federal funds rate.
The federal funds rate is the interest rate at which banks with excess reserve funds at their District’s
Federal Reserve Bank lend these funds to other banks. In the normal course of conducting business, a
bank may find that at the end of a given day, the funds it has on deposit at 11 The information on the
structure and mandate of the Federal Reserve provided in this section was obtained from the Federal
Reserve’s website (http://www.federalreserve.gov/aboutthefed/structure-federal-reserve-banks.htm). 40
its reserve bank are insufficient to meet its reserve requirements for that day; borrowing the necessary
funds overnight from a bank that has more funds in its reserve account than it needs is a simple and
efficient way for the bank to meet its reserve requirements. Through the buying and selling of Treasury
bills in the secondary market, the 12 reserve banks are able to influence the level of the federal funds rate
and ensure that on any given day the federal funds rate is close to the target set by the Federal Open
Market Committee. The federal funds rate is not the same as the rate at which banks can borrow directly
from the Federal Reserve, e.g., to manage higher than normal withdrawals from customers. The rate at
which banks can borrow money directly from the Federal Reserve is known as the discount rate. Banks
typically prefer to borrow from their peers rather than directly from the Federal Reserve because doing
so sends a signal to the market that the bank is creditworthy and recognized as such by its peers.
Through its setting of the federal funds rate and other capital market activities, the FOMC is able to
influence the general level of interest rates in the economy and the overall level of economic activity. For
example, when the FOMC increases the target level of the federal funds rate, it makes it more expensive
for banks to run a shortfall in their reserve accounts. As a result, banks have an incentive to keep more
money on deposit at their reserve bank and underwrite fewer loans. This has the effect of shifting the
supply curve for money. Absent a corresponding shift in the demand curve, the price of money, i.e.,
interest rates, will increase. Conversely, when the FMOC decreases the target level of the federal funds
rate, it makes it cheaper for banks to run a shortfall in their reserve accounts and provides them an
incentive to underwrite a greater number of loans. This has the effect of shifting the supply curve for
money in the opposite direction and, all else being equal, decreasing the level of interest rates charged on
loans. The FOMC’s activities, which include setting the target level for the federal funds rate, are
generically referred to as setting monetary policy. Under the current provisions of the Federal Reserve
Act, the Federal Reserve is to conduct monetary policy in a way that promotes maximum employment,
stable prices, and moderate long-term interest rates. These goals are not mutually exclusive but at times
they may conflict with one another. For example, in order to promote maximum employment, it may at
times be necessary to set interest rates at levels that are lower than the level needed to keep prices stable
over the long term. However, when prices are increasing at a faster rate than is consistent with stable
prices, it may be necessary to set interest rates at levels that are higher than the long-term equilibrium
value even if that means accepting a temporarily higher level of unemployment. The actual workings of
the Federal Reserve System are considerably more complex than discussed here and include additional
activities such as the supervision of member banks and the issuance of U.S. dollars. However, the
discussion presented here should still give one an appreciation of the important role that the Federal
Reserve System plays in the U.S. economy and the determination of interest rates.
Role of Time value of money in finance
Why the Time Value of Money (TVM) Matters to Investors
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BY BRIAN BEERS

Updated Apr 2, 2018

The time value of money (TVM) is an important concept to investors because a dollar on hand today is worth
more than a dollar promised in the future. The dollar on hand today can be used to invest and earn interest or
capital gains. A dollar promised in the future is actually worth less than a dollar today because of inflation.
Provided money can earn interest, this core principle of finance holds that any amount of money is worth more
the sooner it is received. At the most basic level, the time value of money demonstrates that, all things being
equal, it is better to have money now rather than later.
TVM can be broken up into two areas: present value and future value.
What Is Present Value?
Present value determines what a cash flow to be received in the future is worth in today's dollars. It discounts
the future cash flow back to the present date, using the average rate of return and the number of periods. No
matter what the present value is, if you invest that present value amount at the specified rate of return and
number of periods, the investment would grow into the future cash flow amount.
Present value = (future cash flow) / (1+ rate of return)^number of periods
What Is Future Value?
Future value determines what a cash flow received today is worth in the future, based on interest rates or capital
gains. It calculates what a current cash flow would be worth in the future, if it was invested at a specified rate of
return and number of periods.
Future value = present value x {1 + (rate of return x number of periods)}
Both present value and future value take into account compounding interest or capital gains, which is another
important aspect for investors to consider when looking for good investments.
The Bottom Line
Time is literally money. The value of the money you have now is not the same as it will be in the future.
Knowing how to determine TVM by calculating present and future value can help you distinguish between the
worth of investments that offer returns at different times.
Time Value of Money (TVM)
REVIEWED BY JAMES CHEN

Updated Sep 25, 2019

What Is the Time Value of Money (TVM)?
The time value of money (TVM) is the concept that money available at the present time is worth more than the
identical sum in the future due to its potential earning capacity. This core principle of finance holds that
provided money can earn interest, any amount of money is worth more the sooner it is received. TVM is also
sometimes referred to as present discounted value.
Volume 75%

1:14
Understanding The Time Value Of Money
Understanding Time Value of Money (TVM)
The time value of money draws from the idea that rational investors prefer to receive money today rather than
the same amount of money in the future because of money's potential to grow in value over a given period of
time. For example, money deposited into a savings account earns a certain interest rate and is therefore said to
be compounding in value.
Further illustrating the rational investor's preference, assume you have the option to choose between receiving
$10,000 now versus $10,000 in two years. It's reasonable to assume most people would choose the first option.
Despite the equal value at the time of disbursement, receiving the $10,000 today has more value and utility to
the beneficiary than receiving it in the future due to the opportunity costs associated with the wait. Such
opportunity costs could include the potential gain on interest were that money received today and held in a
savings account for two years.
Time Value of Money Formula
Depending on the exact situation in question, the time value of money formula may change slightly. For
example, in the case of annuity or perpetuity payments, the generalized formula has additional or less factors.
But in general, the most fundamental TVM formula takes into account the following variables:
 FV = Future value of money
 PV = Present value of money
 i = interest rate
 n = number of compounding periods per year
 t = number of years
Based on these variables, the formula for TVM is:
FV = PV x [ 1 + (i / n) ] (n x t)
Time Value of Money Examples
Assume a sum of $10,000 is invested for one year at 10% interest. The future value of that money is:
FV = $10,000 x (1 + (10% / 1) ^ (1 x 1) = $11,000
The formula can also be rearranged to find the value of the future sum in present day dollars. For example, the
value of $5,000 one year from today, compounded at 7% interest, is:
PV = $5,000 / (1 + (7% / 1) ^ (1 x 1) = $4,673
Effect of Compounding Periods on Future Value
The number of compounding periods can have a drastic effect on the TVM calculations. Taking the $10,000
example above, if the number of compounding periods is increased to quarterly, monthly or daily, the ending
future value calculations are:
 Quarterly Compounding: FV = $10,000 x (1 + (10% / 4) ^ (4 x 1) = $11,038
 Monthly Compounding: FV = $10,000 x (1 + (10% / 12) ^ (12 x 1) = $11,047
 Daily Compounding: FV = $10,000 x (1 + (10% / 365) ^ (365 x 1) = $11,052
This shows TVM depends not only on interest rate and time horizon, but also on how many times the
compounding calculations are computed each year.
Related Terms
What Is Cumulative Interest?
Cumulative interest is the sum of all interest payments made on a loan over a certain time period.
more
Learn About Compounding
Compounding is the process in which an asset's earnings, from either capital gains or interest, are reinvested to
generate additional earnings over time.
more
Continuous Compounding
Continuous compounding is the process of calculating interest and reinvesting it into an account's balance over
a theoretically infinite number of periods.
more
What the Accounting Rate of Return Shows
The accounting rate of return (ARR) measures the amount of profit, or return, expected on an investment as
compared with the initial cost. ARR divides an asset's average revenue by its initial cost to derive an expected
return.
more
Compound Interest Definition
Compound interest is the numerical value that is calculated on the initial principal and the accumulated interest
of previous periods of a deposit or loan. Compound interest is common on loans but is less often used with
deposit accounts.
more
How to Calculate Present Value, and Why Investors Need to Know It
Present value is the concept that states an amount of money today is worth more than that same amount in the
future. In other words, money received in the future is not worth as much as an equal amount received today.
more
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The importance Of Time Value Of Money
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Have you ever heard the term, a bird at hand is worth two in the bush? Today we are talking about money
instead of birds. Although you can also sell the bird for money – I digress. Time value of money is a very
important concept in finance.
My aim for writing this article is to refresh the concept of time value of money. After reading this article, you
will
1. Know the definition and importance of the time value of money
2. Know the formula for calculating present value and future value of money
3. Solve a life question using the formula mentioned above
4. Get some insight into some of my quirks

Get a handle of your finances now. Time is

burning out.

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Time Value Of Money: Will You Take $10,000 Now Or $100,000 In The Future?
What is the time value of money definition?
The time value of money is a financial concept that basically says money at hand today is worth more
than the same amount of money in the future. Simply put, $1 today is far more valuable than $1 in the
future.
This is due to the potential the current money has to earn more money. This is an important concept to
understand in finance.
Suffice to say, the amount of money that you make is not the only thing that matters. It matters if the
money is received today or in the future.
The time value of money can work for you or against you. For example, if you are deciding between
buying a new phone for 1000 dollars, or invest in a stock for example that yields 10% per year. If you buy
the phone, you have just incurred an opportunity cost of 10%.

Importance of time value of money

No matter how you slice it, every financial decision you make have an impact on your quality of life and the
ability to enjoy the things you love.
Because of this, one of the most fundamental and cornerstone concept in modern finance to help us make those
decisions is the concept of time value of money.
This concept is so important that it is equally applicable and useful in your personal finance and your business.
As an investor, this concept must be clear as day. Time is money and the sooner you earn or save that money,
the faster you can put it to work for you

Time is money and the sooner you earn or save that money, the faster you can put it to work for you.CLICK
TO TWEET

Check out our post on the bizarre truth about the rule of 72 which further reinforce this concept. We even do
the calculations for you and showed how the rule was derived (hint: The rule of 72 is really the rule of 69).

Try our compound interest calculator to determine how fast your money will grow at a certain interest rate.
You will know exactly when your money will double.
Time value of money Video with examples

Time value of money example

Life question: To answer the question in the headline, more information is needed.
What if the question is posed this way: Do you want 100,000 dollars now or 1,000,000 dollars in 30 years?
Which one will you take?
What about 109,000 bucks next year instead? 300,000 dollars in 10 years? Ok, you get the idea.
Still, we need more information.
Pin me Pin me Pin me

Some assumptions
1. The 100,000 dollars accrue 10% interest yearly.
2. The interest is guaranteed. No bull or bear market
3. This is an iron-clad contract. Remember those horror movies with contracts?
4. The person offering the money can’t back out of the contract and you can’t change your mind either.
I know those who believe in the adage that says a bird at hand is better than two in the bush will quickly grab
the 100,000 dollars now and run.
If you are preoccupied with the total sum of the money involved, you might jump at the 1 million bucks. But
which one is the best choice?
Bear with me for a moment and let me use this to explain the concept of the time value of money.
If it helps you concentrate better, since mathematics is my forte, I will try to explain using the simplest
mathematical formula.

You have to be as smart as Einstein to

understand this concept.

The formula for future value of money

FV = PV X (1 + r) ^n
FV = Future value
PV = Present value
R = rate of return
N = the time period the money is invested.
We also assume the money will be invested.

Why 100,000 dollars: I love $100,000 because it is a round number and it is the right amount of money that
will make a difference in most people’s lives. It will definitely make a difference in mine.
The answer to the time value of money example:
To solve the problem presented in the beginning, we need to calculate how much the 100k turned into a 10%
interest rate in 1 year, 10 years and 30 years.
Summoning the equation gods
FV = PV X (1 + r) ^n
1 year
FV = 100,000 x (1+10/100)^1 = 100,000 x (1.10) = 110,000
10 years
FV = 100,000 x (1+0.10)^10 = 100,000 x 2.59 = 259,000
30 years
FV = 100,000 x (1+0.10)^30 = 100,000 x 1.75 = 1,750,000
Here is a calculator to play around with the numbers

Breakdance: A perfect version of air

baby

Verdict
 I will take the 100k now vs 109 k next year
 I will take 300 k in 10 years vs 100 know
 100k now, please! vs 1 million in 30 years.
Of note, we can also do this calculation backward too to find the past value of money.
 My version of air baby. If you think this is
bad, then imagine if I try now

Things I do to practice the time value of money concept

1. Prioritize investing in a retirement account while in fellowship instead of paying off my 2.8% student
loan (thank you Canada).
2. I calculate my tax so that I owe or get a refund less than or equal to 1000 buck. This way, I am not
giving the IRS an interest-free loan and thereby wasting my time value of money.
3. Being a minimalist and worked extra shifts to pay off my student loan even while I was in fellowship
and residency instead of spending like a villain.
4. Pay my bills on the last day or few days before it is due. I figured if I pay in immediately, I am losing a
month of compound interest. I set everything as autopay so I won’t forget. Yes I know it is a bit much
but I do it. The amount might seem nominal for gas and electricity bills to some people, still makes me
feel better.
In summary, it is better to invest now rather than later. Invest early to enjoy a long term compound
interest.
Hustle early and live below your means to have enough cash flow to pay debt and invest.
Remember that the time value of money can work for you or against you, it is your choice.
If you want to start investing early, here is an article on the ultra easy beginners guide to investing.

Please let me know what you think in the comment. Pin our images.
Do you have things you do to reinforce this concept even if it sounds trivial to others?

Free Budgeting And Finance E-Book



Why time value of money is important in financial planning

Published: June 11, 2019 3:51:37 PM
If you thought demonetization was a big game-changer and destroyed the value of money in huge chunks,
there’s a bigger game-changer on the horizon.
 Time can
wreak havoc on your profits, savings, and personal wealth, if due care is not undertaken.
If you thought demonetization was a big game-changer and destroyed the value of money in huge chunks,
there’s a bigger game-changer on the horizon. This game-changer dwarfs demonetization when it comes to
eroding the value of money. It is called time.
Time can wreak havoc on your profits, savings, and personal wealth, if due care is not undertaken. The most
dangerous aspect of this is that erosion of your wealth over time can happen without you even knowing it.
However, if you take timely investment decisions, time can work for you.
In order to see what corrosive impact time can have on your money, let us first understand the concept of ‘time
value of money’.
Time value of money decoded
Time erodes the value of money since what money can buy today, it can buy lesser tomorrow. Let us say you
have a hundred-rupee note in hand today. Assume you can buy a basket of vegetables with that money. If you
keep this cash with you for a year, and try to buy the same basket of vegetables a year later, you won’t be able
to buy them.
This is because the vegetables would have appreciated in price. Chiefly, this may happen due to either higher
demand for these vegetables or an increase in prices due to lower supply of these vegetables. This price rise is
known as inflation.
The purchasing power of your hundred rupees has decreased over a year’s time, since now you need to shell out
more to purchase the same basket of vegetables. So, if the same basket of vegetables costs a hundred and five
rupees after a year—an inflation of five percent—your money needs to earn five percent per year just to keep
pace with inflation and not lose value.
Erosion of the value of money over time is also because of the uncertainty of future. A hundred rupees now
represents some certainty in what you can buy with that money. On the other hand, in future anything could
happen to decrease or nullify the purchasing power of your hundred rupees in hand—you may misplace your
money, the national economy could collapse, or prices of goods could skyrocket. Or, your hundred-rupee note
may get demonetized and you are not able to exchange it at the bank for some reason.
The concept of compounding over time
If you need to stop time from corroding the value of your money, you need to start making it work for you. You
do this by “starting early” and “investing smartly”. Let us say you have a sum of Rs 1 lakh in your savings
account, kept aside for your son’s school fees in six months’ time. Remember, anything that gives you a return
lesser than prevailing inflation is actually causing you to lose money, so money in a savings account usually
represents a loss.
So, you need to move your Rs 1 lakh to an investment whose returns far exceed inflation but also mature in six
months’ time. You can opt for an Fixed Deposit (FD) with a term of six months with quarterly compounding,
wherein the principle plus interest at the end of the first quarter is reinvested at the same rate of interest, so you
earn interest on interest. This is the compounding power of time.
However, the compounded returns after six months may still not be able to beat inflation. In such cases, you can
unleash the full power of compounding by opting for a FD of longer maturity period, say two or three years,
where the returns are the highest in its class.
To deal with the school fees, you can park a part of a regular income like monthly salary in a flexible Recurring
Deposit (RD) for a term of six months. The returns here, like the six-month FD, will be definitely lower than
that of the two-year FD—but you are not parking your entire Rs 1 lakh at this (lower) six-month interest rate.
You are doing it in instalments, which brings down the average principle amount parked at the (lower) six-
month interest rate.
When it comes to investment and financial planning, have time on your side by starting early and investing
smartly in order to avoid the corrosive effects of time.
(By Hemanth Gorur, Co-founder, Hermoneytalks.com, and Managing Partner, Hubwords Media)
Get live Stock Prices from BSE and NSE and latest NAV, portfolio of Mutual Funds, calculate your tax
by Income Tax Calculator, know market’s Top Gainers, Top Losers & Best Equity Funds. Like us
on Facebook and follow us on Twitter.
Introduction: What is time value of money?

Play media comment. Click here to listen to this chapter

Time value of money (TVM) is the idea that money that is available at the present time is worth more than the
same amount in the future, due to its potential earning capacity. This core principle of finance holds that
provided money can earn interest, any amount of money is worth more the sooner it is received. One of the
most fundamental concepts in finance is that money has a time value attached to it. In simpler terms, it would be
safe to say that a dollar was worth more yesterday than today and a dollar today is worth more than a dollar
tomorrow.
This chapter is a practical approach to the time value of money. We fully understand that today's technology
provides multiple calculators and applications to help you derive both present value and future value of money.
If you do not take the time to comprehend how these calculations are derived, you may make critical financial
decisions using inaccurate data (because you may not be able to recognize whether the answers are correct or
incorrect). There are five (5) variables that you need to know:
1. Present value (PV) - This is your current starting amount. It is the money you have in your hand at the
present time, your initial investment for your future.
2. Future value (FV) - This is your ending amount at a point in time in the future. It should be worth more
than the present value, provided it is earning interest and growing over time.
3. The number of periods (N) - This is the timeline for your investment (or debts). It is usually measured
in years, but it could be any scale of time such as quarterly, monthly, or even daily.
4. Interest rate (I) - This is the growth rate of your money over the lifetime of the investment. It is stated
in a percentage value, such as 8% or .08.
5. Payment amount (PMT) - These are a series of equal, evenly-spaced cash flows.
You can calculate the fifth variable if you are given any four of the five (all) variables listed above. A simple
example of this would be: If you invest one dollar (PV) for one year (N) at 6% (I), you will receive $1.06 (FV).
This would be the same as saying the present value of $1.06 you expect to receive in one year, is only $1.00
(PV).

To understand the time value of money successfully, let's learn step by step throughout the five chapters below.
Introduction to the Time Value of Money
Defining the Time Value of Money
The Time Value of Money is the concept that money is worth more today that it is in the future.
LEARNING OBJECTIVES
Identify the variables that are used to calculate the time value of money
KEY TAKEAWAYS
Key Points
 Being given $100 today is better than being given $100 in the future because you don’t have to wait for
your money.
 Money today has a value ( present value, or PV) and money in the future has a value ( future value, or
FV).
  The amount that the value of the money changes after one year is called the interest rate (i). For
example, if money today is worth 10% more in one year, the interest rate is 10%.
Key Terms
 Present Value (PV): The value of the money today.
 Interest Rate (i or r): The cost of not having money for one period, or the amount paid on an
investment per year.
 Future Value (FV): The value of the money in the future.
One of the most fundamental concepts in finance is the Time Value of Money. It states that money today is
worth more than money in the future.
Imagine you are lucky enough to have someone come up to you and say “I want to give you $500. You can
either have $500 right now, or I can give you $500 in a year. What would you prefer? ” Presumably, you would
ask to have the $500 right now. If you took the money now, you could use it to buy a TV. If you chose to take
the money in one year, you could still use it to buy the same TV, but there is a cost. The TV might not be for
sale, inflation may mean that the TV now costs $600, or simply, you would have to wait a year to do so and
should be paid for having to wait. Since there’s no cost to taking the money now, you might as well take it.
There is some value, however, that you could be paid in one year that would be worth the same to you as $500
today. Say it’s $550- you are completely indifferent between taking $500 today and $550 next year because
even if you had to wait a year to get your money, you think $50 is worth waiting.
In finance, there are special names for each of these numbers to help ensure that everyone is talking about the
same thing. The $500 you get today is called the Present Value (PV). This is what the money is worth right
now. The $550 is called the Future Value (FV). This is what $500 today is worth after the time period (t)- one
year in this example. In this example money with a PV of $500 has a FV of $550. The rate that you must be
paid per year in order to not have the money is called an Interest Rate (i or r).
All four of the variables (PV, FV, r, and t) are tied together in the equation in. Don’t worry if this seems
confusing; the concept will be explored in more depth later.

Simple Interest Formula: Simple interest is when interest is only paid on the amount you originally invested
(the principal). You don’t earn interest on interest you previously earned.
Importance of the Time Value of Money
Time value of money is integral in making the best use of a financial player’s limited funds.
LEARNING OBJECTIVES
Describe why the time value of money is important when analyzing a potential project
KEY TAKEAWAYS
Key Points
 Money today is worth more than the same quantity of money in the future. You can invest a dollar today
and receive a return on your investment.
  Loans, investments, and any other deal must be compared at a single point in time to determine if it’s a
good deal or not.
 The process of determining how much a future cash flow is worth today is called discounting. It is done
for most major business transactions during investing decisions in capital budgeting.
Key Terms
 interest rate: The percentage of an amount of money charged for its use per some period of time. It can
also be thought of as the cost of not having money for one period, or the amount paid on an investment
per year.
 discounting: The process of determining how much money paid/received in the future is worth today.
You discount future values of cash back to the present using the discount rate.
Why is the Time Value of Money Important?
The time value of money is a concept integral to all parts of business. A business does not want to know just
what an investment is worth todayit wants to know the total value of the investment. What is the investment
worth in total? Let’s take a look at a couple of examples.
Suppose you are one of the lucky people to win the lottery. You are given two options on how to receive the
money.
1. Option 1: Take $5,000,000 right now.
2. Option 2: Get paid $600,000 every year for the next 10 years.
In option 1, you get $5,000,000 and in option 2 you get $6,000,000. Option 2 may seem like the better bet
because you get an extra $1,000,000, but the time value of money theory says that since some of the money is
paid to you in the future, it is worth less. By figuring out how much option 2 is worth today (through a process
called discounting), you’ll be able to make an apples-to-apples comparison between the two options. If option 2
turns out to be worth less than $5,000,000 today, you should choose option 1, or vice versa.
Let’s look at another example. Suppose you go to the bank and deposit $100. Bank 1 says that if you promise
not to withdraw the money for 5 years, they’ll pay you an interest rate of 5% a year. Before you sign up,
consider that there is a cost to you for not having access to your money for 5 years. At the end of 5 years, Bank
1 will give you back $128. But you also know that you can go to Bank 2 and get a guaranteed 6% interest rate,
so your money is actually worth 6% a year for every year you don’t have it. Converting our present cash worth
into future value using the two different interest rates offered by Banks 1 and 2, we see that putting our money
in Bank 1 gives us roughly $128 in 5 years, while Bank 2’s interest rate gives $134. Between these two options,
Bank 2 is the better deal for maximizing future value.

Compound Interest: In this formula, your deposit ($100) is PV, i is the interest rate (5% for Bank 1, 6% for
Bank 2), t is time (5 years), and FV is the future value.
What is the Time Value of Money?
The time value of money is a basic financial concept that holds that money in the present is worth more than the
same sum of money to be received in the future. This is true because money that you have right now can be
invested and earn a return, thus creating a larger amount of money in the future. (Also, with future money, there
is the additional risk that the money may never actually be received, for one reason or another.) The time value
of money is sometimes referred to as the net present value (NPV) of money.

How the Time Value of Money Works

A simple example can be used to show the time value of money. Assume that someone offers to pay you one of
two ways for some work you are doing for them: They will either pay you $1,000 now or $1,100 one year from
now.
Which pay option should you take? It depends on what kind of investment return you can earn on the money at
the present time. Since $1,100 is 110% of $1,000, then if you believe you can make more than a 10% return on
the money by investing it over the next year, you should opt to take the $1,000 now. On the other hand, if you
don’t think you could earn more than 9% in the next year by investing the money, then you should take the
future payment of $1,100 – as long as you trust the person to pay you then.

Time Value and Purchasing Power

The time value of money is also related to the concepts of inflation and purchasing power. Both factors need to
be taken into consideration along with whatever rate of return may be realized by investing the money.
Why is this important? Because inflation constantly erodes the value, and therefore the purchasing power, of
money. It is best exemplified by the prices of commodities such as gas or food. If, for example, you were given
a certificate for $100 of free gasoline in 1990, you could have bought a lot more gallons of gas than you could
have if you were given $100 of free gas a decade later.
Inflation and purchasing power must be factored in when you invest money because to calculate your real return
on an investment, you must subtract the rate of inflation from whatever percentage return you earn on your
money. If the rate of inflation is actually higher than the rate of your investment return, then even though your
investment shows a nominal positive return, you are actually losing money in terms of purchasing power. For
example, if you earn a 10% on investments, but the rate of inflation is 15%, you’re actually losing 5% in
purchasing power each year (10% – 15% = -5%).

Time Value of Money Formula

The time value of money is an important concept not just for individuals, but also for making business
decisions. Companies consider the time value of money in making decisions about investing in new product
development, acquiring new business equipment or facilities, and in establishing credit terms for the sale of
their products or services.
A specific formula can be used for calculating the future value of money so that it can be compared to the
present value:

Where:
FV = the future value of money
PV = the present value
i = the interest rate or other return that can be earned on the money
t = the number of years to take into consideration
n = the number of compounding periods of interest per year

Using the formula above, let’s look at an example where you have $5,000 and can expect to earn 5% interest on
that sum each year for the next two years. Assuming the interest is only compounded annually, the future value
of your $5,000 today can be calculated as follows:
FV = $5,000 x (1 + (5% / 1) ^ (1 x 2) = $5,512.50

Present Value of Future Money Formula

The formula can also be used to calculate the present value of money to be received in the future. You simply
divide the future value rather than multiplying the present value. This can be helpful in considering two varying
present and future amounts. In our original example, we considered the options of someone paying your $1,000
today versus $1,100 a year from now. If you could earn 5% on investing the money now, and wanted to know
what present value would equal the future value of $1,100 – or how much money you would need in hand now
in order to have $1,100 a year from now – the formula would be as follows:
PV = $1,100 / (1 + (5% / 1) ^ (1 x 1) = $1,047

The calculation above shows you that, with an available return of 5% annually, you would need to receive
$1,047 in the present to equal the future value of $1,100 to be received a year from now.
To make things easy for you, there are a number of online calculators to figure the future value or present value
of money.

Net Present Value Example

Below is an illustration of what the Net Present Value of a series of cash flows looks like. As you can see, the
Future Value of cash flows are listed across the top of the diagram and the Present Value of cash flows are
shown in blue bars along the bottom of the diagram.

This example is taken from CFI’s Free Introduction to Corporate Finance Course, which covers the topic in
more details.
Additional Resources
We hope you’ve enjoyed CFI’s explanation of the time value of money. To learn more about money and
investing, check out the following resources:
 Adjusted Present Value
 Forecasting Methods
 NPV Formula
 Valuation Methods
Valuation Techniques
Learn the most important valuation techniques in CFI’s Business Valuation course!
Step by step instruction on how the professionals on Wall Street value a company.

Learn valuation the easy way with templates and step by step instruction!

What is Time Value of Money (TVM)?

Last updated: August 13, 2019 | by Sreekanth Reddy 12 Comments
Each one of us has financial needs and goals. Once the goals are identified, we need to set goal values (targets).
This means that we should be in a position to convert the needs / goals into financial terms. To do this, we
should be aware of and understand the most important aspect of ‘Financial Planning’ i.e., Time Value of
Money (TVM).
Money has TIME value. A rupee today is more valuable than it will be a year hence or two years hence. Do
you agree with me?
In this post let us understand the importance of Time value of money and basics of TVM.
Why Money Has Time Value
Suppose you were given the choice between receiving Rs 100,000 today or Rs 100,000 in 10 years. Which
option would you rather select? Clearly the first option is more valuable for the following reasons:
 Purchasing power: Because of inflation, Rs 100,000 can be used to buy more goods and services today
than Rs 100,000 in 10 years from now. Put another way, just think back to what Rs 100,000 could buy
you 10 years ago. For example : 10 years back the cost of one litre milk would have been say Rs 5, now
its Rs 30 and after 10 years, it could be Rs 100.
 Opportunity Cost: A rupee received today can be invested now to earn interest, this can result in a
higher value in the future. Sooner is better than later.
  Risk Vs Return: If you are giving your money to be used by another person / company, that means you
are taking the risk associated with it, which is known as ‘default risk’ (you may or may not get back your
payments). So, you expect return / interest to compensate the risk.
Time Value of Money : Compounding & Discounting
The basic principles of TVM are compounding and discounting methods.
Compounding : When we hear the word ‘compounds’, the first thing that comes to mind is GROWTH. That
means we expect our investment to grow and yield some return (or interest).
For example – Rs 10,000 invested today in a bank fixed deposit at 9% pa interest rate for 5 years can fetch you
Rs 15,386 (let’s ignore taxation part). So Rs 5,386 is the accumulation of the interest and also interest on the

interest.
Discounting : Compounding is about the future value of today’s investment, where as discounting is the today’
value (PV) of money to be received in the future (FV – Future Value). Present value is calculated by applying a
discount rate (opportunity cost) to the sums of money to be received in the future.
For example – You want Rs 15,386 in five years from now and the prevailing bank rates are around 9%. What
is the amount that you need to invest now to receive Rs 15,386 after five years?
The value of Rs 15,386 is equal to Rs 10,000 in today’s value at a discounting rate of 9%.
Five components of Time Value of Money
Based on the above examples, we can say that the components of any TVM problems or calculations are;
 Tenure (The total number of compounding or discounting periods)
 Rate of Interest
 Present Value (PV) or Today’s value
 Future Value (FV)
The fifth component is Periodic Payments (Pmt).
For example : If you acquire a home loan of Rs50 Lakh @ 10% pa for a period of 20 years, your EMI (Equated
Monthly Installments) would be around Rs 48,000.
So, Payments (pmt) represents equal periodic payments received or paid each period. When payments are
received they are positive, when payments are made they are negative.
You can use Microsoft Excel to calculate TVM based problems. Use FV, PV, PMT etc., to calculate you
financial goal amounts and also to analyze your investments.

You can also use regular or financial calculators to solve your Time Value of Money problems.
Kindly go through the below articles to understand the importance of TVM. I have used TVM
calculations (using MS Excel functions) in these articles.
 Calculate Future Value of your Investments or Project Future Value of your expenses
 Retirement Planning in 3 easy steps
 Kid’s Education Goal Planning
 Calculate Home Loan EMI payments, total principal repayment / interest amount
  The importance of numeracy in becoming Financially Literate!
Next time, when your insurance agent / financial adviser says that you will receive Rs 50 Lakh when you retire,
do not just blindly believe it and sign the proposal form, instead calculate the present value of the maturity
benefit in today’s value 🙂
These Time Value of Money calculations demonstrate that time literally is money. The value of the money you
have now is not the same as it will be in the future and vice verse. So, it is very important to know how to
calculate the time value of money so that you can distinguish between the worth of investments that offer you
returns at different times.

Time is money – Benjamin Franklin

(Image courtesy of Stuart Miles at FreeDigitalPhotos.net)
Sreekanth Reddy:
Sreekanth is the Man behind ReLakhs.com. He is an Independent Certified Financial Planner (CFP), engaged in
blogging & property consultancy for the last 9 years through his firm ReLakhs Financial Services . He is not
associated with any Financial product / service provider. The main aim of his blog is to "help investors take
informed financial decisions.""Please note that the views given in this Blog/Comments Section/Forum are
clarifications meant for reference and guidance of the readers to explore further on the topics/queries raised and
take informed decisions. These should not be construed as investment advice or legal opinion."
What Is the Time Value of Money and Why Is It So Important in Investment Decisions?
by Neil Kokemuller; Reviewed by Jayne Thompson, LLB, LLM; Updated February 12, 2019

Related Articles
 1The Pros & Cons of the Average Accounting Return Method
 2Description of Capital Budgeting
 3Why Is the Time Value of Money So Important in Capital Budgeting Decisions?
  4Limitations of Capital Budgeting
Small businesses often have limited resources to invest in business operations, activities and expansion. One of
the factors you have to weigh as you choose how to invest is the time value of money, sometimes abbreviated
TVM in finance. In general, this concept refers to the reality that under normal inflation conditions, money
today is worth more than the same amount in the future.
Tip
 The time value of money is the concept that cash in your pocket today is worth more than cash in your
pocket in the future, because you can invest it to make more money.
TVM in Finance
From a financial standpoint, the time value of money refers to a comparison of how much value an amount of
money has presently vs. its similar value in the future. The importance of the time value of money comes in
considering whether a business decision that results in $20,000 in revenue in one year is potentially more
favorable than one that results in $21,000 in revenue in five years, for instance.
While $21,000 is greater, you could easily end up with more money by making $20,000 and investing it further
over the five years. You would only need a 1 percent or higher annualized return to benefit, which is quite
achievable even based simply on putting the money in an ordinary bank account.
General TVM Philosophy
Even in lieu of financial calculations, the time value of money relates closely to the adage "a bird in the hand is
worth two in the bush." When comparing the time frame to generate income from investment options, a
decision that results in more money quickly is often preferred. A small business can see a snowball effect by
getting rapid revenue from an investment that it can then reinvest. Delays in generating revenue on investments
can lead to struggles to grow revenue in the short term.
Paying the Bills
Another important factor in assessing time value of money is the level of debt you carry. If you have significant,
costly debt, it is more advantageous to get money in hand quickly. If you make payments on a 12 percent loan,
generating revenue quickly can help you expedite payments on the debt. This reality warrants strong
consideration of investments with quick returns.
If you anticipate a 5 percent annualized return on an alternative investment when weighing a long-term option,
it makes more sense to take the earlier revenue and pay off the debt. Because of considerations like what debts
businesses carry and what types of investments are available to them, time value of money calculations will
differ from business to business.
Thinking About Future Uncertainty
The future holds no guarantees. When looking at the rate of return over time on investment options, a more
conservative business owner would factor in the level of return certainty. A less-risky investment might produce
a more modest return, but it has a high level of certainty. Riskier investments often promise greater reward in
the long run.
However, uncertainty in societal, economic and market trends contribute to the potential that the returns may
not materialize as expected. The longer you look into the future, the less possible in general it is to predict how
investments will fare or what other opportunities may present themselves.
Time Value of Money Calculator
If you know roughly the rate of return minus inflation you could get on a certain quantity of money, you can
compute the time value of money today versus a certain time in the future by doing compound interest
calculations.
Since this is a common formula, you can find time value of money calculator software available for free use
online. This won't take into effect all considerations around an investment, of course, such as the level of risk or
whether making certain decisions might open new opportunities for you or your business in the future.
What Is the Time Value of Money and Why Does It Matter?
What is the Time Value of Money, and why is it important? Everything you need to know.
Michelle Rama-Poccia
Dec 5, 2018 4:51 PM EST

Salvador Dali
The time value of money -- the idea that money received in the present is more valuable than the same sum in
the future because of its potential to be invested and earn interest -- is one of the founding principles of Western
finance.
Let's say you lent your friend $2000. Would you rather he repaid you today, or tomorrow? The logical choice
would be today, because you'll be able to use your money, and potential gains that come with it, sooner.
What Is the Time Value of Money?
Money is worth more more in the present than in the future because there's an opportunity cost to waiting for it.
In addition to your loss of use if you don't get your hands on it right away, there's also inflation gradually
eroding its value and purchasing power.
If you're going to part with your money for any period of time, you probably expect a larger sum returned to
you than you started with. Whether you're lending or investing, the goal is to make a gain to compensate you for
going without your money for awhile.
Suppose your friend offers to repay you $2000 today or $2050 next year. You must consider whether you'd earn
more than $50 over the next year by investing your money elsewhere before choosing to delay receiving
payment. Other factors include your time preference (whether you need the money right now or can wait awhile
to get it back) and whether you trust your friend to actually repay you -- another reason why money is worth
more in the present: it may never materialize in the future. As the saying goes, "a bird in the hand is worth two
in the bush."
Why Does the Time Value of Money Matter?
The time value of money matters because, as the basis of Western finance, you will use it in your daily
consumer, business and banking decision making. All of these systems are driven by the idea that lenders and
investors earn interest paid by borrowers in an effort to maximize the time value of their money. Your job
within this system is to limit the cost of money to you and to increase returns on your investments.
The concept isn't new -- it dates back to ancient times -- and although, as with Islamic finance, there may be
cultures that forbid charging interest, their decisions are driven by similar monetary concepts.
Formula for Calculating the Time Value of Money
So how do you measure the time value of money? The formula takes the present value, then multiplies it by
compound interest for each of the payment periods and factors in the time period over which the payments are
made.
Formula: FV = PV x [ 1 + (i / n) ] ^(n x t)

 (PV) Present Value = What your money is worth right now.

 (FV) Future Value = What your money will be worth at some future time after it (hopefully) earns
interest.
 (I) Interest = Paying someone for the time their money is held.
 (N) Number of Periods = Investment (or loan) period.
 (T) Number of Years = Amount of time money is held

For instance, if you start with a present value of $2,000 and invest it at 10% for one year, then the future value
is:
FV = $2,000 x (1 + (10% / 1) ^ (1 x 1) = $2,200
How Interest Rates Affect the Time Value of Money
Interest compensates a party for time she spends apart from her money. Expressed as a percentage over a
specific period of time, it's a charge or an income that is a measure of money's value over time.
Usually, the longer someone lends their money to another party, the higher the interest rate they charge for it.
Debt of shorter duration, like a 15-year fixed mortgage, usually commands a lower rate than, say a 30-year
fixed rate mortgage.
Likewise, an interest-bearing investment like a bank certificate of deposit usually pays a lower interest rate the
shorter the term. If you commit to leaving your money in the account longer, you're often rewarded with a
higher interest rate.
There are several different types of interest rate:
 Simple Interest
 Compound Interest
 Fixed Interest Rate
 Variable Interest Rate
Simple vs. Compound Interest
Simple interest is illustrated in the example above -- simply adding a 10% gain to $2,000 for a year yields
$2,200.
Compound interest, however, is calculated by adding the interest accrued up until certain intervals during the
life of the loan or investment in a way that can significantly increase the future value. Time value of money is
usually calculated with compound interest.
Using the same formula as above to compute the same $2,000 at 10% for one year -- but this time compounding
interest quarterly, or four times a year -- yields:
FV = PV x [ 1 + (i / n) ]^ (n x t)
This is calculated as follows: $2000 x [1 + (10% / 4)] ^(4 x 1) = $2,207.63
So that's another $7.63 in the course of a year. Note that, with compound interest, the future value is higher than
it is when calculated with simple interest.
Fixed Interest Rates vs. Variable Interest Rates
In investing and borrowing, consumers often walk a delicate line of trying to maximize the time value of their
money while avoiding too much risk.
As prices rise, many take on debt to be able to afford homes, cars, vacations and other high-cost items. That's
why it's important to look closely at the type of interest you're paying and how it may change over the long term
while also seeking to make strong returns to bolster the time value of your money.
If you have money invested in a certificate of deposit (CD), chances are it pays you a fixed interest rate. Fixed
rate refers to an interest rate that will not change over time. The opposite of that is a variable rate, which is an
interest rate that changes depending on how much benchmark rates rise or fall in the open market.
Calculated simply, if you invest $1,000 in a one-year CD at a fixed 2% interest rate, the future value of your
$1000 will be $1,020. The time value of your $1,000 is 2%, or $20, in exchange for letting the bank keep your
money for a year.
Opportunity Cost and Time Value of Money
Time value of money varies and involves an opportunity cost. That means that if you're putting the $1000 in the
CD, you may be foregoing an opportunity to use the money as a good faith deposit on a home. Calculating the
time value of your money should tell you that instead of investing at all, you should have instead paid down
expensive variable rate credit card debt that's costing you hundreds a month.
An instrument or loan with a variable rate recalculates the interest paid or charged periodically.
For instance, a borrower may take out an adjustable rate mortgage (ARM) that has a low introductory rate of
2%, which will begin to adjust five years into the loan to a spread over a benchmark like the one-year Treasury
bill. That means it adds the 2% to whatever the T-bill rate is and that's the interest rate you pay on your loan for
one year. The following year, it adjusts again depending on what T-bill rates are then, and so on until the loan
matures.
Borrowers calculating the time value of money for these loans like that the interest cost is postponed for several
years. The loan is designed to attract borrowers who may not otherwise be able to afford a fixed-rate mortgage
and who then pin their hopes on interest rates remaining low once the interest rate begins to adjust to market
value.
When that happens, the mortgage rate can jump higher suddenly depending on how much interest rates have
increased since he first took out the loan. There's no way to predict how much interest rates will rise five years
from now, making it impossible to calculate the time value of money on the loan, so these can be risky.
Savvy investors who plan to sell their homes within the next several years make a TVM calculation to reduce
their borrowing costs with an adjustable rate mortgages versus higher-interest fixed-rate loans. Taking
advantage of the lower introductory rate, they aren't worried that the rate will reset much higher because they
won't have the mortgage long enough to pay the higher rates.
Annual Percentage Rates and Time Value of Money
One way investors can guard against paying exorbitant interest rates is to either defer or save up for purchases
they won't be able to pay in full on credit cards with high APRs (annual percentage rates).
An APR is helpful in TVM calculations because it is a rate that reflects what it will actually cost you to borrow
money from a credit card, mortgage or other loan on a yearly basis. In addition to the interest rate, it factors in
fees, points and other costs associated with your debt. The APR makes it clear what the real cost is to you, so
comparing APRs for different debt products can help you identify those with a lower total cost for your TVM
calculation.
Consumers with a high time preference -- meaning they have a hard time waiting to make desired purchases --
fall prey to notoriously high credit card APRs up to 25% and may end up in the position of only being able to
afford the minimum payments. With credit card debt, the time value of money is extremely high -- often higher
than individual investors' returns on investments.
The future value for a $5000 vacation you paid on a credit card with an APR of 25%, if it takes you a year to
pay it off, is about $5,700. The credit card company is making $700 in just one year to lend you money to go on
vacation. Before taking on credit card debt, consider that you're forgoing the $700 you'll spend on interest and
you're missing out on the potential future value of that money.
Concept of future value and present value
Present Value vs Future Value Differences
Present value is that amount without which we cannot obtain the future value. The future value, on the
other hand, is that amount which an individual will get after a certain time period from the cash on hand.
In this article, we look at the differences between Present Value vs Future Value.

What is Present Value?

Present value is a basic concept in the world of finance. Present value is the value which is today’s value.
Suppose you invest today Rs 100 at 10% interest for 1 year then after one year, the amount becomes
Rs110. This Rs 100 which you are investing today is called present value of Rs 110. Future value is that
value which will be the value in the future. So here Rs 110 is the future value of Rs 100 at 10%. Present
value helps in taking decisions on investment which is based on the current value. So present value is the
current value of the cash flows which will happen in future and these cash flows happen at a discounted
rate.
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What is Future Value?

Future value, on the other hand, can be defined as the worth of that asset or the cash but at a particular
date in the future and that amount will be equal in terms of value to a particular sum in the
present. Future value calculations play a very important role in the world of finance. It is the basis of
most important valuation techniques to value a company. With the help of discounting a cash flow that is
projected to be generated at a future period the discounted cash flow technique is used in order to value a
company or any order asset class that generates a certain amount of cash and is expected to continue
generating cash for a particular future period.

Present Value vs Future Value – Infographics

Here we provide you with the top 7 difference between Present Value vs Future Value
Present Value vs Future Value – Key Differences
The key differences between Present Value vs Future Value are as follows –
 Present value is crucial because it is more reliable value and an analyst can be almost certain
about that value, on the other hand since the future value is a projected figure no one can fully
rely on that figure as in the future something can happen which can affect the projections.
 Present value is defined as the current worth of the future cash flow whereas Future value is the
value of the future cash flow after a certain time period in the future.
 While calculating present value inflation is taken into account but while calculating future value
inflation is not considered.
 While calculating present value discount rate and interest both are considered but while
calculating future value only interest is considered.
 Present value helps the investors in understanding and deciding whether an investment should be
made or rejected. Since future value tells about the future gains from an investment it does not
have a significant role in decision making regarding an investment.
 Present value technique uses discounting to find out the investment’s value on today’s date.
Future value technique uses compounding to find out the investment’s future value.

Head to Head Difference Between Present Value vs Future Value

Let’s now look at the head to head difference between Present Value vs Future Value

Basis – Present Value vs

Present Value Future Value
Future Value

Present value is defined as the It is defined as the value of the future

current value of the cash flow in cash flow after a certain future period.
Meaning
future. It is basically the amount of This is the amount of cash which will
cash in hand on today’s date. be received at a specified future date.

It is the current value of an asset It is that value of the asset or

Time Frame or investment at the starting of a investment at the end of a particular
particular time period. time period.

For the present value, inflation is For future value, inflation is not
Inflation Effect
considered. considered.

While calculating present value

While calculating future value only
Rates Applicable both the discount rate and interest
interest rate is taken into account.
rate are taken into account.
 Present value is very much
important for the investors as it
Decision Making
helps to decide whether to invest
or not.
Since this reflects the future profits
from an investment it has lesser
importance in decision making
regarding investments.

While calculating present value Future value calculation uses the

discounting is applied to find out
the present value of every cash
Calculation Method
flow and then all these values are
added up to find the investment’s
value on today’s date.
compounding technique to arrive at
the future value of every cash flow
after a certain time period and then all
these values are added up to get the
investment’s future value.

Present value is that amount which

Future value is that amount which an
Nature is required to obtain the future
individual will get from cash on hand.
value.

Conclusion
Both present values vs future value are very much important to the investors for taking crucial decisions
regarding investment decisions. While present value decides the current value of the future cash flows
future value decides the gains on the future investments after a certain time period. Present value is
crucial because it is a more reliable value and an analyst can be almost certain about that value, that’s
why it is easier to take a decision based on the present.
On the other hand, future value is important as without making projections for the future values it is
very difficult to make any estimation whether its budget projections or any asset valuations. But since the
future value is a projected figure no one can fully rely on that figure as in the future something can
happen which can affect the projections. present value and future value are connected to each other and
have significant importance in the field of finance.

Recommended Articles
This has a been a guide to Present Value vs Future Value. Here we discuss the top 7 difference
between Present Value and Future Value along with infographics and comparison table. You may also
have a look at the following articles –
What Is Present Value – PV?
Present value (PV) is the current value of a future sum of money or stream of cash flows given a specified rate
of return. Future cash flows are discounted at the discount rate, and the higher the discount rate, the lower the
present value of the future cash flows. Determining the appropriate discount rate is the key to properly valuing
future cash flows, whether they be earnings or obligations.
Volume 75%

1:39
Present Value
PV Formula and Calculation
\begin{aligned} &\text{Present Value} = \dfrac{\text{FV}}{(1+r)^n}\\ &\textbf{where:}\\ &\text{FV} =
\text{Future Value}\\ &r = \text{Rate of return}\\ &n = \text{Number of periods}\\ \end{aligned}
Present Value=(1+r)nFVwhere:FV=Future Valuer=Rate of returnn=Number of periods
1. Input the future amount that you expect to receive in the numerator of the formula.
2. Determine the interest rate that you expect to receive between now and the future and plug the rate as a
decimal in place of "r" in the denominator.
3. Input the time period as the exponent "n" in the denominator. So, if you want to calculate the present
value of an amount you expect to receive in three years, you would plug the number three in for "n" in
the denominator.
4. There are a number of online calculators including Investopedia's present value calculator.
KEY TAKEAWAYS
 Present value is the concept that states an amount of money today is worth more than that same amount
in the future. In other words, money received in the future is not worth as much as an equal amount
received today.
 Money not spent today could be expected to lose value in the future by some implied annual rate, which
could be inflation or the rate of return if the money was invested.
 Calculating present value involves making an assumption that a rate of return could be earned on the
funds over the time period.
What Does Present Value Tell You?
Present value is the concept that states an amount of money today is worth more than that same amount in the
future. In other words, money received in the future is not worth as much as an equal amount received today.
Receiving $1,000 today is worth more than $1,000 five years from now. Why? Two factors impact whether an
amount today is worth more than the same amount in the future.
Interest Rate or Rate of Return
An investor can invest the $1,000 today and presumably earn a rate of return over the next five years. Present
value takes into account any interest rate an investment might earn.
If an investor receives $1,000 today and can earn a rate of return 5% per year, the $1,000 today is certainly
worth more than receiving $1,000 five years from now. If an investor waited five years for $1,000, there would
be opportunity cost or the investor would lose out on the rate of return for the five years.
Inflation and Purchasing Power
Inflation is the process in which prices of goods and services rise over time. If you receive money today, you
can buy goods at today's prices. Presumably, inflation will cause the price of goods to rise in the future, which
would lower the purchasing power of your money.
Money not spent today could be expected to lose value in the future by some implied annual rate, which could
be inflation or the rate of return if the money was invested. The present value formula discounts the future value
to today's dollars by factoring in the implied annual rate from either inflation or the rate of return that could be
achieved if a sum was invested.
Future Value Compared With PV
A comparison of present value with future value (FV) best illustrates the principle of the time value of money
and the need for charging or paying additional risk-based interest rates. Simply put, the money today is worth
more than the same money tomorrow because of the passage of time.
In many scenarios, people would rather have a $1 today versus that same $1 tomorrow. Future value can relate
to the future cash inflows from investing today's money, or the future payment required to repay money
borrowed today.
Discount Rate for Finding PV
The discount rate is the investment rate of return that is applied to the present value calculation. In other words,
the discount rate would be the forgone rate of return if an investor chose to accept an amount in the future
versus the same amount today. The discount rate that is chosen for the present value calculation is highly
subjective because it's the expected rate of return you'd receive if you had invested today's dollars for a period
of time.
The discount rate is the sum of the time value and a relevant interest rate that mathematically increases future
value in nominal or absolute terms. Conversely, the discount rate is used to work out future value in terms of
present value, allowing a lender or capital provider to settle on the fair amount of any future earnings or
obligations in relation to the present value of the capital. The word "discount" refers to future value being
discounted to present value.
The calculation of discounted or present value is extremely important in many financial calculations. For
example, net present value, bond yields, spot rates, and pension obligations all rely on discounted or present
value. Learning how to use a financial calculator to make present value calculations can help you decide
whether you should accept such offers as a cash rebate, 0% financing on the purchase of a car, or pay points on
a mortgage.
Future Value vs. Present Value
Future value (FV) is the value of a current asset at a specified date in the future based on an assumed rate of
growth. The FV equation assumes a constant rate of growth and a single upfront payment left untouched for the
duration of the investment. The FV calculation allows investors to predict, with varying degrees of accuracy,
the amount of profit that can be generated by different investments.
Present value (PV) is the current value of a future sum of money or stream of cash flows given a specified rate
of return. Present value takes the future value and applies a discount rate or the interest rate that could be earned
if invested.
Future value tells you what an investment is worth in the future while the present value tells you how much
you'd need in today's dollars to earn a specific amount in the future.
Limitations of Using PV
As stated earlier, calculating present value involves making an assumption that a rate of return could be earned
on the funds over the time period. In our example, we looked at one investment over the course of one year.
However, if a company is deciding to go ahead with a series of projects that has a different rate of return for
each year and each project, the present value becomes less certain if those expected rates of return are not
realistic.
It's important to consider that in any investment decision, no interest rate is guaranteed, and inflation can erode
the rate of return on any investment.
Example of Present Value
Let's say you have the choice of being paid $2,000 today or $2,200 one year from now. You also have the
option of investing the $2,000 that'll earn a 3% rate of return over the next year. Which is the best option?
 Using the present value formula, the calculation is $2,200 (FV) / (1 +. 03)^1.
 PV = $2,135.92, or the minimum amount that you would need to be paid today to have $2,200 one year
from now. In other words, if you were paid $2,000 today and based on a 3% interest rate, the amount
would not be enough to give you $2,200 one year from now.
Of course, the present value calculation includes the assumption that you could earn 3% on the $2,000 over the
next year. If the interest rate was much higher, it might make more sense to take the $2,000 today and invest the
funds because it would yield a greater amount than $2,200 one year from now.
Present value provides a basis for assessing the fairness of any future financial benefits or liabilities. For
example, a future cash rebate discounted to present value may or may not be worth having a potentially higher
purchase price. The same financial calculation applies to 0% financing when buying a car.
Paying some interest on a lower sticker price may work out better for the buyer than paying zero interest on a
higher sticker price. Paying mortgage points now in exchange for lower mortgage payments later makes sense
only if the present value of the future mortgage savings is greater than the mortgage points paid today.
Related Terms
Present Value of an Annuity
The present value of an annuity is the current value of future payments from an annuity, given a specified rate
of return or discount rate
more
Time Value of Money (TVM) Definition
The time value of money is the idea that money presently available is worth more than the same amount in the
future due to its potential earning capacity.
more
Present Value Interest Factor Of Annuity (PVIFA)
The present value interest factor of annuity is a factor that can be used to calculate the present value of a series
of annuities.
more
Valuation Period
The valuation period is the time period during which value is determined for variable investment options.
more
Future Value of an Annuity
The future value of an annuity is the value of a group of recurring payments, known as an annuity, at a specified
date in the future.
more
Understanding the Present Value Interest Factor
The present value interest factor (PVIF) is used to simplify the calculation for determining the present value of a
future sum.
1. Small Business»
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Future Value vs. Present Value
by Jim Woodruff; Reviewed by Michelle Seidel, B.Sc., LL.B., MBA; Updated January 25, 2019

Related Articles
 1Define "Time Value of Money"
 2Calculate Future Cash Flow Discount
 3How Is Net Present Value Related to Cost-Benefit Analysis?
 4Corporate Investment Analysis
The time value of money sounds like one of those boring economic concepts that a small business owner
doesn't have time for – but that would be wrong. Future value and present value are monetary concepts that a
business owner uses every day, whether he realizes it or not. The idea is simple: Money in your pocket today is
worth more than the same amount received several years in the future. The difference is the effect of inflation
and the risk that you may not actually receive the money you expect in the future.
What Is Future Value?
Future value is the amount of money that an original investment will grow to be, over time, at a specific
compounded rate of interest. In simpler terms, an investment of $1,000 today in an account paying 4 percent
interest will be worth $1,217 in five years. That's an example of the time value of money.
Example of Future Value
How is this concept of time value useful in managerial decision-making? Suppose you have an old piece of
machinery that you would like to replace, but a replacement will cost $50,000. You don't want to borrow the
money, so you decide to save enough each month for three years to pay cash. How much will you need to save
each month to reach the goal of $50,000?
Let's assume the current interest rate for savings is 4 percent. A future value calculator shows that 36 payments
of $645 per month will yield $50,051 in three years. If you work this monthly payment into your company's
budget, you can replace the obsolete equipment in three years, paying cash and not taking on additional debt.
What Is Present Value?
Present value is a measure in today's dollars of the receipts from future cash flow. In other words, it is a
comparison of the purchasing power of a dollar today versus the buying power of a dollar in the future. For
clarity, consider this example. Suppose someone offered to pay you $1,000 today or $1,100 in five years. Which
would you take?
With a discount rate of 4 percent, an $1,100 payment in five years would have a present-day value of $904.
Therefore, taking the $1,000 payment today is the better choice.
Example of Present Value
Managers and analysts use present value calculations to determine the attractiveness and viability of a project. If
the net present value of future cash flow from a project exceeds the original investment, then the project could
be accepted.
As an example, suppose you have a proposal to invest $30,000 in a new piece of equipment that will improve
production efficiency. This new machine will reduce operating costs by $10,000 per year for at least five years.
You require that all new projects produce a minimum return of 11 percent. The financial calculator shows that
the present value of $10,000/year discounted at 11 percent yields a present value of $36,959. Because this
present value exceeds the original investment of $30,000 by $6,959, this investment in the new machine should
be accepted.
The time value of money is an economic concept that small business owners must use when evaluating
investments and projects. The financial consequences are significant. Calculations of future and present values
provide basic data on which to make rational business decision
A central concept in business and finance is the time value of money. We will use easy to follow examples and
calculate the present and future value of both sums of money and annuities.
The Time Value of Money
Donna was puzzled about something, so she went to talk to Becky about it. She told her friend that the problem
is whether she would want a dollar today or a dollar one year from now. She doesn't see what the difference is,
since it's still one dollar, no matter when you get it.
Becky had to think about this for a while. When she sees Donna again, she tells her to take that dollar now and
put it in a savings account. The bank will pay interest, so one year from now she'll have more than one dollar.
To sum up the time value of money, money that you have right now will be worth more over time. So one
dollar now will be worth more than a dollar in a year from now.
Future Value
Donna went home and did some research and she discovered a formula for future value, or how much money
put in the bank today will turn into at some point in the future with the interest. She needs to know three things:
1. How much she has now
2. What the interest rate is
3. How many years she wants to put the money away for
Then she can use a formula to figure out how much she'll have at the end. The formula is:
FV = PV (1 + r)n
In this formula,
  PV is how much she has now, or the present value
 r equals the interest rate she will earn on the money
 n equals the number of periods she will put the money away, and
 FV equals how much she will have at the end, or future value.
Let's imagine that Donna puts $100 in the bank for five years at five percent interest, and plug that into the
equation.
FV = 100 (1 + 0.05)5
FV = 100 * 1.2762
FV = $127.62
Pretty nice, huh?
Present Value
Donna's parents think she's a pretty smart girl, especially after she shows her Dad these cool formulas. Dad
knows he will need money in a few years to pay for Donna's college. He's wondering how much he can invest
today in some CDs that would be worth $20,000 or so in 10 years when he'll need it. Donna shows him a
formula for present value, or how much you need to save today to have a specific amount at some point in the
future. Here's the formula:
PV = FV / (1 + r)n
In this formula,
 PV equals how much he needs to have today, or present value
 r equals the interest rate he'll earn
 n equals the number of periods before he needs the money, and
 FV equals how much he will need in the future, or future value.
So, if Dad needs the $20,000 in 10 years and can invest what he has for five percent, let's find out how much he
needs to invest today.
PV = $20,000 / (1.05)10
PV = $20,000 / 1.6289
PV = $12,278
Her dad is very happy to hear that.
Future Value of an Annuity
An annuity is a stream of equal payments. If Donna's parents give her an allowance of $20 every month on the
first, that's an annuity. It isn't just one allowance payment, but a stream of them, since they happen every month,
and it's always just the same amount.
Additional Detail on Present and Future Values
The Relationship Between Present and Future Value
Present value (PV) and future value (FV) measure how much the value of money has changed over time.
LEARNING OBJECTIVES
Discuss the relationship between present value and future value
KEY TAKEAWAYS
Key Points
 The future value (FV) measures the nominal future sum of money that a given sum of money is “worth”
at a specified time in the future assuming a certain interest rate, or more generally, rate of return. The FV
is calculated by multiplying the present value by the accumulation function.
 PV and FV vary jointly: when one increases, the other increases, assuming that the interest rate and
number of periods remain constant.
 As the interest rate ( discount rate) and number of periods increase, FV increases or PV decreases.
Key Terms
 discounting: The process of finding the present value using the discount rate.
 present value: a future amount of money that has been discounted to reflect its current value, as if it
existed today
 capitalization: The process of finding the future value of a sum by evaluating the present value.
The future value (FV) measures the nominal future sum of money that a given sum of money is “worth” at a
specified time in the future assuming a certain interest rate, or more generally, rate of return. The FV is
calculated by multiplying the present value by the accumulation function. The value does not include
corrections for inflation or other factors that affect the true value of money in the future. The process of finding
the FV is often called capitalization.
On the other hand, the present value (PV) is the value on a given date of a payment or series of payments made
at other times. The process of finding the PV from the FV is called discounting .
PV and FV are related, which reflects compounding interest ( simple interest has n multiplied by i, instead of as
the exponent). Since it’s really rare to use simple interest, this formula is the important one.

FV of a single payment: The PV and FV are directly related.

PV and FV vary directly: when one increases, the other increases, assuming that the interest rate and number of
periods remain constant.
The interest rate (or discount rate) and the number of periods are the two other variables that affect the FV and
PV. The higher the interest rate, the lower the PV and the higher the FV. The same relationships apply for the
number of periods. The more time that passes, or the more interest accrued per period, the higher the FV will be
if the PV is constant, and vice versa.
The formula implicitly assumes that there is only a single payment. If there are multiple payments, the PV is the
sum of the present values of each payment and the FV is the sum of the future values of each payment.
Calculating Perpetuities
The present value of a perpetuity is simply the payment size divided by the interest rate and there is no future
value.
LEARNING OBJECTIVES
Calculate the present value of a perpetuity
KEY TAKEAWAYS
Key Points
 Perpetuities are a special type of annuity; a perpetuity is an annuity that has no end, or a stream of cash
payments that continues forever.
 To find the future value of a perpetuity requires having a future date, which effectively converts the
perpetuity to an ordinary annuity until that point.
 Perpetuities with growing payments are called Growing Perpetuities; the growth rate is subtracted from
the interest rate in the present value equation.
Key Terms
 growth rate: The percentage by which the payments grow each period.
Perpetuities are a special type of annuity; a perpetuity is an annuity that has no end, or a stream of cash
payments that continues forever. Essentially, they are ordinary annuities, but have no end date. There aren’t
many actual perpetuities, but the United Kingdom has issued them in the past.
Since there is no end date, the annuity formulas we have explored don’t apply here. There is no end date, so
there is no future value formula. To find the FV of a perpetuity would require setting a number of periods which
would mean that the perpetuity up to that point can be treated as an ordinary annuity.
There is, however, a PV formula for perpetuities. The PV is simply the payment size (A) divided by the interest
rate (r). Notice that there is no n, or number of periods. More accurately, is what results when you take the limit
of the ordinary annuity PV formula as n → ∞.
It is also possible that an annuity has payments that grow at a certain rate per period. The rate at which the
payments change is fittingly called the growth rate (g). The PV of a growing perpetuity is represented
as PVGP = A(i−g)PVGP = A(i−g). It is essentially the same as in except that the growth rate is subtracted from
the interest rate. Another way to think about it is that for a normal perpetuity, the growth rate is just 0, so the
formula boils down to the payment size divided by r.
Calculating Values for Different Durations of Compounding Periods
Finding the Effective Annual Rate (EAR) accounts for compounding during the year, and is easily adjusted to
different period durations.
LEARNING OBJECTIVES
Calculate the present and future value of something that has different compounding periods
KEY TAKEAWAYS
Key Points
 The units of the period (e.g. one year) must be the same as the units in the interest rate (e.g. 7% per
year).
  When interest compounds more than once a year, the effective interest rate (EAR) is different from the
nominal interest rate.
 The equation in skips the step of solving for EAR, and is directly usable to find the present or future
value of a sum.
Key Terms
 present value: Also known as present discounted value, is the value on a given date of a payment or
series of payments made at other times. If the payments are in the future, they are discounted to reflect
the time value of money and other factors such as investment risk. If they are in the past, their value is
correspondingly enhanced to reflect that those payments have been (or could have been) earning interest
in the intervening time. Present value calculations are widely used in business and economics to provide
a means to compare cash flows at different times on a meaningful “like to like” basis.
 Future Value: The value of an asset at a specific date. It measures the nominal future sum of money
that a given sum of money is “worth” at a specified time in the future, assuming a certain interest rate, or
more generally, rate of return, it is the present value multiplied by the accumulation function.
Sometimes, the units of the number of periods does not match the units in the interest rate. For example, the
interest rate could be 12% compounded monthly, but one period is one year. Since the units have to be
consistent to find the PV or FV, you could change one period to one month. But suppose you want to convert
the interest rate into an annual rate. Since interest generally compounds, it is not as simple as multiplying 1% by
12 (1% compounded each month). This atom will discuss how to handle different compounding periods.
Effective Annual Rate
The effective annual rate (EAR) is a measurement of how much interest actually accrues per year if it
compounds more than once per year. The EAR can be found through the formula in where i is the nominal
interest rate and n is the number of times the interest compounds per year (for continuous compounding, see ).
Once the EAR is solved, that becomes the interest rate that is used in any of the capitalization or discounting
formulas.

EAR with Continuous Compounding: The effective rate when interest compounds continuously.

Calculating the effective annual rate: The effective annual rate for interest that compounds more than once
per year.
For example, if there is 8% interest that compounds quarterly, you plug.08 in for i and 4 in for n. That calculates
an EAR of.0824 or 8.24%. You can think of it as 2% interest accruing every quarter, but since the interest
compounds, the amount of interest that actually accrues is slightly more than 8%. If you wanted to find the FV
of a sum of money, you would have to use 8.24% not 8%.
Solving for Present and Future Values with Different Compounding Periods
Solving for the EAR and then using that number as the effective interest rate in present and future value
(PV/FV) calculations is demonstrated here. Luckily, it’s possible to incorporate compounding periods into the
standard time-value of money formula. The equation in is the same as the formulas we have used before, except
with different notation. In this equation, A(t) corresponds to FV, A0 corresponds to Present Value, r is the
nominal interest rate, n is the number of compounding periods per year, and t is the number of years.

FV Periodic Compounding: Finding the FV (A(t)) given the PV (Ao), nominal interest rate (r), number of
compounding periods per year (n), and number of years (t).
The equation follows the same logic as the standard formula. r/n is simply the nominal interest per
compounding period, and nt represents the total number of compounding periods.
Solving for n
The last tricky part of using these formulas is figuring out how many periods there are. If PV, FV, and the
interest rate are known, solving for the number of periods can be tricky because n is in the exponent. It makes
solving for n manually messy. shows an easy way to solve for n. Remember that the units are important: the
units on n must be consistent with the units of the interest rate (i).

Solving for n: This formula allows you to figure out how many periods are needed to achieve a certain future
value, given a present value and an interest rate.
Comparing Interest Rates
Variables, such as compounding, inflation, and the cost of capital must be considered before comparing interest
rates.
LEARNING OBJECTIVES
Discuss the differences between effective interest rates, real interest rates, and cost of capital
KEY TAKEAWAYS
Key Points
 A nominal interest rate that compounds has a different effective rate (EAR), because interest is accrued
on interest.
 The Fisher Equation approximates the amount of interest accrued after accounting for inflation.
 A company will theoretically only invest if the expected return is higher than their cost of capital, even
if the return has a high nominal value.
Key Terms
 inflation: An increase in the general level of prices or in the cost of living.
The amount of interest you would have to pay on a loan or would earn on an investment is clearly an important
consideration when making any financial decisions. However, it is not enough to simply compare the nominal
values of two interest rates to see which is higher.
Effective Interest Rates
The reason why the nominal interest rate is only part of the story is due to compounding. Since interest
compounds, the amount of interest actually accrued may be different than the nominal amount. The last section
went through one method for finding the amount of interest that actually accrues: the Effective Annual Rate
(EAR).
The EAR is a calculation that account for interest that compounds more than one time per year. It provides an
annual interest rate that accounts for compounded interest during the year. If two investments are otherwise
identical, you would naturally pick the one with the higher EAR, even if the nominal rate is lower.
Real Interest Rates
Interest rates are charged for a number of reasons, but one is to ensure that the creditor lowers his or her
exposure to inflation. Inflation causes a nominal amount of money in the present to have less purchasing power
in the future. Expected inflation rates are an integral part of determining whether or not an interest rate is high
enough for the creditor.
The Fisher Equation is a simple way of determining the real interest rate, or the interest rate accrued after
accounting for inflation. To find the real interest rate, simply subtract the expected inflation rate from the
nominal interest rate.

Fisher Equation: The nominal interest rate is approximately the sum of the real interest rate and inflation.
For example, suppose you have the option of choosing to invest in two companies. Company 1 will pay you 5%
per year, but is in a country with an expected inflation rate of 4% per year. Company 2 will only pay 3% per
year, but is in a country with an expected inflation of 1% per year. By the Fisher Equation, the real interest rates
are 1% and 2% for Company 1 and Company 2, respectively. Thus, Company 2 is the better investment, even
though Company 1 pays a higher nominal interest rate.
Cost of Capital
Another major consideration is whether or not the interest rate is higher than your cost of capital. The cost of
capital is the rate of return that capital could be expected to earn in an alternative investment of equivalent risk.
Many companies have a standard cost of capital that they use to determine whether or not an investment is
worthwhile.
In theory, a company will never make an investment if the expected return on the investment is less than their
cost of capital. Even if a 10% annual return sounds really nice, a company with a 13% cost of capital will not
make that investment.
Calculating Values for Fractional Time Periods
The value of money and the balance of the account may be different when considering fractional time periods.
LEARNING OBJECTIVES
Calculate the future and present value of an account when a fraction of a compounding period has passed
KEY TAKEAWAYS
Key Points
  The balance of an account only changes when interest is paid. To find the balance, round the fractional
time period down to the period when interest was last accrued.
 To find the PV or FV, ignore when interest was last paid an use the fractional time period as the time
period in the equation.
 The discount rate is really the cost of not having the money over time, so for PV/FV calculations, it
doesn’t matter if the interest hasn’t been added to the account yet.
Key Terms
 time period assumption: business profit or loses are measured on timely basis
 compounding period: The length of time between the points at which interest is paid.
 time value of money: the value of an asset accounting for a given amount of interest earned or inflation
accrued over a given period
Up to this point, we have implicitly assumed that the number of periods in question matches to a multiple of the
compounding period. That means that the point in the future is also a point where interest accrues. But what
happens if we are dealing with fractional time periods?
Compounding periods can be any length of time, and the length of the period affects the rate at which interest
accrues.

Compounding Interest: The effect of earning 20% annual interest on an initial $1,000 investment at various
compounding frequencies.
Suppose the compounding period is one year, starting January1, 2012. If the problem asks you to find the value
at June 1, 2014, there is a bit of a conundrum. The last time interest was actually paid was at January 1, 2014,
but the time-value of money theory clearly suggests that it should be worth more in June than in January.
In the case of fractional time periods, the devil is in the details. The question could ask for the future value,
present value, etc., or it could ask for the future balance, which have different answers.
Future/Present Value
If the problem asks for the future value (FV) or present value (PV), it doesn’t really matter that you are dealing
with a fractional time period. You can plug in a fractional time period to the appropriate equation to find the FV
or PV. The reasoning behind this is that the interest rate in the equation isn’t exactly the interest rate that is
earned on the money. It is the same as that number, but more broadly, is the cost of not having the money for a
time period. Since there is still a cost to not having the money for that fraction of a compounding period, the FV
still rises.
Account Balance
The question could alternatively ask for the balance of the account. In this case, you need to find the amount of
money that is actually in the account, so you round the number of periods down to the nearest whole number
(assuming one period is the same as a compounding period; if not, round down to the nearest compounding
period). Even if interest compounds every period, and you are asked to find the balance at the 6.9999th period,
you need to round down to 6. The last time the account actually accrued interest was at period 6; the interest for
period 7 has not yet been paid.
If the account accrues interest continuously, there is no problem: there can’t be a fractional time period, so the
balance of the account is always exactly the value of the money.
Loans and Loan Amortization
When borrowing money to be paid back via a number of installments over time, it is important to understand
the time value of money and how to build an amortization schedule.
LEARNING OBJECTIVES
Understand amortization schedules
KEY TAKEAWAYS
Key Points
 Amortization of a loan is the process of identifying a payment amount for each period of repayment on a
given outstanding debt.
 Repaying capital over time at an interest rate requires an amortization schedule, which both parties agree
to prior to the exchange of capital. This schedule determines the repayment period, as well as the
amount of repayment per period.
 Time value of money is a central concept to amortization. A dollar today, for example, is worth more
than a dollar tomorrow due to the opportunity cost of other investments.
 When purchasing a home for $100,000 over 30 years at 8% interest (consistent payments each month),
for example, the total amount of repayment is more than 2.5 times the original principal of $100,000.
Key Terms
 amortization: This is the process of scheduling intervals of payment over time to pay back an existing
debt, taking into account the time value of money.
When lending money (or borrowing, depending on your perspective), it is common to have multiple payback
periods over time (i.e. multiple, smaller cash flow installments to pay back the larger borrowed sum). In these
situations, an amortization schedule will be created. This will determine how much will be paid back each
period, and how many periods of repayment will be required to cover the principal balance. This must be agreed
upon prior to the initial borrowing occurs, and signed by both parties.
Time Value of Money
Now if you add up all of the separate payments in an amortization schedule, you’ll find the total exceeds the
amount borrowed. This is because amortization schedules must take into account the time value of money. Time
value of money is a fairly simple concept at it’s core: a dollar today is worth more than a dollar tomorrow.
Why? Because capital can be invested, and those investments can yield returns. Lending your money to
someone means incurring the opportunity cost of the other things you could do with that money. This gets even
more drastic as the scale of capital increases, as the returns on capital over time are expressed in a percentage of
the capital invested. Say you spend $100 on some stock, and turn 10% on that investment. You now have $110,
a profit of $10. Say instead of only a $100, you put in $10,000. Now you have $11,000, a profit of $1,000.
Principle and Interest
As a result of this calculation, amortization schedules charge interest over time as a percentage of the principal
borrowed. The calculation will incorporate the number of payment periods (n), the principal (P), the
amortization payment (A) and the interest rate (r).
P=A⋅1−(11+r)nrP=A⋅1−(11+r)nr
To make this a bit more realistic, let’s insert some numbers. Let’s say you find a dream house, at the reasonable
rate of $100,000. Unfortunately, a bit of irresponsible borrowing in your past means you must pay 8% interest
over a 30 year loan, which will be paid via a monthly amortization schedule (12 months x 30 years = 360
payments total). If you do the math, you should find yourself paying $734 per month 360 times. 360 x 734 will
leave you in the ballpark of $264,000 in total repayment. that means you are paying more than 2.5 times as
much for this house due to time value of money! This bit of knowledge is absolutely critical for personal
financial decisions, as well as for high level business decisions.

Amortization Schedule Example: This shows the first few installments in the example discussed above (i.e.
borrowing $100,000 at 8% interest paid monthly over 30 years).
e Value of Money
Value of Money Depends Upon Time
In the previous article we learned about the concept of nominal and real values of money. We realized that
money today is more valuable than the same sum received at a future date because there is no risk involved in
obtaining it and also the real value of money is not expected to decrease by the time we receive it.
The simple implication of this is that we cannot compare the dollars we have on hand today to the dollars that
we have been promised at a future date. In corporate finance, we call the value of money that we have on hand
today the present value and the value of amount of money that we will receive at a future date the future value
of money.
In corporate finance, we may often come across complex schedules of payments and receipts. Sometimes cash
may have to be paid today while sometimes we may have to pay it at a later date. Similarly the receipts may be
today or at a later date. Hence, to calculate, we must first convert all the values to present values. This article
will explain how to do so with the help of an example:
Calculating Future Values
Let’s understand the future values calculation with the help of an example. Let’s say that we have $1000 today
and we have calculated that our cost of capital is 10%. This 10% reflects both the expectation of inflation i.e.
fall in the real value of money as well as the risk involved in this investment. Let’s consider that we have to
invest this money for a period of 3 years.
The formula for calculating the future values is as follows:
Future Value = Present Value (1 + (cost of capital / 100)number of years
i.e. Future Value = $ 1000(1.10)3
i.e. Future Value = $ 1331
This means that the equivalent sum of money that we should expect in 3 years, given our cost of capital is
$1331. This means that we should accept proposals where future value is more than $1331, reject proposals
where future value is less than $1331 and be indifferent towards proposals where future value is equal to $1331.
From henceforth, we will refer to this by stating that the future value of $1000, at our given cost of capital, for a
period of 3 years is $1331. Also, it must be noted that future values are nominal in nature.
Present Values
Present values are the exact opposite of future values. During future values we were compounding a present
value at a given rate to reach a future value. But in present value calculations, we will discount the future
values, which are nominal in nature, at the given cost of capital for the given period to reach the present value.
Let’s look at it with the help of an example.
Now, we have a proposal that offers to pay us $1000, 3 years from hence. Our given cost of capital is 10%.
The formula for calculating the present values is as follows:
Present Value = Future Value / (1 + (cost of capital / 100)number of years
i.e. Present Value = $1000 / (1.10)3
i.e. Present Value = $ 751.31
This means that the equivalent sum of money that we should expect today, given our cost of capital is $751.31.
This means that we should accept proposals where present value is more than $751.31, reject proposals where
present value is less than $751.31 and be indifferent towards proposals where future value is equal to $751.31.
When the term present value is used, finance professionals are referring to the discounted present day values
which are equivalent to nominal future values.
The concept of present values and future values form the basis of corporate finance. Hence, it is essential
that any student be well versed with these concepts. Variations of these concepts will be regularly used
throughout the corporate finance course and hence due attention must be paid to mastering this concept before
moving forward.
Future value is the value of an asset at a specific date.[1] It measures the nominal future sum of money that a
given sum of money is "worth" at a specified time in the future assuming a certain interest rate, or more
generally, rate of return; it is the present value multiplied by the accumulation function.[2] The value does not
include corrections for inflation or other factors that affect the true value of money in the future. This is used
in time value of money calculations.

Contents
 1Overview
 2Simple interest
 3Compound interest
 4See also
 5References
 6External links
Overview[edit]
Money value fluctuates over time: $100 today has a different value than $100 in five years. This is because one
can invest $100 today in an interest-bearing bank account or any other investment, and that money will
grow/shrink due to the rate of return. Also, if $100 today allows the purchase of an item, it is possible that $100
will not be enough to purchase the same item in five years, because of inflation (increase in purchase price).
An investor who has some money has two options: to spend it right now or to invest it. The financial
compensation for saving it (and not spending it) is that the money value will accrue through the interests that he
will receive from a borrower (the bank account on which he has the money deposited).
Therefore, to evaluate the real worthiness of an amount of money today after a given period of time, economic
agents compound the amount of money at a given interest rate. Most actuarial calculations use the risk-free
interest rate which corresponds the minimum guaranteed rate provided the bank's saving account, for example.
If one wants to compare their change in purchasing power, then they should use the real interest rate (nominal
interest rate minus inflation rate).
The operation of evaluating a present value into the future value is called capitalization (how much will $100
today be worth in 5 years?). The reverse operation which consists in evaluating the present value of a future
amount of money is called a discounting (how much $100 that will be received in 5 years- at a lottery, for
example -are worth today?).
It follows that if one has to choose between receiving $100 today and $100 in one year, the rational decision is
to cash the $100 today. If the money is to be received in one year and assuming the savings account interest rate
is 5%, the person has to be offered at least $105 in one year so that two options are equivalent (either receiving
$100 today or receiving $105 in one year). This is because if you have cash of $100 today and deposit in your
savings account, you will have $105 in one year.
Simple interest[edit]
To determine future value (FV) using simple interest (i.e., without compounding):

where PV is the present value or principal, t is the time in years (or a fraction of year), and r stands for the per
annum interest rate. Simple interest is rarely used, as compounding is considered more meaningful[citation needed].
Indeed, the Future Value in this case grows linearly (it's a linear function of the initial investment): it doesn't
take into account the fact that the interest earned might be compounded itself and produce further interest
(which corresponds to an exponential growth of the initial investment -see below-).

This section needs

expansion. You can help
by adding to it. (January
2010)

Compound interest[edit]
To determine future value using compound interest:

[3]

where PV is the present value, t is the number of compounding periods (not necessarily an integer), and i is the
interest rate for that period. Thus the future value increases exponentially with time when i is positive.
The growth rate is given by the period, and i, the interest rate for that period. Alternatively the growth rate is
expressed by the interest per unit time based on continuous compounding. For example, the following all
represent the same growth rate:
 3 % per half year
 6.09 % per year (effective annual rate, annual rate of return, the standard way of expressing the growth
rate, for easy comparisons)
 2.95588022 % per half year based on continuous compounding (because ln 1.03 = 0.0295588022)
 5.91176045 % per year based on continuous compounding (simply twice the previous percentage)
Also the growth rate may be expressed in a percentage per period (nominal rate), with another period as
compounding basis; for the same growth rate we have:
 6% per year with half a year as compounding basis
To convert an interest rate from one compounding basis to another compounding basis (between different
periodic interest rates), the following formula applies:

where i1 is the periodic interest rate with compounding frequency n1 and i2 is the periodic interest rate with
compounding frequency n2.
If the compounding frequency is annual, n2 will be 1, and to get the annual interest rate (which may be referred
to as the effective interest rate, or the annual percentage rate), the formula can be simplified to:
where r is the annual rate, i the periodic rate, and n the number of compounding periods per year.
Problems become more complex as you account for more variables. For example, when accounting
for annuities (annual payments), there is no simple PV to plug into the equation. Either the PV must be
calculated first, or a more complex annuity equation must be used. Another complication is when the interest
rate is applied multiple times per period. For example, suppose the 10% interest rate in the earlier example is
compounded twice a year (semi-annually). Compounding means that each successive application of the interest
rate applies to all of the previously accumulated amount, so instead of getting 0.05 each 6 months, one must
figure out the true annual interest rate, which in this case would be 1.1025 (one would divide the 10% by two to
get 5%, then apply it twice: 1.052.) This 1.1025 represents the original amount 1.00 plus 0.05 in 6 months to
make a total of 1.05, and get the same rate of interest on that 1.05 for the remaining 6 months of the year. The
second six-month period returns more than the first six months because the interest rate applies to the
accumulated interest as well as the original amount.
This formula gives the future value (FV) of an ordinary annuity (assuming compound interest):[4]

where r = interest rate; n = number of periods. The simplest way to understand the above formula is to
cognitively split the right side of the equation into two parts, the payment amount, and the ratio of compounding
over basic interest. The ratio of compounding is composed of the aforementioned effective interest rate over the
basic (nominal) interest rate. This provides a ratio that increases the payment amount in terms present value.
Making timelines
Using a Timeline to Solve Time Value of Money Problems
Uncategorized
When solving a time value of money problem, it is sometimes easy to draw a timeline to present the cash flows
on it. Once we have the timeline, we can easily understand the variables and visualize the present value or
future value calculations.
In the previous pages, we demonstrated the time line for an ordinary annuity and for uneven cash flows.
Let’s take one more example to demonstrate the use of a time line.
Example: Loan Payments
You have taken a loan of $10,000 at an annual interest rate of 12% for a period of 2 years. Calculate the
monthly payments you will make on this loan.
The payments (PMT) or Equated Monthly Instalments will be paid monthly for the next 24 months.
Project planning on a financial timeline
Financial planning and project management are two sides of the same coin.
Long-term projects are made of interrelated activities that all have highly time-dependent financial
consequences. Gantt charts and project timelines dominate the project planning industry – and for good reason.
They are a quick, visual way of understanding the relationships between different parts of a project across time
and also a system for changing these timings to illustrate different scenarios.
But the same focus on time is rarely seen in financial planning tools. This, I think, is a mistake. Timing is
crucially important to financial planning and the benefits of a project-management style timeline are obvious.
And I’m not just talking about short-term cash flow forecasting. Nothing in a business happens in a vacuum –
everything impacts everything else, on a financial, operational or personal level. So, why not run the whole
business on a timeline? Well… why not? It’s a great idea!
Today I’m going to show you why planning when things happen is critical to financial planning. I’ll also show

you how using the Timeline in Brixx makes this a doddle

Imagine you start a new major project (The Project), which means your team is working flat out. What drops by
the wayside?
 Maybe it’s the research that you’ve all been working on in your spare time?
 Maybe you just don’t have the bandwidth to improve your internal systems?
 Maybe you can’t afford the same personal touch to sales and marketing as you did?
 Or perhaps you need to hire in contractors to take some of the pressure off your team?
You can’t plan this project just by projecting some figures into the future. It’s more complex, more interrelated
with other business activities.
If there’s one thing I could tell anybody getting stuck into planning their business it’s this:
Planning is about the real world and the timing of events. The good news is – we live in the real world! No
specialist financial knowledge required there.
Let’s run with the example above and imagine planning for it. The consequences of my team working flat out
on The Project could be many…
Due to a lack of focus on marketing activities, sales drop. So we contract in a marketing company to help while
the core team is busy. The contractors are smart but costly, and even with their experience, it takes them a few
months to learn the ropes of generating cost-effective sales in our competitive marketplace…
Meanwhile, the core team’s work on The Project is hitting some expected, and some unexpected roadblocks –
which require more time, licenced software and equipment to overcome.
The Project is now running 2 months late, sales are picking up again after a 3 month hiatus, at the cost of
engaging an external team of marketers (on a 6 month rolling contract…), we bought a new server and several
licensed software products and the business’ long-term research project is on the backburner, preventing it from
generating revenue in 18 months time as we had hoped.
We’ve had no time to find lower cost alternatives to our current systems, and in fact, have added to the
complexity of what we do with the new systems required to make The Project possible. In the midst of this, we
need to ensure that the business still has the cash to pay salaries each month, and can survive if The Project
suffers further delays… and think about what the financial outcome of The Project will be once it is complete!
Did this version of events go as well as we wanted? Well, no.
But could we plan for this? Yes, absolutely.
So how do you go about planning the financials for a business activity like The Project?
Imagining the future consequences of The Project is one challenge – but one that’s close to your heart. It is,
after all, your project and you know your business. And you have many tools available to you, like market
research, to help you make realistic assumptions for your forecasts.
A big challenge though is timing. Everything involved in The Project has an effect that happens at a specific
time, or over a period of time. And we can’t answer key questions like “Do the salaries get paid this month?”
without understanding the timing of everything The Project effects. What’s more, one of the major issues The
Project could face is slippage – things taking longer than expected, or sales not being generated quickly enough
by the contractors. We need to be able to make adjustments to all of the financial activities related to The
Project and see the consequences of these changes in our financial position – in particular, our cash flow
forecast.
This sounds like a big job. But, like all big jobs, using the right tool for the job makes a huge difference.
The right tool for this job is the Brixx Timeline, where you can change exactly when any business activity or
groups of activities happen in your plan. It’s a drag and drop interface, combining the simple immediacy of a
gantt chart with automatically recalculating financial reports and charts.
Every component in a Brixx plan sits in a particular place in the plan’s Timeline, with a clearly displayed start-
point and end-point. This means that any financial activity in a Brixx plan, be it a source of income, the
purchase of an asset, the sale of shares, can be changed to take place at a different time. You can also adjust the
Timeline for groups of components – the applications of which are almost endless.
Making a change on the Timeline automatically updates all of the plan’s financial dashboard figures, as well as
financial reports and KPIs, providing fast feedback on any change you make.
Here’s a simple example – a group including a new product line:

Currently, this group and everything in it starts 1 month after the start of the plan. By dragging the group’s grey
timeline bar, all components in the group can be moved at once, ensuring that all products in the product line
and their associated cost of sale component are moved together. We might do this to represent the product line
being delayed or brought forward.
The group of components described above is pretty simple, but sets of grouped financial activities can be more
complex.
For example, what about a buy-to-let property purchase, with its associated mortgage, repair and maintenance
costs for the property and the rental income gained from renting the property out after some initial
refurbishment costs. In Brixx this whole set of related financial activities is easy to assemble into a group of
components. They can then be moved forward or backwards in time depending on the situation being modelled.
Perhaps the property purchase is delayed, or renovation takes longer than expected.
Finally – the big one – let’s look at how The Project would look on the Brixx Timeline…
And how the figures from these items are displayed on the cash flow dashboard…
I hope you’ve enjoyed thinking about time with me – and learning about the Timeline in Brixx! There are a

wealth of uses for it, so get on and experiment

And remember that the secret to good planning is…

…
…timing.
Your Financial Timeline:
How Much is Enough?
What if you could afford to retire right now?
Would you?
 Or would you rather keep working? Or cut back, go part time, do some consultancy or undertake
voluntary work?
 How much do you need to provide for your lifestyle?
 What if someone came in and offered to buy your business?
Wouldn't it be great to know 'how much is enough?' to do what you (and your family) want to do, when you
want to do it, for as long as you want to do it for.
One of our major goals in financial planning for clients is to ensure 'the right money, in the right place, at the
right time'
'Your Financial Timeline' helps us to do that for you.
This process will help you identify how much money you need to accumulate to reach your definition of
financial independence. It is an ongoing service designed to ensure that you can always enjoy the lifestyle you
choose to lead, without ever having the worry of running out of funds. You are able to look into your financial
future so you can understand what actions you may need to take now to achieve your desired lifestyle.
We could generate an 80 page report with a plethora of charts. We could waffle on for pages about your
finances. We could buy a computer program that churned out identical paragraphs for everyone.
And we could charge you to have it all printed on luxury paper in an expensive binder. But we don't.
We aim to bring SIMPLICITY to managing your finances and we do it personally, just for you.
My Financial Timeline
by Mike | Personal Finance | 3 comments
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According to many of my friends (myself included), I am still just a kid. In fact, I really like to describe myself

as a kid with kids. I am only 28 (turning 29 before the maple leaves turn red ) but I feel that I’ve had an
interesting financial timeline so far. There are a few important steps in my life that happened and helped me
realize several very important facts about personal finance. So here is my financial timeline and what I have
learned so far:
8-15 Years old: My First Contact With Money
At the age of 8, I had my very first contact with money. I will always remember that day where I thought that
everything deserves a reward… I had spent about 30 minutes shovelling snow on my parents’ patio while they
were shovelling some serious snowfall in the driveway. Once I was done, I asked my father to be paid since I
had worked pretty hard (according to me anyways!). He looked back at me and gave me a quarter… I was so
insulted at first! Then, I realized that sometimes, helping is what matters, not getting money for every single
thing you do in life ;-).
Later on, at the age of 13, I’ve probably learned my biggest lesson; the hard wall of going bankrupt. My dad
lost his job and 2 months after, we were leaving our house for a small shack in far far away land. It was hard to
grow up as a teenager without a single penny in my pockets but I promised myself to never go bankrupt, ever.
Since then, I’ve always been careful when spending money and made sure I make more than I have spending
each year!
15-20 Years old: Feeling like a king while really being a jester
Man, these were the good years! I was working 35 hours a week (in a dollar store and for my dad’s new
company), no debts and a lot of money in my pockets ;-). While I was not making much in reality, the fact that I
was living in my parents’ home and that I didn’t have any bills to pay made me feel like a millionaire.
I traveled across Europe, had a nice car and played all the video games available for my Playstation ;-). I was
able to go through school without any debt as well… life was good!
20-25 Years old: Learning the ropes
At the age of 20, I left my house while I hadn’t finished with my bachelor degree. My girlfriend (now my wife)
and I simply had to leave the parent’s nest to live our life. It was hard as we rapidly got into debt since I was not
working full time yet.
During these 5 years, I finished my bachelor degree, paid off my debts, bought land, sold it, bought my first
house, sold it, and bought my second house while having 2 kids. This was a crazy period for us as we learned
how to manage our budget, buy real estate and manage our careers while raising a family.
25-29 Years old: Establishing the first stones of my success
These are definitely the best financial years of my life so far. I’ve completed my MBA, started an online
company and I also work as a CFP. I now work 4 days a week and my wife is at home and takes care of the
kids. My only debts are my mortgage and a car loan so we are in a good position to start saving money and look
forward to the future.
It wasn’t easy to get where I am but I certainly appreciate it every day. Not having money problems is a piece of
mind that is priceless! I’ve now slowed down my rhythm in order to appreciate life and my family. There is
nothing more fun than spending an afternoon with the kids running around while I walk hand in hand with my
wife!
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3 Comments
1. IntelligentSpeculator on July 27, 2010 at 4:59 pm
Love the chart, would be interested in hearing more about your father’s bankruptcy, how did it impact your life
and the way you manage your finances?
Reply
2. Financial Samurai on July 29, 2010 at 2:14 am
Nice chart and time line Mike. What will the 30’s and 40’s look like??
Reply
3. Sam on July 31, 2010 at 7:38 pm
This chart is awesome. I must say that you really have to be really motivated and determined to be where you
are right now. What are your future goals and how do you plan on reaching those goals?
Reply
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Annuities

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An annuity is the payment or receipt of equal cash flows per period for a specified amount of time.
An ordinary annuity is one in which the payments or receipts occur at the end of each period, as shown.
An annuity due is one in which payments or receipts occur at the beginning of each period, as
shown.Most lease payments, such as apartment rentals, and life insurance premiums are annuities due.
In a 4-year ordinary annuity, the last payment is made at the end of the fourth year. In a 4-year annuity
due, the last payment is made at the end of the third year (the beginning of the fourth year).
Future Value of an Ordinary Annuity
A future value of an ordinary annuity (FVANn) problem asks the question: If PMT dollars are deposited
in an account at the end of each year for n years and if the deposits earn interest rate i compounded
annually, what will be the value of the account at the end of n years? To illustrate, suppose Ms. Jefferson
receives a 3-year ordinary annuity of $1,000 per year and deposits the money in a savings account at the
end of each year. The account earns interest at a rate of 6 percent compounded annually. How much will
her account be worth at the end of the 3-year period? illustrates this concept.
Present Value of $100 at Various Discount Rates

Timeline of an Ordinary Annuity of $100 per Period for Four Periods

Timeline of an Annuity Due of $100 per Period for Four Periods

The problem involves the calculation of future values. The last deposit, PMT3, made at the end of year 3,
will earn no interest. Thus, its future value is as follows:
FV3rd = PMT3(1 + 0.06)0 = $1,000(1) = $1,000
The second deposit, PMT2, made at the end of year 2, will be in the account for one full year before the
end of the 3-year period, and it will earn interest. Thus, its future value is as follows:
FV2nd = PMT2(1 + 0.06)1 =$1,000(1.06) = $1,060
The first deposit, PMT1, made at the end of year 1, will be in the account earning interest for two full
years before the end of the 3-year period. Therefore its future value is the following:
FV1st = PMT1(1 + 0.06)2 = $1,000(1.124) = $1,124
The sum of the three figures is the future value of the annuity:
FVAN3 = FV3rd + FV2nd + FV1st = $1,000 + $1,060 + $1,124 = $3,184
Timeline of the Future Value of an Ordinary Annuity

The future value of an annuity interest factor (FVIFA) is the sum of the future value interest factors
presented in Table I. In this example, the future value of an annuity interest factor is calculated as
FVIFA0.06, 3 = FVIF0.06, 2 + FVIF0.06, 1 + FVIF0.06, 0 = 1.124 + 1.060 + 1.000 = 3.184
Tables of the future value of an ordinary annuity interest factors are available to simplify computations.
Table at the end of the book provides a number of future value of an annuity interest factors. A portion
of Table III is reproduced here as Table. FVIFAs can also be computed as follows:
FVIFAi, n = (1 + i)n – 1 / i
This formula can be used when you do not have access to interest tables with the appropriate values
of i and n or to a financial calculator.
The future value of an ordinary annuity (FVANn) may be calculated by multiplying the annuity
payment, PMT, by the appropriate interest factor, FVIFAi, n: FVANn = PMT(FVIFAi, n)
can be used to solve the problem involving Jefferson’s annuity. Because PMT = $1,000 and the interest
factor for n = 3 years and i = 6% is 3.184, the future value of an ordinary annuity can be calculated as
follows:
FVAN3 = PMT(FVIFA0.06, 3) = $1,000(3.184) = $3,184
The spreadsheet solution is shown here.
Sinking Fund Problem Future value of an annuity interest factors can also be used to find the annuity
amount that must be invested each year to produce a future value. This type of problem is sometimes
called a sinking fund problem. Suppose the Omega Graphics Company wishes to set aside an equal,
annual, end-of-year amount in a “sinking fund account” earning 9.5 percent per annum over the next
five years. The firm wants to have $5 million in the account at the end of five years to retire (pay off) $5
million in outstanding bonds. How much must be deposited in the account at the end of each year?
This problem can be solved using either Equation or a financial calculator. Substituting n = 5, FVAN5 =
$5,000,000, and i = 0.095 into Equation yields
$5,000,000 = PMT(FVIFA0.095, 5)
Since the interest rate of 9.5 percent is not in Table, one must use Equation 5.15 to determine
FVIFA0.095, 5.

By depositing approximately $827,182 at the end of each of the next five years in the account earning 9.5
percent per annum, Omega will accumulate the $5 million needed to retire the bonds.
Future Value of an Ordinary Annuity Interest Factors (FVIFA) for $1 per

Future Value of an Annuity Due

Table at the end of the book (future value of an annuity interest factors) assumes ordinary (end-of-period)
annuities. For an annuity due, in which payments are made at the beginning of each period, the interest
factors in Table III must be modified.
Consider the case of Jefferson cited earlier. If she deposits $1,000 in a savings account at the beginning of
each year for the next three years and the account earns 6 percent interest, compounded annually, how
much will be in the account at the end of three years? (Recall that when the deposits were made at the
end of each year, the account totaled $3,184 at the end of three years.)
We illustrates this problem as an annuity due. PMT1 is compounded for three years, PMT2 for two years,
and PMT3 for one year. The correct annuity due interest factor may be obtained from Table by
multiplying the FVIFA for three years and 6 percent (3.184) by 1 plus the interest rate (1 + 0.06). This
yields a FVIFA for an annuity due of 3.375, and the future value of the annuity due (FVANDn) is
calculated as follows:

1
FVANDn = PMT[FVIFAt, n(1 + i)]
2
FVAND3 = $1,000(3.375) = $3,375
3

The spreadsheet solution is shown here.

Present Value of an Ordinary Annuity

The present value of an ordinary annuity (PVAN0) is the sum of the present value of a series of equal
periodic payments. For example, to find the present value of an ordinary $1,000 annuity received at the
end of each year for five years discounted at a 6 percent rate, the sum of the individual present values
would be determined as follows:

1
PVAN0 = $1,000(PVIF0.06, 1) + $1,000(PVIF0.06, 2) + $1,000(PVIF0.06, 3) + $1,000(PVIF0.06, 4) +
$1,000(PVIF0.06, 5)
2
 = $1,000(0.943) + $1,000(0.890) + $1,000(0.840) + $1,000(0.792) + $1,000(0.747)
3
= $1,000(0.943 + 0.890 + 0.840 + 0.792 + 0.747)
4
= $4,212
5

illustrates this concept. Tables of the present value of an ordinary annuity interest factors (PVIFA) are
available to simplify computations. Table at the end of the book provides a number of the present value
of an annuity interest factors. A portion of Table is reproduced here as Table. PVIFAs can also be
computed as follows:
Timeline of the Future Value of an Annuity Due (PMT = $1,000; i = 6%, n = 3)
PVIFAi, n = 1- [1/(1+i)n] /i

This formula is useful when one does not have access to interest tables with the appropriate values
of i and n or a financial calculator.
The present value of an annuity can be determined by multiplying the annuity payment, PMT, by the
appropriate interest factor, PVIFAi, n:
PVAN0 = PMT(PVIFAi, n)
Referring to Table to determine the interest factor for i = 6% and n = 5, the present value of an annuity
in the previous problem can be calculated as follows:
PVAN0 = PMT(PVIFA0.06, 5) = $1,000(4.212) = $4,212
The present value of an ordinary annuity using a spreadsheet is shown next.
Timeline of a Present Value of an Ordinary Annuity (PMT = $1,000; i = 6%; n = 5)
Present Value of an Ordinary Annuity Interest Factors (PVIFA) for $1 per

Solving for the Interest Rate Present value of an annuity interest factors can also be used to solve for the
rate of return expected from an investment.Suppose IBM purchases a machine for $100,000. This
machine is expected to generate annual cash flows of $23,742 to the firm over the next five years.What is
the expected rate of return from this investment?
Using Equation,we can determine the expected rate of return in this example as follows:

1
PVAN0 = PMT(PVIFAi, 5)
2
$100,000 = $23,742(PVIFAi, 5)
3
PVIFAi, 5 = 4.212
4

From the 5-year row in Table 5.4 or Table IV, we see that a PVIFA of 4.212 occurs in the 6 percent
column.7 Hence, this investment offers a 6 percent expected rate of return. Loan Amortization and
Capital Recovery Problems Present value of an annuity interest factors can be used to solve a loan
amortization problem, where the objective is to determine the payments necessary to pay off, or amortize,
a loan, such as a home mortgage. For example, suppose you borrowed $10,000 from Lexington State
Bank. The loan is for a period of four years at an interest rate of 9.0 percent. It requires that you make
four equal, annual, end-of-year payments that include both principal and interest on the outstanding
balance.This problem can be solved using either Equation or a financial calculator.
Substituting n = 4, PVAN0 = $10,000, and i = 0.09 into Equation yields:

1
$10,000 = PMT(PVIFA0.09, 4)
2
10,000 = PMT(3.240)
3
PMT = 3,086.42
4

By making four annual, end-of-year payments to the bank of $3,086.69 (see more accurate calculator
solution), you will completely pay off your loan, plus provide the bank with its 9.0 percent interest return.
This can be seen in the loan amortization schedule developed in Table. At the end of each year, you pay
the bank $3,087. During the first year, $900 of this payment is interest (0.09 _ $10,000 remaining
balance), and the rest ($2,187) is applied against the principal balance owed at the beginning of the year.
Hence, after the first payment, you owe $7,813 ($10,000 – $2,187). Similar calculations are done for years
2, 3, and 4. Present value of an annuity interest factors can also be used to find the annuity amount
necessary to recover a capital investment, given a required rate of return on that investment. This type of
problem is called a capital recovery problem.
A spreadsheet solution to this problem is shown next.
Loan Amortization Schedule: Lexington State Bank

Present Value of an Annuity Due

Annuity due calculations are also important when dealing with the present value of an annuity problem.
In these cases, the interest factors in Table must be modified. Consider the case of a 5-year annuity of
$1,000 each year, discounted at 6 percent.What is the present value of this annuity if each payment is
received at the beginning of each year? (Recall the example presented earlier, illustrating the concept of
the present value of an ordinary annuity, in which each payment was received at the end of each year and
the present value was $4,212.) Figure illustrates this problem.
The first payment received at the beginning of year 1 (end of year 0) is already in its present value form
and therefore requires no discounting.PMT2 is discounted for one period, PMT3 is discounted for two
periods, PMT4 is discounted for three periods, and PMT5 is discounted for four periods.
The correct annuity due interest factor for this problem may be obtained from Table IV by multiplying
the present value of an ordinary annuity interest factor for five years and 6 percent (4.212) by 1 plus the
interest rate (1 + 0.06). This yields a PVIFA for an annuity due of 4.465, and the present value of this
annuity due (PVAND0) is calculated as follows:

1
PVAND0 = PMT[PVIFAi, n(1 + i)]
2
PVAND0 = $1,000(4.465) = $4,465
3

A spreadsheet solution to this problem is shown here.

Annuity due calculations are especially important when dealing with rental or lease contracts because it
is common for these contracts to require that payments be made at the beginning of each period.

« Previous Topics Next Topics »

Present Value Present Value: Some Additional Cash Flow Patterns

 Compound Interest And Future Value Compounding Periods And Effective Interest Rates

Simple Interest Solving The Financial Challenge

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Annuities: Present Value Versus Future Value

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BY CLAIRE BOYTE-WHITE

Updated May 4, 2019

The present value of an annuity is the sum that must be invested now to guarantee a desired payment in
the future, while the future value of an annuity is the amount to which current investments will grow
over time.
What Is an Annuity?
Though often associated with a specific insurance-related product, an annuity is any asset that generates
regular payments for a set time period. This type of investment is often used by those preparing
for retirement or for a period of planned unemployment. Depending on the types of investments used,
annuities may generate either fixed or variable returns.
Annuities purchased by retirees are often sold by insurance companies. The insurance company takes a
lump sum of money up front then invests it, minus fees. The company then pays out smaller sums of
money over a period of time back to the beneficiary. There are several arrangements that can be made,
and some annuities pay until the death of the beneficiary, thus shifting the longevity risk from the
beneficiary to the insurance company. For insurance companies, this the income and payment stream
model complements their other business lines nicely. With an annuity, insurance companies take in a
lump sum up front, paying out a little at a time in a predictable stream, compared to other lines of
insurance where small amounts are taken in over time in the form of premiums, then lump sums are paid
out at unpredictable intervals.
Both the present and future value calculations assume a regular annuity with a fixed growth rate. Many
online calculators determine both the present and future value of an annuity, given the interest rate,
payment amount and duration.
Present Value of an Annuity
The present value of an annuity is simply the current value of all the income generated by that
investment in the future – or, in more practical terms, the amount of money that would need to be
invested today to generate consistent income down the road. Using the interest rate, desired payment
amount and number of payments, the present value calculation discounts the value of future payments to
determine the contribution necessary to achieve and maintain fixed payments for a set time period.
For example, the present-value formula would be used to determine how much to invest now if you want
to guarantee monthly payments of $1,000 for the next 10 years.
Future Value of an Annuity
The future value of an annuity represents the amount of money that will be accrued by making consistent
investments over a set period, assuming compound interest. Rather than planning for a guaranteed
amount of income in the future by calculating how much must be invested now, this formula estimates
the growth of savings, given a fixed rate of investment for a given amount of time.
The future-value calculation would be used to estimate the balance of an investment account, including
interest growth, after making monthly $1,000 contributions for 10 years
An annuity is a series of payments made at equal intervals.[1] Examples of annuities are regular deposits to
a savings account, monthly home mortgage payments, monthly insurance payments and pension payments.
Annuities can be classified by the frequency of payment dates. The payments (deposits) may be made weekly,
monthly, quarterly, yearly, or at any other regular interval of time.
An annuity which provides for payments for the remainder of a person's lifetime is a life annuity.

Contents
 1Types
o 1.1Timing of payments
o 1.2Contingency of payments
o 1.3Variability of payments
o 1.4Deferral of payments
  2Valuation
o 2.1Annuity-certain
 2.1.1Annuity-immediate
 2.1.1.1Proof of annuity-immediate formula
 2.1.2Annuity-due
 2.1.3Perpetuity
o 2.2Life annuities
 3Amortization calculations
 4Example calculations
 5Legal regimes
 6See also
 7References
Types[edit]
Annuities may be classified in several ways.
Timing of payments[edit]
Payments of an annuity-immediate are made at the end of payment periods, so that interest accrues between the
issue of the annuity and the first payment. Payments of an annuity-due are made at the beginning of payment
periods, so a payment is made immediately on issueter.
Contingency of payments[edit]
Annuities that provide payments that will be paid over a period known in advance are annuities
certain or guaranteed annuities. Annuities paid only under certain circumstances are contingent annuities. A
common example is a life annuity, which is paid over the remaining lifetime of the annuitant. Certain and life
annuities are guaranteed to be paid for a number of years and then become contingent on the annuitant being
alive.
Variability of payments[edit]
 Fixed annuities – These are annuities with fixed payments. If provided by an insurance company, the
company guarantees a fixed return on the initial investment. Fixed annuities are not regulated by
the Securities and Exchange Commission.
 Variable annuities – Registered products that are regulated by the SEC in the United States of America.
They allow direct investment into various funds that are specially created for Variable annuities.
Typically, the insurance company guarantees a certain death benefit or lifetime withdrawal benefits.
 Equity-indexed annuities – Annuities with payments linked to an index. Typically, the minimum
payment will be 0% and the maximum will be predetermined. The performance of an index determines
whether the minimum, the maximum or something in between is credited to the customer.
Deferral of payments[edit]
An annuity which begins payments only after a period is a deferred annuity. An annuity which begins payments
without a deferral period is an immediate annuity.
Valuation[edit]
Valuation of an annuity entails calculation of the present value of the future annuity payments. The valuation of
an annuity entails concepts such as time value of money, interest rate, and future value.[2]
Annuity-certain[edit]
If the number of payments is known in advance, the annuity is an annuity certain or guaranteed annuity.
Valuation of annuities certain may be calculated using formulas depending on the timing of payments.
Annuity-immediate[edit]
If the payments are made at the end of the time periods, so that interest is accumulated before the payment, the
annuity is called an annuity-immediate, or ordinary annuity. Mortgage payments are annuity-immediate,
interest is earned before being paid.

↓ ↓ ... ↓ payments

——— ——— ——— ——— —

0 1 2 ... n periods

The present value of an annuity is the value of a stream of payments, discounted by the interest rate to account
for the fact that payments are being made at various moments in the future. The present value is given
in actuarial notation by:

Where is the number of terms and is the per period interest rate. Present value is linear in the amount

of payments, therefore the present value for payments, or rent is:

In practice, often loans are stated per annum while interest is compounded and payments are made monthly. In

this case, the interest is stated as a nominal interest rate, and .

The future value of an annuity is the accumulated amount, including payments and interest, of a stream of
payments made to an interest-bearing account. For an annuity-immediate, it is the value immediately after the n-
th payment. The future value is given by:

Where is the number of terms and is the per period interest rate. Future value is linear in the amount

of payments, therefore the future value for payments, or rent is:

Example: The present value of a 5-year annuity with a nominal annual interest rate of 12% and monthly
payments of $100 is:

The rent is understood as either the amount paid at the end of each period in return for an amount PV borrowed
at time zero, the principal of the loan, or the amount paid out by an interest-bearing account at the end of each
period when the amount PV is invested at time zero, and the account becomes zero with the n-th withdrawal.
Future and present values are related since:

and

Proof of annuity-immediate formula[edit]

To calculate present value, the k-th payment must be discounted to the present by dividing by the interest,

compounded by k terms. Hence the contribution of the k-th payment R would be . Just considering R to be
one, then:

Which gives us the result as required.

Similarly, we can prove the formula for the future value. The payment made at the end of the last year would
accumulate no interest and the payment made at the end of the first year would accumulate interest for a total of
(n−1) years. Therefore,

Annuity-due[edit]
An annuity-due is an annuity whose payments are made at the beginning of each period.[3] Deposits in savings,
rent or lease payments, and insurance premiums are examples of annuities due.

↓ ↓ ... ↓ payments

——— ——— ——— ——— —

0 1 ... n-1 n periods

Each annuity payment is allowed to compound for one extra period. Thus, the present and future values of an
annuity-due can be calculated.
where is the number of terms, is the per term interest rate, and is the effective rate of

discount given by .
The future and present values for annuities due are related since:

Example: The final value of a 7-year annuity-due with a nominal annual interest rate of 9% and monthly
payments of $100 can be calculated by:

Note that in Excel, the PV and FV functions take on optional fifth argument which selects from annuity-
immediate or annuity-due.
An annuity-due with n payments is the sum of one annuity payment now and an ordinary annuity with one
payment less, and also equal, with a time shift, to an ordinary annuity. Thus we have:

. The value at the time of the first of n payments of 1.

. The value one period after the time of the last of n payments of 1.
Perpetuity[edit]
A perpetuity is an annuity for which the payments continue forever. Observe that

Therefore a perpetuity has a finite present value when there is a non-zero discount rate. The formulae for a
perpetuity are

Where is the interest rate and is the effective discount rate.

Life annuities[edit]
Valuation of life annuities may be performed by calculating the actuarial present value of the future life
contingent payments. Life tables are used to calculate the probability that the annuitant lives to each future
payment period. Valuation of life annuities also depends on the timing of payments just as with annuities
certain, however life annuities may not be calculated with similar formulas because actuarial present value
accounts for the probability of death at each age.
Amortization calculations[edit]
If an annuity is for repaying a debt P with interest, the amount owed after n payments is
Because the scheme is equivalent with borrowing the amount to create a perpetuity with coupon , and

putting of that borrowed amount in the bank to grow with interest .

Also, this can be thought of as the present value of the remaining payments

See also fixed rate mortgage.

Example calculations[edit]
Formula for Finding the Periodic payment(R), Given A:

R = A/(1+〖(1-(1+((j/m) )〗^(-(n-1))/(j/m))

Examples:
1. Find the periodic payment of an annuity due of $70,000, payable annually for 3 years at 15%
compounded annually.

o R = 70,000/(1+〖(1-(1+((.15)/1) )〗^(-(3-1))/((.15)/1))

o R = 70,000/2.625708885
o R = $26659.46724
2. Find the periodic payment of an annuity due of $250,700, payable quarterly for 8 years at 5%
compounded quarterly.

o R= 250,700/(1+〖(1-(1+((.05)/4) )〗^(-(32-1))/((.05)/4))

o R = 250,700/26.5692901
o R = $9,435.71
Finding the Periodic Payment(R), Given S:

R = S\,/((〖((1+(j/m) )〗^(n+1)-1)/(j/m)-1)

Examples:
1. Find the periodic payment of an accumulated value of $55,000, payable monthly for 3 years at 15%
compounded monthly.

o R=55,000/((〖((1+((.15)/12) )〗^(36+1)-1)/((.15)/12)-1)

o R = 55,000/45.67944932
o R = $1,204.04
 2. Find the periodic payment of an accumulated value of $1,600,000, payable annually for 3 years at 9%
compounded annually.

o R=1,600,000/((〖((1+((.09)/1) )〗^(3+1)-1)/((.09)/1)-1)

o R = 1,600,000/3.573129
o R = $447,786.80
Legal regimes[edit]
 Annuities under American law
 Annuities under European law
 Annuities under Swiss law
What is an Annuity?
Home » Accounting Dictionary » What is an Annuity?

Definition: An annuity is a series of equal payments made at equal intervals during a period of time. In other
words, it’s a system of making or receiving payments where the payment amount and time period between
payments is equal.

What Does Annuity Mean?

What is the definition of annuity? Most investment and loans are set up as annuities to keep the terms simple.
Let’s take a look at both of these examples.

Example
Many people play the lottery in hopes to cash in on the big jackpot. Unfortunately, most people don’t win it big,
but an extremely small percentage of people do. After they win, they often have to make the choice whether to
be paid in a lump sum or in an annuity. For example, a million dollar jackpot could be paid out immediately in
one lump sum of $600,000 or in $5,000 monthly installments for 15 years.

This option takes the time value of money into consideration. Notice that neither option actually pays out a full
$1,000,000. This is because over time money should earn interest. Thus, $600,000 today will equal $1,000,000
in the future after interest is added up over the years. The same is true for the annuity payments.

Loans are also set up as annuities. Sometimes people don’t think of them as annuities because they are not
receiving the payments. Remember annuities are just agreements with equal payments and time intervals. When
a business signs a loan with a bank, it agrees to make a payment each month for specific amount. The payments
are due each month until the loan principle is paid off.
The bank determines the interest rate and the time value of money needed to recoup their principle and generate
the adequate return on the loan.

Accounting for annuities can be simple or complicated depending on the agreement, payment terms, and
compounding interest arrangement. The key thing to remember is that prevent value and future value tables are
often needed to calculate terms without a financial calculator.

Examples in The News

“An annuity is a contract with an insurance company generally purchased for future income in retirement.” –
Washington Post

Summary Definition
Define Annuities: Annuity means a regular payment stream of equal amounts over a stated period.
How to Calculate Annuity? | Cash Flow | Company | Financial Management

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ADVERTISEMENTS:
The following article will guide to learn how to calculate annuity of cash flows in a company.
An annuity is a cash flow, either income or outgoings, involving the same sum in each period. An annuity is the
payment or receipt of equal cash flows per period for a specified amount of time. For example, when a company
set aside a fixed sum each year to meet a future obligation, it is using annuity. The time period between two
successive payments is called ‘payment period’ or ‘rent period’.
The word ‘annuity’ is broader in sense, which includes payments which can be annual, semiannual, quarterly or
any other fixed length of time. Annuity does not necessarily mean payment taken to be one year.
Future Value of Ordinary Annuity:
ADVERTISEMENTS:
An ordinary annuity is one in which the payments or receipts occur at the end of each period. In a five year
ordinary annuity, the last payment is made at the end of the fifth year.

Where, A = Annual or future value which is the sum of the compound amounts of all payments.
P = Amount of each instalment
ADVERTISEMENTS:
i = Interest rate per period
n = Number of periods
Problem 1:
Mr. X is depositing Rs.2,000 in a recurring bank deposit which pays 9% p.a. compounded interest. How much
amount Mr. X will get at the end of 5th year.
ADVERTISEMENTS:
Solution:

Problem 2:
ADVERTISEMENTS:
Find the future value of ordinary annuity Rs.4,000 each six months for 15 years at 5% p.a. compounded semi-
annually.
Solution:

Where, P = Rs. 4,000

ADVERTISEMENTS:
i = 0.05/2 = 0.025
n = 15 x 2 =30

Let x = (1.025)30
ADVERTISEMENTS:
Log x = 30 log 1.025 = 30x 0.0107 = 0.321
x = antilog 0.321 = 2.094

Problem 3:
ADVERTISEMENTS:
Calculate the future value of Rs.1,000 invested in State Bank Cash Certificate scheme for 2 years @ 5.5% p.a.,
compounded semi-annually.
Solution:
Present Value of Ordinary Annuity:
The present value of an ordinary annuity is the sum of the present value of a series of equal periodic payments.

Where, V = Present value of annuity

Problem 4:
Mr. Y is depositing Rs.8,000 annually for 4 years, in a post office savings bank account at an interest of 5% p.a.
Find the present value of annuity.
Solution:

P = Rs. 8,000 i = 0.05 n = 4

Let:
x = (1.05) -4
Log x = -4 log 1.05 = -4 x 0.0212 = -0.0848
= -1 + 1 – 0.0848 = 1̅.9152
x = antilog (1̅.9152) = 0.8226
V = 1,60,000 x (1 -0.8226) = 1,60,000 x .1774 = Rs.28,384
Present Value of Deferred Annuity:
An annuity where the first payment is delayed beyond one year, the annuity is called a ‘deferred annuity’.
The present value ‘V’ of a deferred annuity ‘P’ to begin at the end of ‘m’ years and to continue for ‘n’ years is
given by:

Calculation of present value by applying the above formula would be extremely tedious. The simple way of
calculation is presented in the following illustration.
Problem 5:
Z Ltd. intend to invest Rs.15,000 per annum at the end of years 5,6,7 and 8 at an annual interest rate of 12%.
Find out the present value of the deferred annuity payments.
Solution:
Present Value of Perpetuity:
A perpetuity is a financial instrument that promises to pay an equal cash flow per period forever, that is, an
infinite series of payments and principal amount never be repaid.
The present value of perpetuity is calculated with the following formula:

Problem 6:
X Ltd. had taken a freehold land for an annual rent of Rs.1,200. Find out the present value of freehold land
which is enjoyable in perpetuity if the interest rate is 8% p.a.

What is an Annuity?
An annuity is a financial product that provides certain cash flows at equal time intervals. Annuities are created
by financial institutions, primarily life insurance companies, to provide regular income to a client.
An annuity is a reasonable alternative to some other investments as a source of income since it provides
guaranteed income to an individual. However, annuities are less liquid than investments in securities because
the initially deposited lump sum cannot be withdrawn without penalties.
Upon the issuance of an annuity, an individual pays a lump sum to the issuer of the annuity (financial
institution). Then, the issuer holds the amount for a certain period (called an accumulation period). After the
accumulation period, the issuer must make fixed payments to the individual according to predetermined time
intervals.
Annuities are primarily bought by individuals who want to receive stable retirement income.
Types of Annuities
There are several types of annuities that are classified according to frequency and types of payments. For
example, the cash flows of annuities can be paid at different time intervals. The payments can be made weekly,
biweekly, or monthly. The primary types of annuities are:

1. Fixed annuities
Annuities that provide fixed payments. The payments are guaranteed, but the rate of return is usually minimal.

2. Variable annuities
Annuities that allow an individual to choose a selection of investments that will pay an income based on the
performance of the selected investments. Variable annuities do not guarantee the amount of income, but the rate
of return is generally higher relative to fixed annuities.

3. Life annuities
Life annuities provide fixed payments to their holders until his/her death.

4. Perpetuity
An annuity that provides perpetual cash flows with no end date. Examples of financial instruments that grant the
perpetual cash flows to its holders are extremely rare.
The most notable example is a UK Government bond called consol. The first consols were issued in the middle
of the 18th century. The bonds did not specify an explicit end date and were redeemable at the option of the
Parliament. However, the UK Government redeemed all consols in 2015.
Valuation of Annuities
Annuities are valued by discounting the future cash flows of the annuities and finding the present value of the
cash flows. The general formula for annuity valuation is:
Where:
 PV = Present value of the annuity
 P = Fixed payment
 r = Interest rate
 n = Total number of periods of annuity payments

The valuation of perpetuity is different because it does not include a specified end date. Therefore, the value of
the perpetuity is found using the following formula:
PV = P / r

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Annuities
An annuity is a contract between you, the purchaser or owner, and an insurance company, the annuity issuer. In
its simplest form, you pay money to an annuity issuer, and the issuer pays out the principal and earnings back to
you or to a named beneficiary. Life insurance companies first developed annuities to provide income to
individuals during their retirement years.
Annuities are either qualified or nonqualified. Qualified annuities are used in connection with tax-advantaged
retirement plans, such as 401(k) plans, Section 403(b) retirement plans (TSAs), or IRAs. Qualified annuities are
subject to the contribution, withdrawal, and tax rules that apply to tax-advantaged retirement plans. One of the
attractive aspects of a nonqualified annuity is that its earnings are tax deferred until you begin to receive
payments back from the annuity issuer. In this respect, an annuity is similar to a qualified retirement plan. Over
a long period of time, your investment in an annuity can grow substantially larger than if you had invested
money in a comparable taxable investment. Like a qualified retirement plan, a 10 percent tax penalty on the
taxable portion of the distribution may be imposed if you begin withdrawals from an annuity before age 59½.
Unlike a qualified retirement plan, contributions to a nonqualified annuity are not tax deductible, and taxes are
paid only on the earnings when distributed.

Four parties to an annuity contract

There are four parties to an annuity contract: the annuity issuer, the owner, the annuitant, and the beneficiary.
The annuity issuer is the company (e.g., an insurance company) that issues the annuity. The owner is the
individual or other entity who buys the annuity from the annuity issuer and makes the contributions to the
annuity. The annuitant is the individual whose life will be used as the measuring life for determining the timing
and amount of distribution benefits that will be paid out. The owner and the annuitant are usually the same
person but do not have to be. Finally, the beneficiary is the person who receives a death benefit from the annuity
at the death of the annuitant.

Two distinct phases to an annuity

There are two distinct phases to an annuity: (1) the accumulation (or investment) phase and (2) the distribution
phase.
The accumulation (or investment) phase is the time period when you add money to the annuity. When using this
option, you'll have purchased a deferred annuity. You can purchase the annuity in one lump sum (known as a
single premium annuity), or you make investments periodically, over time.
The distribution phase is when you begin receiving distributions from the annuity. You have two general
options for receiving distributions from your annuity. Under the first option, you can withdraw some or all of
the money in the annuity in lump sums.
The second option (commonly referred to as the guaranteed income or annuitization option) provides you with a
guaranteed income stream from the annuity for your entire lifetime (no matter how long you live) or for a
specific period of time (e.g., 10 years). (Guarantees are based on the claims-paying ability of the issuing
insurance company.) This option generally can be elected several years after you purchased your deferred
annuity. Or, if you want to invest in an annuity and start receiving payments within the first year, you'll
purchase what is known as an immediate annuity.
You can also elect to receive the annuity payments over both your lifetime and the lifetime of another person.
This option is known as a joint and survivor annuity. Under a joint and survivor annuity, the annuity issuer
promises to pay you an amount of money on a periodic basis (e.g., monthly, quarterly, or yearly). The amount
you receive for each payment period will depend on how much money you have in the annuity, how earnings
are credited to your account (whether fixed or variable), and the age at which you begin the annuitization phase.
The length of the distribution period will also affect how much you receive.

When is an annuity appropriate?

It is important to understand that annuities can be an excellent tool if you use them properly. Annuities are not
right for everyone.
Nonqualified annuity contributions are not tax deductible. That's why most experts advise funding other
retirement plans first. However, if you have already contributed the maximum allowable amount to other
available retirement plans, an annuity can be an excellent choice. There is no limit to how much you can invest
in a nonqualified annuity, and like other qualified retirement plans, the funds are allowed to grow tax deferred
until you begin taking distributions.
Annuities are designed to be long-term investment vehicles. In most cases, you'll pay a penalty for early
withdrawals. And if you take a lump-sum distribution of your annuity funds within the first few years after
purchasing your annuity, you may be subject to surrender charges imposed by the issuer. As long as you're sure
you won't need the money until at least age 59½, an annuity is worth considering. If your needs are more short
term, you should explore other options.

Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2014.

IMPORTANT DISCLOSURES

Broadridge Investor Communication Solutions, Inc. does not provide investment, tax, or legal advice. The
information presented here is not specific to any individual's personal circumstances.

To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used,
by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek
independent advice from a tax professional based on his or her individual circumstances.

These materials are provided for general information and educational purposes based upon publicly available
information from sources believed to be reliable—we cannot assure the accuracy or completeness of these
materials. The information in these materials may change at any time and without notice.
An annuity is a contract between you and an insurance company in which you make a lump sum payment or
series of payments and, in return, obtain regular disbursements beginning either immediately or at some point in
the future.
The goal of annuity is to provide a steady stream of income during retirement. Funds accrue on a tax-deferred
basis, and like 401(k) contributions, can only be withdrawn without penalty after age 59.5.
Many aspects of an annuity can be tailored to the specific needs of the recipient. In addition to choosing
between a lump sum payment or a series of payments to the insurer, you can choose when you want to annuitize
your contributions - that is, start receiving payments. An annuity that begins paying out immediately is referred
to as an immediate annuity, while one that starts at a preset date in the future is called a deferred annuity.
The duration of the disbursements can also vary. You can choose to receive payments for a specific period of
time - for example, 25 years - or obtain them until your death. Of course, securing a lifetime of payments lowers
the amount of each check, but it helps ensure that you don't outlive your assets.
Annuities come in three main varieties - fixed, variable and indexed - that each have their own level of risk
and payout potential. Fixed annuities pay out a guaranteed amount based on the balance of your account. The
downside of this predictability is a modest annual return, generally slightly higher than a CD.
You have the opportunity for a higher return, accompanied by greater risk, with a variable annuity. In this case,
you pick from a menu of mutual funds that comprise your personal "sub-account." Here, your payments in
retirement are based on the performance of investments in your sub-account.
Indexed annuities are somewhere in between when it comes to risk and potential reward. You receive a
guaranteed minimum payout, although a portion of your disbursements is tied to the performance of a market
index, such as the S&P 500.
Despite their potential for greater earnings, variable and indexed annuities are sometimes criticized for their
fees and their relative complexity. For example, many annuitants find that they have to pay steep surrender
charges if they try to withdraw their money within the first few years of the contract.
An important feature to consider with any annuity is its tax treatment. While your balance grows tax-free,
disbursements are subject to income tax. Conversely, mutual funds that you hold for over a year are taxed at the
long-term capital gains rate. Additionally, unlike 401(k) accounts, contributions to annuities don't reduce
your taxable income. For this reason, some finance experts recommend annuities only after maximizing your
contributions to pretax retirement accounts.
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ANNUITIES
What Are Annuities?
An annuity is a contract between you and an insurance company that requires the insurer to make
payments to you, either immediately or in the future. You buy an annuity by making either a single
payment or a series of payments. Similarly, your payout may come either as one lump-sum payment or as
a series of payments over time.
Why do people buy annuities?
What kinds of annuities are there?
What are the benefits and risks of variable annuities?
How to buy and sell annuities
Understanding fees
Avoiding fraud
Additional information
Why Do People Buy Annuities?
People typically buy annuities to help manage their income in retirement. Annuities provide three things:
 Periodic payments for a specific amount of time. This may be for the rest of your life, or the life of
your spouse or another person.
  Death benefits. If you die before you start receiving payments, the person you name as your
beneficiary receives a specific payment.
 Tax-deferred growth. You pay no taxes on the income and investment gains from your annuity
until you withdraw the money.
What Kinds Of Annuities Are There?
There are three basic types of annuities, fixed, variable and indexed. Here is how they work:
 Fixed annuity. The insurance company promises you a minimum rate of interest and a fixed
amount of periodic payments. Fixed annuities are regulated by state insurance commissioners.
Please check with your state insurance commission about the risks and benefits of fixed annuities
and to confirm that your insurance broker is registered to sell insurance in your state.
 Variable annuity. The insurance company allows you to direct your annuity payments to different
investment options, usually mutual funds. Your payout will vary depending on how much you put
in, the rate of return on your investments, and expenses. The SEC regulates variable annuities.
 Indexed annuity. This annuity combines features of securities and insurance products. The
insurance company credits you with a return that is based on a stock market index, such as the
Standard & Poor’s 500 Index. Indexed annuities are regulated by state insurance commissioners.
What Are The Benefits And Risks Of Variable Annuities?
Some people look to annuities to “insure” their retirement and to receive periodic payments once they no
longer receive a salary. There are two phases to annuities, the accumulation phase and the payout phase.
 During the accumulation phase, you make payments that may be split among various investment
options. In addition, variable annuities often allow you to put some of your money in an account
that pays a fixed rate of interest.
 During the payout phase, you get your payments back, along with any investment income and
gains. You may take the payout in one lump-sum payment, or you may choose to receive a regular
stream of payments, generally monthly.
All investments carry a level of risk. Make sure you consider the financial strength of the insurance
company issuing the annuity. You want to be sure the company will still be around, and financially
sound, during your payout phase.
Variable annuities have a number of features that you need to understand before you invest. Understand
that variable annuities are designed as an investment for long-term goals, such as retirement. They are
not suitable for short-term goals because you typically will pay substantial taxes and charges or other
penalties if you withdraw your money early. Variable annuities also involve investment risks, just as
mutual funds do.
How To Buy And Sell Annuities
Insurance companies sell annuities, as do some banks, brokerage firms, and mutual fund
companies. Make sure you read and understand your annuity contract. All fees should be clearly stated
in the contract. Your most important source of information about investment options within a variable
annuity is the mutual fund prospectus. Request prospectuses for all the mutual fund options you might
want to select. Read the prospectuses carefully before you decide how to allocate your purchase payments
among the investment options.
Realize that if you are investing in a variable annuity through a tax-advantaged retirement plan, such as
a 401(k) plan or an Individual Retirement Account, you will get no additional tax advantages from a
variable annuity. In such cases, consider buying a variable annuity only if it makes sense because of the
annuity’s other features.
Note that if you sell or withdraw money from a variable annuity too soon after your purchase, the
insurance company will impose a “surrender charge.” This is a type of sales charge that applies in the
"surrender period," typically six to eight years after you buy the annuity. Surrender charges will reduce
the value of -- and the return on -- your investment.
Understanding Fees
You will pay several charges when you invest in a variable annuity. Be sure you understand all charges
before you invest. Besides surrender charges, there are a number of other charges, including:
 Mortality and expense risk charge. This charge is equal to a certain percentage of your account
value, typically about 1.25% per year. This charge pays the issuer for the insurance risk it
assumes under the annuity contract. The profit from this charge sometimes is used to pay a
commission to the person who sold you the annuity.
 Administrative fees. The issuer may charge you for record keeping and other administrative
expenses. This may be a flat annual fee, or a percentage of your account value.
 Underlying fund expenses. In addition to fees charged by the issuer, you will pay the fees and
expenses for underlying mutual fund investments.
 Fees and charges for other features. Additional fees typically apply for special features, such as a
guaranteed minimum income benefit or long-term care insurance. Initial sales loads, fees for
transferring part of your account from one investment option to another, and other fees also may
apply.
 Penalties. If you withdraw money from an annuity before you are age 59 ½, you may have to pay a
10% tax penalty to the Internal Revenue Service on top of any taxes you owe on the income.
Avoiding Fraud
Variable annuities are considered to be securities. All broker-dealers and investment advisers that sell
variable annuities must be registered. Before buying an annuity from a broker or adviser, confirm that
they are registered using the free and simple search tool on Investor.gov.
In most cases, the investments offered within a variable annuity are mutual funds. By law, each mutual
fund is required to file a prospectus and regular shareholder reports with the SEC. Before you invest, be
sure to read these materials.
Additional Information
Annuities
Investor Bulletin: Indexed Annuities
Updated Investor Bulletin: Variable Annuities
Perpetuity
REVIEWED BY JULIA KAGAN
Updated Sep 16, 2019
What Is Perpetuity?
A perpetuity is a security that pays for an infinite amount of time. In finance, perpetuity is a constant stream of
identical cash flows with no end. The formula to calculate the present value of a perpetuity, or security with
perpetual cash flows, is:

PV = Present Value, C = cash flow, r = discount rate.

The concept of a perpetuity is also used in a number of financial theories, such as in the dividend discount
model (DDM).
KEY TAKEAWAYS
 A perpetuity, in finance, refers to a security that pays a never-ending cash stream.
 The present value of a perpetuity is determined using a formula that divides cash flows by some discount
rate.
 The British consol is an example of a perpetuity.
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Perpetuity
Understanding Perpetuity
An annuity is a stream of cash flows. A perpetuity is a type of annuity that lasts forever, into perpetuity. The
stream of cash flows continues for an infinite amount of time. In finance, a person uses the perpetuity
calculation in valuation methodologies to find the present value of a company's cash flows when discounted
back at a certain rate. An example of a financial instrument with perpetual cash flows is the British-issued
bonds known as consols. By purchasing a consol from the British government, the bondholder is entitled to
receive annual interest payments forever. Although it may seem a bit illogical, an infinite series of cash flows
can have a finite present value. Because of the time value of money, each payment is only a fraction of the last.
Specifically, the perpetuity formula determines the amount of cash flows in the terminal year of operation. In
valuation, a company is said to be a going concern, meaning that it goes on forever. For this reason, the terminal
year is a perpetuity, and analysts use the perpetuity formula to find its value.
Perpetuity Formula
The basic method used to calculate a perpetuity is to divide cash flows by some discount rate. The formula used
to calculate the terminal value in a stream of cash flows for valuation purposes is a bit more complicated. It is
the estimate of cash flows in year 10 of the company, multiplied by one plus the company’s long-term growth
rate, and then divided by the difference between the cost of capital and the growth rate. Simplified, the terminal
value is some amount of cash flows divided by some discount rate, which is the basic formula for a perpetuity.
Perpetuity Example
For example, if a company is projected to make $100,000 in year 10, and the company’s cost of capital is 8%,
with a long-term growth rate of 3%, the value of the perpetuity is:
= [Cash FlowYear 10 x (1 + g)] / (r - g)
= ($100,000 x 1.03) / (0.08 - 0.03)
= $103,000 / 0.05
= $2.06 million
This means that $100,000 paid into a perpetuity, assuming a 3% rate of growth with an 8% cost of capital, is
worth $2.06 million in 10 years. Now, a person must find the value of that $2.06 million today. To do this,
analysts use another formula referred to as the present value of a perpetuity.
Related Terms
Dividend Discount Model – DDM
The dividend discount model (DDM) is a system for evaluating a stock by using predicted dividends and
discounting them back to present value.
more
Terminal Value (TV) Definition
Terminal value (TV) determines the value of a business or project beyond the forecast period when future cash
flows can be estimated.
more
Understanding Gordon Growth Model
The Gordon Growth Model (GGM) is used to determine the intrinsic value of a stock based on a future series of
dividends that grow at a constant rate.
more
Perpetual Bond
A perpetual bond is a bond with no maturity date that is not redeemable but pays a steady stream of interest
forever.
more
Future Value of an Annuity
The future value of an annuity is the value of a group of recurring payments, known as an annuity, at a specified
date in the future.
more
Equivalent Annual Annuity Approach (EAA)
The equivalent annual annuity approach is one of two methods used in capital budgeting to compare mutually
exclusive projects with unequal lives.
What is a perpetuity?
A perpetuity in the financial system is a situation where a stream of cash flow payments continues indefinitely
or is an annuity which has no end. In valuation analysis, perpetuities are used to find the present value of a
company’s future projected cash flow stream and the company’s terminal value. Essentially, a perpetuity is a
series of cash flows that keep paying out forever.

Finite present value of perpetuity

Although the total value of a perpetuity is infinite, it has a limited present value. The present value of an infinite
stream of cash flow is calculated by adding up the discounted values of each annuity and the decrease of the
discounted annuity value in each period until it reaches close to zero.
The finite present value of a perpetuity is used by an analyst to determine the exact value of the company if it
continues to perform at the same rate.

Real-life examples
Although a perpetuity is somewhat theoretical (can anything really last forever?), classic examples include
businesses, real estate, and certain types of bonds.
One of the examples of a perpetuity is the UK’s government bond, known as a Consol. Bondholders will
receive annual fixed coupons (interest payment) as long as they hold the amount and the government does not
discontinue the Consol.
The second example is in the real-estate sector when an owner purchases a property and then rents it out. The
owner is entitled to an infinite stream of cash flow from the renter as long as the property continues to exist
(assuming the renter will rent)
Another real-life example is preferred stock; the perpetuity calculation assumes the company will continue to
exist indefinitely in the market and keep paying dividends.

Present value of perpetuity formula

Here is the formula:
PV = C / R

Where:
PV = Present value
C = Amount of continuous cash payment
r = Interest rate or yield

Example – Calculate the PV of a Constant Perpetuity

Company “Rich” pays $2 dividends annually and estimates they will pay it indefinitely. How much are
investors willing to pay for the dividend with a required rate of return of 5%?
PV = 2/5% = $40
An investor will consider investing in the company if it’s worth $40 or less.

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Perpetuity with growth formula

Formula:
PV = C / (r – g)

Where:
PV = Present value
C = Amount of continuous cash payment
r = Interest rate or yield
g = Growth Rate

Example calculation
Taking the above example, imagine if the $2 dividend is expected to grow annually by 2%.
PV = $2 / (5 – 2%) = $66.67

Importance of a growth rate

The growth model is important for some terminal value calculations in the discounted cash flow model. The
last, or terminal year, in the DCF model, will be assumed to grow at a constant rate forever. This, in essence,
means that the terminal year cash flow is a continues stream of cash flow.
Additional resources
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Valuation Analyst (FMVA) designation, designed to transform anyone into a world-class financial analyst. To
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 Valuation Methods
 Cost of Preferred Stock
 Market Risk Premium
 Debt Schedule
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A perpetuity is an annuity that has no end, or a stream of cash payments that continues forever. There are few
actual perpetuities in existence. For example, the United Kingdom (UK) government issued them in the past;
these were known as consols and were all finally redeemed in 2015. Real estate and preferred stock are among
some types of investments that affect the results of a perpetuity, and prices can be established using techniques
for valuing a perpetuity.[1] Perpetuities are but one of the time value of money methods for valuing financial
assets. Perpetuities are a form of ordinary annuities.
The concept is closely linked to terminal value and terminal growth rate in valuation.

Contents
 1Detailed description
 2Real-life examples
 3References
 4See also
Detailed description[edit]
A perpetuity is an annuity in which the periodic payments begin on a fixed date and continue indefinitely. It is
sometimes referred to as a perpetual annuity. Fixed coupon payments on permanently invested (irredeemable)
sums of money are prime examples of perpetuities. Scholarships paid perpetually from an endowment fit the
definition of perpetuity.
The value of the perpetuity is finite because receipts that are anticipated far in the future have extremely low
present value (present value of the future cash flows). Unlike a typical bond, because the principal is never
repaid, there is no present value for the principal. Assuming that payments begin at the end of the current
period, the price of a perpetuity is simply the coupon amount over the appropriate discount rate or yield; that is,

where PV = present value of the perpetuity, A = the amount of the periodic payment, and r = yield, discount
rate or interest rate.[2]
To give a numerical example, a 3% UK government war loan will trade at 50 pence per pound in a yield
environment of 6%, while at 3% yield it is trading at par. That is, if the face value of the loan is £100 and the
annual payment £3, the value of the loan is £50 when market interest rates are 6%, and £100 when they are 3%.
Real-life examples[edit]
Valuing real estate with a capitalization rate or cap rate (the convention used in real estate finance) is a more
current example . Using a cap rate, the value of a particular real estate asset is either the net income or the net
cash flow of the property, divided by the cap rate. Effectively, the use of a cap rate to value a piece of real estate
assumes that the current income from the property continues in perpetuity. Underlying this valuation is the
assumption that rents will rise at the same rate as inflation. Although the property may be sold in future (or even
the very near future), the assumption is that other investors will apply the same valuation approach to the
property.
UK government perpetuities (called consols) were undated as well as irredeemable except by act of
Parliament. As with war bonds, they paid fixed coupons (interest payments), and traded actively in the bond
market until the government redeemed them in 2015. Very long dated bonds have financial characteristics that
can appeal to some investors and in some circumstances: e.g. long-dated bonds have prices that change rapidly
(either up or down) when yields change (fall or rise) in the financial markets.
The constant growth dividend discount model for the valuation of the common stock of a corporation is another
example. This model assumes that the market price per share is equal to the discounted stream of all future
dividends, which is assumed to be perpetual. If the discount rate for stocks (shares) with this level of systematic
risk is 12.50%, then a constant perpetuity of dividend income per dollar is eight dollars. However, if the future
dividends represent a perpetuity increasing at 5.00% per year, then the dividend discount model, in effect,
subtracts 5.00% off the discount rate of 12.50% for 7.50% implying that the price per dollar of income is $13.33