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Business cycles and reasons for business fluctuations ......................................................... 3 Economic measures and reasons for changes in the economy ............................................ 14 Market influences on business strategies......................................................................... 28 Implications of dealing in foreign currencies .................................................................... 67 Appendix I: Homework reading...................................................................................... 80 Appendix II: Homework reading .................................................................................... 84 Appendix III: Homework reading ................................................................................... 88 Terminology ............................................................................................................... 97 Class questions ........................................................................................................... 99
Business Environment & Concepts 2
Becker CPA Review
Business Environment & Concepts 2
BUSINESS CYCLES AND REASONS FOR BUSINESS FLUCTUATIONS I. BUSINESS CYCLES A. INTRODUCTION Business cycles refer to the rise and fall of economic activity relative to its long-term growth trend (i.e., the swings in total national output, income, and employment over time). Although the economy tends to grow over time, the growth in economic activity is not stable. Rather, economic activity is characterized by fluctuations, and these fluctuations are known as business cycles. Business cycles vary in duration and severity. Some cycles are quite mild. Others are characterized by large increases in unemployment and/or inflation. The analysis of business cycles is part of the field of macroeconomics. Macroeconomics is the study of the economy as a whole. It examines the determinants of national income, unemployment, and inflation and how monetary and fiscal policies affect economic activity. On the other hand, microeconomics studies consumers, producers, and suppliers operating in a narrowly defined market. B. MEASURING ECONOMIC ACTIVITY: GROSS DOMESTIC PRODUCT Because business cycles refer to the rise and fall of economic activity, it is important to first examine how economic activity is measured. The most common measure of the economic activity or output of an economy is Gross Domestic Product (GDP). GDP is the total market value of all final goods and services (the term "final goods and services" excludes used goods that have been resold) produced within the borders of a nation in a particular time period (i.e., the nation's output of goods and services). Note that GDP includes all final goods and services produced by resources within a country regardless of who owns the resources. Thus, U.S. GDP includes the output of foreign-owned factories in the U.S. but excludes the output of U.S.-owned factories operating abroad. C. NOMINAL VERSUS REAL GDP 1. Nominal GDP Nominal GDP (unadjusted) measures the value of all final goods and services in prices prevailing at the time of production. That is, nominal GDP measures the value of all final goods and services in current prices. 2. Real GDP a. Definition Real GDP (adjusted) measures the value of all final goods and services in constant prices. That is, real GDP is adjusted to account for changes in the price level (i.e., it removes the effects of inflation by using a price index). Real GDP is the most commonly used measure of economic activity and national output (i.e. the total output of an economy). b. Price Index (GDP Deflator) The price index used to calculate real GDP is called the GDP Deflator. It is a price index for all goods and services included in GDP. Using the GDP deflator, real GDP is calculated as the ratio of nominal GDP to the GDP deflator times 100.
Real GDP = Nominal GDP × 100 GDP Deflator
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Real GDP per capita is also used to measure economic growth. firm profits are likely to be at their highest level. All rights reserved. economic activity begins to increase and return to its long-term growth trend. Real GDP per capita is typically used to compare standards of living across countries or across time. 5. Firms are also likely to increase the size of their workforce during an expansion. Firms are also likely to experience significant excess production capacity. 4. Firm profits are likely to be rising during an expansionary phase as the demand for goods and services increases. economic activity is characterized by fluctuations. REAL GDP PER CAPITA AND ECONOMIC GROWTH Real Per Capita GDP (Real GDP per Capita) is real GDP divided by population. B2-4 © 2009 DeVry/Becker Educational Development Corp. Expansionary Phase An expansionary phase is characterized by rising economic activity (real GDP) and growth. Further. At this point of the business cycle. SUMMARY COMPOSITION OF BUSINESS CYCLES As noted above. firm profits are likely to be at their lowest level. Firms are also likely to face capacity constraints and input shortages (raw material and labor). It marks the end of an expansionary phase and the beginning of a contractionary phase in economic activity. 2. Contractionary Phase A contractionary phase is characterized by falling economic activity and growth and follows a peak. During a recovery phase. Trough A trough is a low point of economic activity. Business cycles are typically comprised of: 1. leading to higher costs and a higher overall price level. and these fluctuations are known as business cycles. firm profits typically begin to stabilize as the demand for goods and services begins to rise. firm profits are likely to be falling from their highest levels. E. Peak A peak is a high point of economic activity.Business Environment & Concepts 2 Becker CPA Review D. 3. . At the peak of a business cycle. economic activity is rising above its long-term growth trend. During a contractionary phase. Recovery Phase A recovery phase follows a trough. leading them to reduce the size of their workforce and cut costs. During an expansionary phase. and the price of goods and services is likely to be rising. Economic growth is the increase in real GDP per capita over time.
As a result. Firms are also likely to have excess capacity. Furthermore. firm profits tend to fall and many firms incur losses. C. Graph A Output (Real GDP) Contractionary Phase Peak Long-term growth trend in national output Expansionary Phase Peak Recovery Phase Trough Trough Time (Years) © 2009 DeVry/Becker Educational Development Corp.Becker CPA Review Business Environment & Concepts 2 II. firms will experience significant excess capacity. B2-5 . DEPRESSION A depression is a very severe recession. TERMINOLOGY USED IN DESCRIBING BUSINESS CYCLES A. Economists define a recession as two consecutive quarters of falling national output. due to the significant reduction in the demand for goods and services. As a result. during a recession. it is likely that many firms will go out of business during a depression. During a recession. All rights reserved. It is characterized by a relatively long period of stagnation in business activity and high unemployment rates. ILLUSTRATION Graph A illustrates the business cycle. RECESSION A recession occurs when the economy experiences negative real economic growth (declines in national output). resources (including labor) are likely to be underutilized and unemployment is likely to be high. B.
2. A. All rights reserved. firms. Aggregate demand and aggregate supply curves can be used to illustrate the relationship between a country's output (real GDP) and price level (the GDP Deflator). They include: 1. Economic indicators (gathered by The Conference Board) are variables that have historically correlated highly with economic activity. 6. B2-6 © 2009 DeVry/Becker Educational Development Corp. This particular "line" just happens to be drawn as a straight line. 2.Business Environment & Concepts 2 Becker CPA Review III. 4. B. Prime rate charged by banks Average duration of unemployment Bank loans outstanding C. ECONOMIC INDICATORS Although business cycles tend to be irregular and unpredictable. economists nevertheless attempt to predict business cycles and their severity and duration using economic indicators." "lagging indicators. Note that this "aggregate" demand curve is the macroeconomic demand curve of the "total" demand in the economy as a whole. although it is often drawn as a curve. REASONS FOR FLUCTUATIONS While there are a variety of theories regarding the cause of business cycles. leading indicators are subject to change. They give signals after the fact and include the following: 1. Industrial production Manufacturing and trade sales IV. COINCIDENT INDICATORS Coincident indicators tend to occur coincident to economic activity. and the government are willing and able to purchase at any given price level. 3. 2. AGGREGATE DEMAND (AD) CURVE The aggregate demand (AD) curve illustrates the maximum quantity of all goods and services that households. LEADING INDICATORS Leading indicators tend to predict economic activity. 5. economists generally agree that business cycles result from shifts in aggregate demand and/or aggregate supply. 7. They are also used to examine the causes of economic fluctuations. The government routinely revises the numbers as more data becomes available. . 3. Average new unemployment claims Building permits for residences Average length of the workweek Money supply Prices of selected stocks Orders for goods Price changes of materials Index of consumer expectations LAGGING INDICATORS Lagging indicators tend to follow economic activity. Thus. The x-axis is real GDP." or "coincident indicators. They include the following: 1." A. They can be "leading indicators. It shows the relationship between total output (real GDP) of the economy and the price level. 8.
2. Potential Level of Output (Potential GDP) Potential GDP refers to the level of real GDP (national output) that the economy would produce if its resources (capital and labor) were fully employed. Long-Run Aggregate Supply Curve The long-run aggregate supply (LRAS) curve is vertical. Similarly. B2-7 . Short-Run Aggregate Supply Curve The short-run aggregate supply (SRAS) curve is upward sloping. The position of the long-run aggregate supply (LRAS) curve determines the level of output in the long run. C. Note that this "aggregate" supply curve is the macroeconomic supply curve of the "total" supply in the economy as a whole. This curve corresponds to the potential level of output in the economy. if all resources are fully utilized. illustrating the fact that as the price level rises. the economy will typically be experiencing an expansion. When real GDP is below the potential level of output. when real GDP rises above the potential level of output. The LRAS curve is vertical at the economy’s potential level of output. All rights reserved. illustrating the fact that in the long-run. output is determined solely by the factors of production. 3. the economy will typically be experiencing a recession. © 2009 DeVry/Becker Educational Development Corp. Graph B Price Level Long-Run Aggregate Supply Short-Run Aggregate Supply P0 Aggregate Demand Y* Real GDP The intersection of the Short-Run Aggregate Supply (SRAS) curve and the Aggregate Demand (AD) curve determines the level of output (real GDP) and price level in the short run.Becker CPA Review Business Environment & Concepts 2 B. AGGREGATE SUPPLY (AS) CURVE The aggregate supply (AS) curve illustrates the maximum quantity of all goods and services producers are willing and able to produce at any given price level. firms are willing to produce more goods and services. ILLUSTRATION Graph B illustrates the aggregate demand and aggregate supply curves for an economy. 1. Y* = GDP at the potential (equilibrium) level of output.
Firms are also likely to experience a reduction in excess capacity. AGGREGATE SUPPLY. 2. B2-8 . leading to lower unemployment. leading them to increase the size of their workforce. Reduction of Supply If circumstances cause firms to reduce their supply of goods and services. 3. and governments to increase their demand for goods and services.Business Environment & Concepts 2 Becker CPA Review D. AGGREGATE DEMAND. This is illustrated as the leftward shift in the short run aggregate supply curve. real GDP falls from Y0 to Y1. an increase in demand tends to cause firm profits to rise. All rights reserved. they are also likely to reduce the size of their workforce. leading to higher unemployment. As a result. are the result of shifts in aggregate demand and short-run aggregate supply (note that shifts in the long-run aggregate supply curve are associated with long-run growth in the economy and do not affect business cycles). Increase in Supply If circumstances cause firms to increase their supply of goods and services. businesses. if circumstances cause individuals. Graphs C and D illustrate recessions caused by shifts in aggregate demand and short-run aggregate supply. or governments to reduce their demand for goods and services. businesses. Increase in Demand In contrast. economic activity (real GDP) will decline. they are also likely to increase the size of their workforce. Graph C Price Level LRAS SRAS Graph D Price Level LRAS SRAS1 SRAS P0 P1 AD AD1 Y1 Y0 Output (Real GDP) P1 P0 AD Y1 Y0 Output (Real GDP) A recession caused by a shift in the aggregate demand curve: A decrease in aggregate demand causes actual GDP to fall below potential GDP. economic activity will rise. As a result. real GDP falls from Y0 to Y1. As firms increase their supply. or economic fluctuations. leading to a contraction or possibly a recession. As firms reduce their supply. Reduction in Demand If circumstances cause individuals. As a result. 4. A recession caused by a shift in the short run aggregate supply curve: A decrease in short-run aggregate supply causes actual GDP to fall below potential GDP. © 2009 DeVry/Becker Educational Development Corp. This is illustrated as the leftward shift in aggregate demand. leading to an expansionary phase of economic activity. a reduction in demand tends to cause firm profits to decline. As a result. economic activity will rise. leading to a recovery or an expansion in economic activity. leading them to reduce the size of their workforce. leading to a contraction in economic activity and possibly a recession. Firms are also likely to experience an increase in excess capacity. economic activity will fall. AND ECONOMIC FLUCTUATIONS Business cycles. 1.
an increase in wealth causes the economy to expand and leads to an increase in national output (real GDP). shifting aggregate demand to the left and causing national output to fall. Changes in Wealth a. thereby increasing the demand for investment goods and shifting the aggregate demand curve to the right. Changes in Real Interest Rates a. causing a contraction and possibly a recession. therefore. an increase in real interest rates causes the cost of capital to rise and shifts the aggregate demand curve to the left. Increase in Wealth An increase in wealth causes the aggregate demand curve to shift to the right. causing national output to fall. tends to reduce consumer demand for durable goods such as new cars and homes and firm demand for new plants and equipment. All rights reserved. Changes in Expectations about the Future Economic Outlook (Consumer Confidence) a. b. 3. a large decline in stock prices would decrease consumer wealth and therefore shift the aggregate demand curve to the left. consumers tend to reduce current spending. Increase in Real Interest Rates An increase in interest rates increases the cost of capital and. For example. As a result. Confident Economic Outlook If households become confident about the economic outlook (consumer confidence increases). causing national output to rise. Decrease in Wealth A decrease in wealth causes the aggregate demand curve to shift to the left. A decrease in real interest rates reduces the cost of capital. Uncertain Economic Outlook When the economic outlook appears more uncertain. b. national output would fall. 2. © 2009 DeVry/Becker Educational Development Corp. the willingness to acquire investment and consumer goods increases and the aggregate demand curve shifts right. Conversely. B2-9 . Decrease in Real Interest Rates A decrease in real interest rates does the opposite of an increase in real interest rates. Thus. b. causing national output to rise. FACTORS THAT SHIFT AGGREGATE DEMAND The primary factors that shift aggregate demand are: 1. A decrease in wealth does the opposite of an increase in wealth.Becker CPA Review Business Environment & Concepts 2 E.
while foreign goods will become relatively cheap for its residents. Depreciated Currencies If the currency of a country depreciates in real terms relative to the currencies of its trading partners. Changes in Consumer Taxes a. b. 5. Increase in Consumer Taxes An increase in consumer taxes (e. causing national output to fall. B2-10 © 2009 DeVry/Becker Educational Development Corp. b. its goods will become relatively cheap for foreigners. b. net exports (exports minus imports) will rise. its goods will become relatively expensive for foreigners. while foreign goods will become relatively expensive for its residents. Changes in Exchange Rates a.g. All rights reserved. therefore. . net exports (exports minus imports) will fall. the personal income tax) reduces the disposable income (gross income minus taxes) of consumers and. 6. causing national output to rise. shifting the aggregate demand curve to the right and causing national output to rise. Decrease in Government Spending A decrease in government spending shifts the aggregate demand curve to the left. Appreciated Currencies If the currency of a country appreciates in real terms relative to the currencies of its trading partners. Increase in Government Spending An increase in government spending shifts the aggregate demand curve to the right. As a result.Business Environment & Concepts 2 Becker CPA Review 4. As a result. shifting the aggregate demand curve to the left and causing national output to fall. Changes in Government Spending a.. shifts the aggregate demand curve to the left. Decrease in Consumer Taxes A decrease in taxes increases the disposable income of consumers and therefore shifts the aggregate demand curve to the right causing national output to rise. causing national output to fall.
and Graph F illustrates the effect of a decrease in government spending and/or an increase in taxes (known as contractionary fiscal policy). Using the MPC. the economy is initially in an expansionary phase. the MPC is typically less than one. F. Graph E Price Level LRAS SRAS Graph F Price Level LRAS SRAS P1 P0 AD1 AD Y0 Y1 Output (Real GDP) Y1 Y0 AD P0 P1 AD1 Output (Real GDP) In graph E. Because people tend to save part of their income. which is above the potential level of output Y1. a $1 increase in government spending results in a greater than $1 increase in real GDP. which in turn spend that income. In graph F. the economy is initially in a recession. B2-11 . illustrated as output level Y0. Their spending gives other households and firms income. © 2009 DeVry/Becker Educational Development Corp. The MPC is the change in consumption due to a $1 increase in income. produces a multiplied increase in the level of economic activity. which is below the potential level of output Y1. and so on. so be aware of this terminology as well. The multiplier effect results from the marginal propensity to consume (MPC). firm. The multiplier effect stems from the fact that increases in spending generate income for firms. the effect of a $1 increase in spending is magnified by the multiplier effect. For example. illustrated as output level Y0. THE MULTIPLIER EFFECT The multiplier effect refers to the fact that an increase in consumer. Illustration: Changes in Government Spending and/or Taxes Graph E illustrates the effect of an increase in government spending and/or a decrease in taxes (known as expansionary fiscal policy). The government can stimulate the economy by increasing government spending or decreasing taxes (or both) shifting the aggregate demand curve to the right and causing national output (real GDP) to rise. shifting the aggregate demand curve to the left and causing national output (real GDP) to fall. The government can contract the economy by decreasing government spending or increasing taxes (or both). the size of the multiplier effect can be calculated using the following formula: Multiplier = 1 × Change in Spending (1 − MPC) Note: The examiners could refer to "1 – MPC" as the marginal propensity to save (MPS). All rights reserved.Becker CPA Review Business Environment & Concepts 2 7. or government spending. Therefore.
the change in consumption due to a $1 increase in income is 80 cents) and that spending increases by $100. damage to infrastructure caused by earthquakes. Thus.Business Environment & Concepts 2 Becker CPA Review For example. a large increase in oil prices (oil is a primary input in production) would shift the short-run aggregate supply curve to the left. when discussing business cycles we focus on shifts in the shortrun aggregate supply curve. Decrease in Input Prices A decrease in input prices causes the short-run aggregate supply curve to shift to the right. Therefore. Then the multiplier would be: Multiplier = 1 × $100 = $500 (1 − 0.) causes the shortrun aggregate supply curve to shift left. b. EXAMPLE For example. G. suppose the MPC is 0. 2. etc.8) Thus a $100 dollar increase in spending results in a $500 increase in real GDP. Supply Shocks a. causing national output to increase. Supplies are Curtailed If resource supplies are curtailed (e. A decrease in input prices causes the economy to expand and leads to an increase in national output (real GDP). Increase in Input Prices An increase in input prices (raw material prices.e. The primary factors that shift short-run aggregate supply are: 1. causing a contraction and possibly a recession.) the short-run supply curve will shift to the left. Changes in Input (Resource) Prices a. Supplies are Plentiful If resource supplies become more plentiful. All rights reserved. the short-run aggregate supply curve will shift to the right. As a result. etc. national output would fall.. FACTORS THAT SHIFT SHORT-RUN AGGREGATE SUPPLY Recall that shifts in long-run aggregate supply are associated with economic growth NOT business cycles. an increase in input prices causes the economy to contract and leads to a decrease in national output (real GDP). . This is illustrated in Graph D.8 (i. causing national output (real GDP) to decline. b.g. B2-12 © 2009 DeVry/Becker Educational Development Corp.. wages. crop failures.
g. a decline in consumer confidence) tend to cause firm profits to fall. Example As was discussed above. Effect of Economic Events on the Firm When economic events (such as those discussed above) cause either the aggregate demand curve or short-run aggregate supply curve to shift. Shifts in Aggregate Supply Economic events that shift the aggregate supply curve also affect firm profits. B2-13 . a rise in input costs tends to reduce firm profits and cause firms to reduce the size of their workforce.Becker CPA Review Business Environment & Concepts 2 H. economic events that cause aggregate demand to decrease (e. when the aggregate demand curve shifts right (an increase in aggregate demand). All rights reserved.. 2. © 2009 DeVry/Becker Educational Development Corp. 1. employment. a. SHIFTS IN AGGREGATE DEMAND AND SUPPLY AND THE EFFECTS ON FIRM BUSINESS OPERATIONS Shifts in either the aggregate demand or aggregate supply curve affect the business conditions of firms. firms are likely to experience a decrease in excess capacity. In contrast.g.. Shifts in Aggregate Demand Economic events that cause aggregate demand to increase (e. In addition. and other conditions. b. For example. an increase in wealth or a decrease in interest rates) tend to cause firm profits to rise. firm profits tend to increase. they also affect the business conditions of firms. leading them to increase the size of their workforce.
economy. II. Similarly. State. and (4) interest rates. The combined economic output of the following four sectors is called Gross Domestic Product (GDP). Some of the most commonly cited economic measures are: (1) real Gross Domestic Product (real GDP). 1.S. TWO METHODS OF MEASURING GDP The two methods of measuring GDP are the expenditure approach and the income approach. when real GDP is rising. both discussed in detail below) are calculated using NIPA. GDP is the sum of the following four components: G I C E Government purchases of goods and services Gross private domestic investment (nonresidential fixed investment. and change in business inventories) Personal consumption expenditures (durable goods. . OVERVIEW Economists and policy-makers rely on a host of economic measures or indicators to determine the overall state of economic activity. and services) Net exports (exports minus imports) B2-14 © 2009 DeVry/Becker Educational Development Corp. (3) the inflation rate. and Local Governments The Foreign Sector Remember that GDP was introduced on page B2-3 where nominal GDP and real GDP were discussed. unemployment tends to be falling. THE NATIONAL INCOME ACCOUNTING SYSTEM The National Income and Product Accounting (NIPA) system was developed by the U. non-durable goods. when the unemployment rate is rising the inflation rate tends to be falling. A.Business Environment & Concepts 2 Becker CPA Review ECONOMIC MEASURES AND REASONS FOR CHANGES IN THE ECONOMY I. (2) the unemployment rate. Households (or Consumers) Businesses Federal. All rights reserved. The two approaches to measuring GDP (expenditure approach and income approach. Department of Commerce in order to monitor the health and performance of the U. For example. It is important to remember that these economic measures tend to move together. residential fixed investment. The Expenditure Approach Under the expenditure approach. the total dollar value of all new final goods and services produced within the economy in a given time period.S.
Calculate GDP through the income approach by using the following mnemonic: I P I R A T E D B. interest.9 526. and business taxes.4 4.931.698. 1.7 (96. rent.0 572. The aggregate expenditures approach on the left is a flow-of-product approach (at market prices).Becker CPA Review Business Environment & Concepts 2 2.4 Aggregate Expenditure $6.4 © 2009 DeVry/Becker Educational Development Corp. a. The Income Approach The income approach accounts for GDP as the value of resource costs and incomes generated during the measurement period.8 $6.014.931.5 4. All rights reserved. Income of proprietors Profits of corporations Interest (net) Rental income Adjustments for net foreign income and miscellaneous items Taxes (indirect business taxes) Employee compensation (wages) Depreciation (also known as capital consumption allowance) COMPARISON OF APPROACHES The different approaches to preparing an "income statement" for the domestic economy (the GDP) are shown in the table below. The income approach on the right is a flow of earnings and costs approach (valueadded items plus taxes). B2-15 .008.4) Income Approach (Earnings and Cost) Income of proprietors Profits of corporations Interest (net) Rental income Adjustments for net foreign income/miscellaneous Taxes (indirect business) Employee compensation Depreciation (consumption of fixed capital) Domestic Income $ 450. 2. Table 1 (Billions of Dollars) Expenditures Approach (Flow-of-Product) Government purchases Investment Consumption Exports (net) $1. wages.3 818.314. The income approach includes business profits. depreciation.7 1.8 116. b.5 392.6 45.
For example. 3. Specifically. Net National Product (NNP) Net national product (NNP) is defined as the total income of a country's residents less losses from economic depreciation (i. and Disposable Income (DI). that production is counted as part of U. National Income (NI).g. but it is not counted as part of U.S. Net Domestic Product Net domestic product (NDP) is GDP minus depreciation (the capital consumption allowance). losses in the value of capital goods due to age and wear). 1.e.S. sales tax). B2-16 © 2009 DeVry/Becker Educational Development Corp. It is the amount of income households have available either to spend or save. Net National Product (NNP). .S. there are several other noteworthy measures. which is allocation of costs to accounting periods. GDP. Personal Income (PI). Gross National Product (GNP) GNP is defined as the market value of final goods and services produced by residents of a country in a given time period. This depreciation is not accounting depreciation.S. It measures the income received by all factors of production within a country.. National Income (NI) National income (NI) is NNP less indirect business taxes (e. GNP because BMW is a foreign-owned company. Personal Income (PI) Personal Income (PI) is the income received by households and noncorporate businesses. NI Less: Undistributed corporate profits (retained earnings) Net interest Contributions for social measures (social security contributions) Corporate income taxes Government transfer payments to individuals Personal interest income Business transfer payments/dividends PI Plus: = 6.. Disposable Income (DI) Disposable Income (DI) is personal income less personal taxes. All rights reserved. GNP differs from GDP because GNP includes goods and services that are produced overseas by U. NNP equals GNP minus economic depreciation. These measures are calculated by making specific deductions and additions to GDP and include: Net Domestic Product (NDP). if BMW produces cars in the U. 2. 5. firms and excludes goods and services that are produced domestically by foreign firms. OTHER MEASURES OF NATIONAL INCOME While GDP is the most common measure of national income and an economy's output and performance. 4. Gross National Product (GNP). Thus.Business Environment & Concepts 2 Becker CPA Review C.. the expenditure necessary to maintain production capacity (or "depreciation" to accountants).
the demand for labor increases and then decreases again after Christmas. Seasonal Unemployment Seasonal unemployment is the result of seasonal changes in the demand and supply of labor. TYPES OF UNEMPLOYMENT 1. When real GDP is above the potential level of output. Full Employment Full employment is defined as the level of unemployment when there is no cyclical unemployment. B2-17 . b. All rights reserved. structural. When real GDP is below the potential level of output. © 2009 DeVry/Becker Educational Development Corp. B. Thus. 4. 3. shortly before Christmas.) Note that to be counted as unemployed a person must be actively looking for work. Cyclical Unemployment Cyclical unemployment is the amount of unemployment resulting from declines in real GDP during periods of contraction or recession or in any period when the economy fails to operate at its potential. Structural Unemployment Structural unemployment occurs when: a. 2. Jobs available in the market do not correspond to the skills of the work force. cyclical unemployment is negative. and seasonal unemployment or the employment rate that exists when the economy is at its potential output level (recall that the position of the Long-Run Aggregate Supply (LRAS) curve is determined by the potential level of output). and Unemployed workers do not live where the jobs are located. there is still frictional.Becker CPA Review Business Environment & Concepts 2 III. (An unemployed person is defined as a person 16 years of age or older who is available for work and who has actively sought employment during the previous four weeks. THE UNEMPLOYMENT RATE The unemployment rate measures the ratio of the number of people classified as unemployed to the total labor force. For example. Frictional Unemployment Frictional unemployment is normal unemployment resulting from workers routinely changing jobs or from workers being temporarily laid off. When the economy is operating at full employment. and seasonal unemployment. cyclical unemployment rises during a recession and falls during an expansion. 2. Natural Rate of Unemployment The natural rate of unemployment is the "normal" rate of unemployment around which the unemployment rate fluctuates due to cyclical unemployment. cyclical unemployment is positive. The unemployment rate can be expressed as: Unemployment Rate = Number of Unemployed × 100 Total Labor Force A. It is the unemployment that arises because of the time needed to match qualified job seekers with available jobs. The total labor force includes all non-institutionalized individuals 16 years of age or older who are either working or actively looking for work. the natural rate of unemployment is the sum of frictional. Thus. NATURAL RATE OF UNEMPLOYMENT AND THE MEANING OF FULL EMPLOYMENT 1. Full employment does not mean zero unemployment. structural.
Obviously the opposite is true when the demand for goods and services decreases. Inflation Inflation is defined as a sustained increase in the general prices of goods and services. The reason for the link between the two variables is straightforward. Consumer Price Index (CPI) The CPI is a measure of the overall cost of a fixed basket of goods and services purchased by an average household. DEFINITIONS 1. the unemployment rate tends to be falling. Formula Using the CPI. when the economy is in a recession). THE LINK BETWEEN UNEMPLOYMENT AND OUTPUT (REAL GDP) The unemployment rate and national output (real GDP) tend to move in opposite directions. . Similarly. That is. 3. (The Producer Price Index (PPI) measures the overall cost of a basket of goods and services typically purchased by firms. THE PRICE LEVEL AND INFLATION A.Business Environment & Concepts 2 Becker CPA Review C. Most economists believe deflation is a much bigger economic problem than inflation. Consequently. All rights reserved. It occurs when prices on average are falling over time. During periods of deflation. the inflation rate is calculated as the percentage change in the CPI from one period to the next: CPI this period − CPI last period CPI last period × 100 Inflation Rate = B2-18 © 2009 DeVry/Becker Educational Development Corp. when real GDP is falling (for example. IV. When the demand for goods and services increases (when real GDP is rising). 2.) b. Deflation Deflation is defined as a sustained decrease in the general prices of goods and services. a. the unemployment rate tends to be rising. when real GDP is rising. firms are likely to experience significant excess production capacity. firms typically need to hire additional workers to produce the additional goods and services demanded and hence the unemployment rate tends to fall. It occurs when prices on average are increasing over time. Inflation/Deflation Rate The inflation or deflation rate is typically measured as the percentage change in the Consumer Price Index (CPI) from one period to the next. firm profits are likely to be falling during periods of deflation. This occurs because consumers tend to hold off purchasing goods and services during a period of deflation because they realize the price of goods and services is likely to continue to fall.
Decreases in taxes. CAUSES OF INFLATION AND DEFLATION Inflation and deflation are caused by shifts in the aggregate demand and short-run aggregate supply curves. Cost-Push Inflation: A decrease in shortrun aggregate supply causes the short-run equilibrium price level to rise from P0 to P1. All rights reserved. 3. Similarly. Similarly. demand-pull inflation could be caused by factors such as: a. Thus. Demand-Pull Inflation Demand-pull inflation is caused by increases in aggregate demand. An increase in oil prices. Increases in government spending. © 2009 DeVry/Becker Educational Development Corp. Illustrations Graphs G and H illustrate demand-pull and cost-push inflation using the aggregate demand and short-run aggregate supply curves. Graph G Price Level SRAS Graph H Price Level SRAS1 SRAS P1 P0 AD1 AD Y0 Y1 Output (Real GDP) P1 P0 AD Y1 Y0 Output (Real GDP) Demand-Pull Inflation: An increase in aggregate demand causes the short-run equilibrium price level to rise from P0 to P1. leading to inflation. 1. 2. b. b. Increases in wealth. a shift left in the short-run aggregate supply curve will also cause the price level to rise. and Increases in the money supply. A shift left in aggregate demand (perhaps brought about by a stock market crash or a large increase in taxes) will cause the aggregate price level to fall.Becker CPA Review Business Environment & Concepts 2 B. a shift right in the short-run aggregate supply curve will also cause the aggregate price level to fall. Thus. or An increase in nominal wages. d. c. B2-19 . leading to inflation. costpush inflation could be caused by factors such as: a. Cost-Push Inflation Cost-push inflation is caused by reductions in short-run aggregate supply. 4. Deflation Deflation is also caused by shifts in aggregate demand or short-run aggregate supply. A shift right in the aggregate demand curve will cause the price level to rise.
The actions of OPEC in 197374 led to a recession in the U. those with a fixed amount of money or income (e. those with a fixed amount of debt (e.00 per barrel in late 1973 to $10. All rights reserved.e. Monetary Assets and Liabilities Monetary assets and liabilities (e. etc. EXAMPLE B2-20 This increase in the price of crude oil had a substantial effect on the U. machinery. OPEC (Organization of Petroleum Exporting Countries) substantially curtailed its production of crude oil..Business Environment & Concepts 2 Becker CPA Review C. that was particularly harsh because not only was the unemployment rate rising. the debt will be repaid with inflated dollars). The combination of falling national output and a rising price level is known as stagflation. inflation also tends to be benefit firms with large amounts of outstanding debt. Definitions a. Thus. a building. 2.g. but the newly unemployed were facing higher prices for goods and services due to inflation! © 2009 DeVry/Becker Educational Development Corp. As the price level rises.g. retired persons) will be hurt (i. Specifically. the value of money declines.) are fixed in dollar amounts regardless of changes in specific prices or the general price level. firms that lend out money at fixed interest rates are likely to be hurt by inflation. Non-Monetary Assets and Liabilities The value of non-monetary assets (e. national output (real GDP) began to decline. economy. Similarly. 3. firms cut back production and the short-run aggregate supply curve shifted left. cash. firms.) and non-monetary liabilities will fluctuate with inflation and deflation.. those with home mortgages) will be aided (i. As a result. notes payable.S.g. As the short-run aggregate supply curve shifted left. land.S. As a result.. Holding Monetary Liabilities During a period of inflation... OPEC and the Stagflation of the 1970s Between 1973 and 1974. INFLATION AND THE VALUE OF MONEY Inflation has an inverse relationship with purchasing power. etc. accounts receivable.00 per barrel in late 1974. Holding Monetary Assets During a period of inflation. This is the situation depicted in Graph D.g.S. the price of a barrel of crude oil rose from approximately $2. and the aggregate price level began to rise (cost-push inflation).. . 1. their purchasing power will be eroded). rising crude oil prices represented an increase in input costs for U.e. b. unemployment began to rise.
) increased interest rates in an attempt to control inflation. INVERSE RELATIONSHIP BETWEEN INFLATION AND UNEMPLOYMENT A. the price level also fell and the nation experienced a period of deflation. shortly before the stock market crash. which shifted the aggregate demand curve to the left. thereby decreasing the demand for investment goods and shifting the aggregate demand curve even further to the left. Specifically. the Federal Reserve (the Central Bank of the U. The deflation that occurred can be seen by noting that between 1929 and 1933 the price level fell continuously. B2-21 . V. 1929. It then increased interest rates again in early 1931. While unemployment and inflation have historically moved in opposite directions. By 1932. THE PHILLIPS CURVE Inflation and unemployment are traditionally thought to have an inverse relationship in the short run.8 748. All rights reserved.3 599. the Great Depression was characterized by falling output (falling real GDP). It illustrates the tradeoff that exists in the short run between inflation and unemployment. In addition. © 2009 DeVry/Becker Educational Development Corp. Furthermore.65% 24. the stock market crash reduced household wealth. The Phillips Curve illustrates the inverse relationship between the rate of inflation and the unemployment rate. and protectionist trade policies.7 587. the oil shocks (negative supply shocks) of the 1970s led to a situation where both unemployment and the price level were rising. rising unemployment and deflation. Table 1 Year EXAMPLE Real GDP (Billions of 1987 Dollars) 821.7 13.9 691.0 1929 1930 1931 1932 1933 As the table illustrates. the stock market crash. and the price level (as measured by the CPI) between 1929 and 1933. Specifically. The depression was caused by a number of factors including ill-timed interest rate hikes by the Federal Reserve.71% 15. as in Graph C. the interest rate hikes. As aggregate demand fell. the Dow Jones industrial average had fallen 89% from its peak in 1929. In addition.2 13.15% 8. increased the cost of capital. during the oil shocks of the 1970s the Phillips Curve broke down.91% 23.1 Unemployment Rate 3. at the height of the Great Depression. one out of every four workers was unemployed! The data suggests that the Great Depression was caused by a shift left in aggregate demand.7 15.S. orchestrated by the Federal Reserve.1 16. the unemployment rate.87% Price Level (CPI) 17. While the stock market crash was not the only cause of the great depression. it does mark the beginning of the depression.Becker CPA Review Business Environment & Concepts 2 The Great Depression and Deflation The Great Depression began with the stock market crash of October 24. Table 1 shows what happened to real GDP.
The budget deficit and the budget surplus are important indicators of the current and future health of an economy.Business Environment & Concepts 2 Becker CPA Review B. B2-22 © 2009 DeVry/Becker Educational Development Corp. Unemployment Rate VI. For example. However. The government could also finance budget deficits by printing new money. BUDGET SURPLUSES A budget surplus occurs when government revenues exceed government spending during the year. inflation tends to be high. fees. 2. All rights reserved. Structural deficits are not caused by temporarily low economic activity. which affects interest rates. B. Financing Budget Deficits Budget deficits are usually financed by government borrowing. ILLUSTRATION OF THE PHILLIPS CURVE The Phillips Curve is illustrated in Graph I. Structural Budget Deficit A structural budget deficit is one that is caused by a structural imbalance between government spending and revenue. inflation tends to be low. financing budget deficits by printing money causes inflation. BUDGET DEFICITS A budget deficit occurs when a country spends more than it takes in (mostly in the form of taxes). . and other means (and for borrowing funds if necessary). Inflation Rate Graph I The Phillips Curve illustrates the tradeoff between inflation and unemployment. and when unemployment is very low. A. 1. BUDGET DEFICITS AND SURPLUSES The budget is the federal government's plan for spending funds and raising revenues through taxation. When unemployment is high. Cyclical Budget Deficit A cyclical budget deficit is caused by temporarily low economic activity. 3. a cyclical budget deficit might be caused by a recession.
Becker CPA Review Business Environment & Concepts 2 VII. Real Interest Rate The real interest rate is defined as the nominal interest rate minus the inflation rate. if real interest rates do not change. after adjusting for the fact that the dollars with which you will repay the loan in the future are worth less than current dollars due to inflation. Nominal Interest Rate The nominal interest rate is the amount of interest paid (or earned) measured in current dollars. Relationship Between Nominal Interest Rates and Inflation Nominal interest rates and inflation tend to move together. INTEREST RATES A. nominal interest rates are not a good measure of how much borrowers really pay or lenders really receive when they take out or make a loan. if you take out a loan with a 10% nominal interest rate and the inflation rate is 3%. 2. That is. All rights reserved. When the economy experiences inflation. so does the nominal interest rate. © 2009 DeVry/Becker Educational Development Corp. It is a measure of the purchasing power of interest earned or paid. B2-23 . a 1% increase in the inflation rate will lead to a 1% increase in nominal interest rates. The relationship between nominal interest rates and inflation may be shown by rearranging the above equation for real interest rates as follows: Nominal Interest Rate = Real Interest Rate + Inflation Thus. then your real interest rate is only 7%. When the inflation rate increases. Real Interest Rate = Nominal Interest Rate – Inflation Rate EXAMPLE For example. NOMINAL AND REAL INTEREST RATES 1. you are really only paying 7% to borrow the money! 3. A more accurate measure of the interest borrowers pay or lenders receive is the real interest rate.
00% 10. M1 and M2 are the most common measures of money supply and are reported (periodically) in financial publications such as the Wall Street Journal. M2 is defined broadly as M1 plus liquid assets that cannot be used as a medium of exchange but that can be converted easily into checkable deposits or other components of M1. and traveler's checks.00% 0. mutual fund accounts. . M3 includes all items in M2 as well as time certificates of deposit in excess of $100. money market deposit accounts at banks. It typically includes coins. currency.00% Inflation Rate 2. There are several definitions of money supply.00% 4. The money supply is defined as the stock of all liquid assets available for transactions in the economy at any given point in time. checkable deposits (accounts that allow holders to write checks against interest-bearing funds within them).00% Interest Rate/Inflation Rate 12. M1 does not typically include savings accounts or certificates of deposit (CDs).000. the nominal interest rate also increases.00% 16. and savings accounts.00% 1955 Nominal Interest Rate 1960 1965 1970 1975 Year 1980 1985 1990 1995 Note the close relationship between nominal interest rates and the inflation rate.Business Environment & Concepts 2 Becker CPA Review Illustration: Nominal Interest Rates and Inflation (Graph J) Nominal Interest Rates and Inflation 20.00% 8. Also note that around 1974/1975 the inflation rate was actually higher than the nominal interest rate implying real interest rates were negative! B. B2-24 © 2009 DeVry/Becker Educational Development Corp. As the inflation rate increases. DEFINITION OF MONEY AND THE MONEY SUPPLY Money is the set of liquid assets that are generally accepted in exchange for goods and services. M1 is defined broadly as money that is used for purchases of goods and services.00% 14.00% 18.00% 6. These include time certificates of deposit less than $100. All rights reserved.000.
Lowering the discount rate encourages borrowing by member banks and increases the money supply. Lowering the reserve requirement increases the money supply. changes in the price level. b. b. it decreases the money supply (i. a.e. Understanding the effects of changes in the money supply is important because changes in the money supply lead to changes in interest rates. © 2009 DeVry/Becker Educational Development Corp.. Raising the reserve requirement decreases the money supply. 3. Open Market Operations (OMO) Open Market Operations (OMO) consist of the purchase and sale of government securities (Treasury Bills and bonds) in the open market. 2. and changes in national output (real GDP). Decrease in the Money Supply When the Fed sells government securities. it becomes more expensive to hold money (because holding money rather than saving or investing it means you do not earn interest). Raising the discount rate discourages borrowing by member banks and decreases the money supply. The demand for money is inversely related to the interest rate—as interest rates rise. D. increase reserves. Member banks may borrow money from the Fed to cover liquidity needs. puts money into circulation to pay for the securities). Increase in the Money Supply When the Fed purchases government securities. it increases the money supply (i. thus reducing the demand for money.Becker CPA Review Business Environment & Concepts 2 C. Changes in the Discount Rate The discount rate is the interest rate the Fed charges member banks for short-term (normally overnight) loans. takes money out of circulation). b. or make investments. All rights reserved. Demand for Money is Inversely Related to Interest Rates Changes in the money supply have a direct effect on interest rates because interest rates are determined by the supply of and demand for money. The demand for money is the relationship between how much money individuals want to hold and the interest rate. c. a. B2-25 . MONETARY POLICY AND THE MONEY SUPPLY Monetary policy is the use of the money supply to stabilize the economy.e. a. INTEREST RATES AND THE SUPPLY OF AND DEMAND FOR MONEY 1. The Federal Reserve uses monetary policy to increase or decrease the money supply in an effort to promote price stability and full employment. Changes in the Required Reserve Ratio (RRR) The Required Reserve Ratio (RRR) is the fraction of total deposits banks must hold in reserve. The Fed controls the money supply through: 1..
real GDP. Increases in desired investment and consumption cause an increase in aggregate demand. and the unemployment rate. The Money Market MS MS1 Interest Rate Equilibrium interest rate.Business Environment & Concepts 2 Becker CPA Review 2. Conversely. shifts in aggregate demand cause changes in the price level. a decrease in the money supply will cause interest rates to rise. EXPANSIONARY MONETARY POLICY (INCREASES IN THE MONEY SUPPLY) Expansionary monetary policy results when the Fed increases the money supply. . 3. 2. © 2009 DeVry/Becker Educational Development Corp. the supply of money is determined by the Federal Reserve and is therefore fixed at any given point in time at the level set by the Federal Reserve. I0 I1 Demand for Money Quantity of Money The Money Market: The equilibrium interest rate is found where the demand for money intersects the supply of money. The intersection of the money demand curve and the money supply line determines the interest rate. Specifically. As we saw earlier. as illustrated by the fall in interest rates from I0 to I1. interest rates will fall. OUTPUT (REAL GDP) AND UNEMPLOYMENT When the Federal Reserve increases or decreases the money supply it has a direct effect on interest rates and an indirect effect on the price level. Graph K An increase in the money supply will cause interest rates to fall. causing real GDP to rise. and the price level to rise. MONETARY POLICY AND ITS EFFECTS ON INTEREST RATES. real GDP. If the Fed increases the money supply. B2-26 An increase in the money supply causes interest rates to fall. VIII. Supply of Money is Fixed at a Given Point in Time As noted above. Falling interest rates reduce the cost of capital and hence stimulate the desired levels of firm investment and household consumption. a. when the Fed changes the money supply. Expansionary monetary policy affects the economy through the following chain of events: 1. Aggregate demand shifts to the right. changes in the interest rate directly affect the cost of capital and thus shift the aggregate demand curve. The money supply curve is vertical since the Federal Reserve controls the supply of money (thus it is independent of the interest rate). Finally. All rights reserved. it causes interest rates to either increase or decrease. A. THE PRICE LEVEL. and the unemployment rate. b. the unemployment rate to fall. 4. Graph K illustrates the demand for and supply of money.
During the recession. In 2001. Alan Greenspan.S. A decrease in the money supply causes interest rates to rise. 3. Specifically. Lower interest rates helped keep the economy from slipping even further into a recession.Becker CPA Review Business Environment & Concepts 2 B. Graph L illustrates the money market and the expansionary monetary policy of the Federal Reserve. the Federal Reserve caused interest rates to fall from I0 to I1. In addition. As the economy began to falter. economy experienced two consecutive quarters of negative real GDP growth implying the economy had slipped into a recession. Aggregate demand shifts to the left. All rights reserved. By increasing the money supply. and the price level to fall. the Federal Reserve began lowering interest rates by increasing the money supply. The 2001 Recession and Monetary Policy After growing steadily for almost a decade. which is below the potential level of output Y1. the U. Lower interest rates spurred new home investments and consumer consumption of durable goods such as automobiles. The recession of 2001 and the actions taken by the Federal Reserve are illustrated in Graphs L and M. Specifically: 1. including zero-percent financing! This helped increase consumer purchases of automobiles and overall demand for goods and services in the economy. 2. lower interest rates made it possible for the auto industry to offer attractive financing rates. indicating a recession.S. Graph L Interest Rate EXAMPLE Graph M Price Level MS0 MS1 LRAS SRAS I0 P1 I1 Money Demand Mo M1 AD0 Quantity of Money Y0 Y1 Real GDP P0 AD1 Graph M illustrates the recession of 2001. the Chairman of the Federal Reserve. Rising interest rates reduce the desired levels of firm investment and household consumption. Specifically. the unemployment rate to rise. the U. lower interest rates led to a large increase in home purchases starting in 2001 and continuing through 2002. Decreases in desired investment and consumption cause a decrease in aggregate demand. output (real GDP) is at Y0. economy started to slow down at the end of 2000. The increased consumption and investment led to a shift right in aggregate demand as depicted in graph M. initiated expansionary monetary policy. 4. The effect of contractionary monetary policy is the exact opposite of expansionary monetary policy. As aggregate demand shifted right. The slowdown in the economy was accompanied by a large drop in stock prices that marked the end of the bull market of the late 1990's. CONTRACTIONARY MONETARY POLICY (DECREASES IN THE MONEY SUPPLY) Contractionary monetary policy results when the Fed decreases the money supply. real GDP began to increase and the economy began to recover from the recession. causing real GDP to fall. B2-27 . © 2009 DeVry/Becker Educational Development Corp.
and the overall company focus on the vision. and are more likely to focus on net income. directed focus on planning for flexible responses for new developments in the market. such as the unification of organizational and operational decisions. opportunities. Generally. Organizations with build missions tend to take a long-term view and are likely to invest in significant capital projects. and immediate return. and corporate culture and will be discussed in detail later in this lecture. however. b. goal-orientation toward the desired company achievements. there are two broad and distinct paths for achieving organizational goals: cost leadership and differentiation. INTRODUCTION The strategic goals of a firm are influenced by the market in which the firm operates. Ultimately. Strategic thinking encompasses a wide variety of issues with various types of benefits. Harvest Missions Harvest missions are for organizations that reap immediate benefits from the organization. identifying the strategy. Organizations with harvest missions tend to have a short-term view. Define the Firm's Vision and Mission Statements Organizational mission statements usually represent one or two line descriptions of what the organization is in business to do. Set the Goals of the Firm Organizations can choose any number of ways to achieve their missions. The ability of a firm to achieve success is a direct result of how well the strategic plan fits the market in which the firm operates and how well the firm carries out its strategic plan. . and objectives of the firm. and threats. 1. Build Missions Build missions are for organizations that accommodate a volume or range of work as a means of accomplishing organizational objectives. mission philosophies fall into one of three basic categories that impact the overall manner in which the organization carries out its business. identifying the critical success factors. Hold Missions Hold missions are for organizations that maintain their current competitive position. STEPS IN STRATEGIC MANAGEMENT (STRATEGIC POSITIONING) Strategic management (positioning) normally involves defining the mission. are less likely to invest in significant capital projects. All rights reserved. c. The firm must create an overall plan (a strategic plan) to assist in combating competition and helping it to develop an approach to achieve its objectives (in line with the firm's vision and mission statement). cash flows. Each path has its own characteristics and implications for operational planning. however. A. B2-28 © 2009 DeVry/Becker Educational Development Corp. weaknesses. budgeting. 2. a.Business Environment & Concepts 2 Becker CPA Review MARKET INFLUENCES ON BUSINESS STRATEGIES I. mission statement. the creation of bases for evaluation. and analyzing those success factors by recognition of strengths.
Internal Business Processes (Non-Financial) Internal business process measures of success generally relate to non-financial measures of efficiency or production effectiveness derived from internal records. and growth in the market value of the organization's stock. b. Factors internal to an organization that impact strategy are the sources of strengths and weaknesses. Customer measures of success include market share data. critical success factors. b. Examples of financial measures include sales or earnings growth. the organization builds clarity regarding the mission. etc. cash flows. c. which may be either financial or non-financial. Non-Financial Objectives Non-financial objectives are the improvement of the overall ability of the firm to compete in the market in the long run. 5. 4. and the impact of internal and external factors on the business. Customer Measures (Non-Financial) Customer measures of success are non-financial measures of organizational effectiveness derived from information provided directly or indirectly by customers or from data derived from responses to customers. which is the ultimate focus for overall shareholder wealth maximization. credit ratings. yields. d. Financial Measures (Financial) Financial measures of success are generally derived from the financial reporting system of the organization or the marketplace. Define the Objectives of the Firm a. education and training. Internal business process measures of success include quality measures. reduction in waste. Decide What to Measure and Take a Baseline Measurement Organizations use various measures of success to determine the achievement of strategic objectives. Strategic Analysis (SWOT) Organizations use strategic or SWOT (Strengths. B2-29 . Financial Objectives Financial objectives are the improvement of the overall financial outcomes of a firm's strategy. All rights reserved. © 2009 DeVry/Becker Educational Development Corp. cycle time computations. innovation in new products and methods. consensus as to strategy. a. Opportunities. etc. etc. Factors external to the organization are the sources of opportunities and threats. Outstanding skills that represent strengths in relation to competitors are referred to as core competencies. and Threats) analysis to ascertain the overall strategy and critical success factors that the organization will measure.Becker CPA Review Business Environment & Concepts 2 3. dividend growth. customer satisfaction data. Weaknesses. These measures are generally referred to as critical success factors. on-time delivery data. As managers review these factors. brand recognition information. Advance Learning and Innovation (Non-Financial) Learning and innovation measures of success are internal measures of effective use of human resources including morale and corporate culture. etc.
Respond to competitive movements and other issues. a strategic plan of a company must create a set of steps to achieve the objectives of the firm while staying in line with the firm's vision and mission statement. b. d. limited career opportunities in low-growth industries and markets will reduce the pool of talent available for management) 7.. c. Strategic Plans Vary Based on Segments Strategic plans may vary for each segment of an organization based on the characteristics of that segment. B2-30 © 2009 DeVry/Becker Educational Development Corp. the overall vision.g. Conduct business operations. Characteristics that will affect strategic planning include: (1) (2) (3) (4) (5) (6) Growth potential as indicated by industry maturity and regulatory constraints Profitability Discretionary cash flow Contribution margins Levels of risk Management talent (e. 8. and Provide a way to address the needs and preferences of its customers. Create the Strategic Plan a. objectives. Focus of the Plan In general. The plan must focus on the ways the company will: (1) (2) (3) (4) b. Achieve/maintain competitive advantage. The levels (from top to bottom) include: a. and Operating level. All rights reserved. The plan should be able to address those areas that will be applicable at all the different levels of the firm so that the plan is executed as a team that shares a common goal. Implement the Strategic Plan In general. . Functional level. mission statement. Corporate level. The plan must provide an environment and a model under which the goals and profitability of the firm can be achieved. and strategy of the firm must be embraced and executed at various levels within the organization.Business Environment & Concepts 2 Becker CPA Review 6. Evaluate and Revise the Plan as Necessary The plan must be evaluated and revised as necessary. Business level.
© 2009 DeVry/Becker Educational Development Corp. C. Regulatory laws. Technology. Three Questions a Firm Should Ask Itself The firm must have an on-going process of attempting to determine three things: a. Do the goals of the firm continue to be aligned with the mission statement and current strategy? Has the firm been able to attain or maintain competitive advantage? Is the firm able to be profitable under the current strategy? Flexibility of the Plan is Necessary The selected strategic plan of the firm must be flexible to adapt to changes in such things as: a. CHOICE OF A BUSINESS MODEL Once a strategic plan is in place. c.Becker CPA Review Business Environment & Concepts 2 B. b. the company will choose a business model concerned with cash flows and profits under which it believes the company will best be able to achieve its strategic plan. THE LAWS OF DEMAND AND SUPPLY Basic principles of microeconomic theory are very important on the CPA Exam. Crisis situations. All rights reserved. Managers are more likely to be successful if they understand how their actions and various governmental policies or collusive actions (e.g. Competition.. A market is simply a collection of buyers and sellers meeting or communicating in order to trade goods or services. Proper Reaction is Essential The firm must have a strategic plan that will allow it to be able to react to the changes in the market in such a way as to still maintain competitive advantage and attain its goals in line with its vision and mission statement. c. For example. Contingency planning will first consider the impact of changes in variables and then document and quantify management's corrective action to deal with those changes. II. 3. cartels) affect their market and firm. b. Sustaining competitive advantage is crucial to the success of a firm. 2. CONTINUAL REVISION AND EVALUATION OF THE PLAN (CONTINGENCY PLANNING) Contingency planning addresses development of alternative plans in the event that adopted plans do not work. or objectives become impractical or irrelevant. and Customer preferences. assumed variables prove to be faulty. e. 1. but understanding the fundamentals is also important to the business manager. d. B2-31 . contingency plans that are part of the strategic plan focus on the ability of the firm to change products or adapt to new markets.
then the "demand point" will change along this demand curve.e. there will be a move up the demand curve. however. a decrease in the price of a good increases a consumer's real income even when nominal income remains constant.Business Environment & Concepts 2 Becker CPA Review A. b. A change in demand cannot be due to a change in price. Changes in quantity demanded are shown by movements along the demand curve (D). However. Fundamental Law of Demand The fundamental law of demand states that the price of a product (or service) and the quantity demanded of that product (or service) are inversely related. Demand Curve The demand curve illustrates the maximum quantity of a good consumers are willing and able to purchase at each and every price (at any given price). if the price of Pepsi-Cola decreases. As the price of the product increases. if the price of a product increases. All rights reserved. B2-32 © 2009 DeVry/Becker Educational Development Corp. as purchasing power or real income increases). For example. illustrate the same kind of relationship. For example. Note that this demand curve is similar to the aggregate demand curve discussed on page B2-6 except that the x-axis here is quantity and not real GDP. c. A change in demand causes a shift in the demand curve. Change in Quantity Demanded A change in quantity demanded is a change in the amount of a good demanded resulting solely from a change in price. Change in Demand A change in demand is a change in the amount of a good demanded resulting from a change in something other than the price of the good. d. For example. Quantity demanded is inversely related to price for two reasons: a. Income Effect The income effect means that as prices are lowered with income remaining constant (i. Definitions a.. all else equal. this demand curve is the microeconomics demand curve for a certain good or product and not the total demand in the economy as a whole. the quantity demanded decreases. . 2. Substitution Effect The substitution effect refers to the fact that consumers tend to purchase more (less) of a good when its price falls (rises) in relation to the price of other goods. When the assumptions regarding price or quantity change. people will purchase more of all of the lower priced products. the consumer can purchase more of all goods. DEMAND 1. The substitution effect exists because people tend to substitute one similar good for another when the price of a good they usually purchase increases. Quantity Demanded Quantity demanded is defined as the quantity of a good (or service) individuals are willing and able to purchase at each and every price (at any given price). it will be used as a substitute for Coca-Cola (a similar good). As a result. b. It does. all else equal.
in the clothing industry. Factors that Shift Demand Curves (Factors Other than Price) Mnemonic: W R I T E N W R a. This is also depicted as the shift from D1 to D2. a revival of the "1960s era" will increase the demand for bell-bottom jeans (retro clothing). demand increases for peripherals such as monitors and laser printers).. d.Becker CPA Review Business Environment & Concepts 2 3. Changes in Wealth For example. now perceived as a bargain. if consumers anticipate that there will be a future price increase. e. an increase in the number of buyers will shift the demand curve to the right. if personal computer prices diminish.g. if the price of a similar good (a substitute good) increases. b. I T E N c. Changes in the Price of Related Goods (substitutes and complements) For example. If the price of a good used in conjunction with the original good (referred to as a complementary good) decreases. Changes in Consumer Expectations For example. Changes in the Number of Buyers Served by the Market For example. people whose wealth increases may increase their demand for luxury cars. an increase in income will shift the demand curve to the right (depicted as the shift from D1 to D2). then the demand for the original good will increase (e. f. the demand curve will shift to the right (increase) for the original good. immediate demand will increase for that product (at the current lower price). Graph A: Change in Quantity Demanded Graph B: Change in Demand D3 D1 D2 An increase in demand Price (in $) A decrease in demand D2 D1 D3 Quantity Price (in $) PX1 PX 2 D D X1 X2 Quantity Changes in price cause movements along the demand curve Shift in demand curve or change in demand caused by external influences (other than the price of the good) © 2009 DeVry/Becker Educational Development Corp. All rights reserved. B2-33 . Changes in Consumer Income For example. Changes in Consumer Tastes or Preferences for a Product For example.
A change in supply cannot be due to a change in price. Definitions The fundamental law of supply states that price and quantity supplied are positively related (i. Market Demand Market demand is the total amount of a good all individuals are willing and able to purchase at each and every price. d. The market demand curve is derived by summing the quantities demanded at each price over all individuals. When price changes.e. The higher the price received for a good. a. Graph C illustrates how the market demand curve is constructed when the market contains just two individuals. c. Supply Curve The supply curve illustrates the maximum quantity of a good sellers are willing and able to produce at each and every price (at any given price). all else equal.Business Environment & Concepts 2 Becker CPA Review 4. Note that this supply curve is similar to the aggregate supply curve discussed on page B2-7 except that the x-axis here is quantity and not real GDP. All rights reserved. Change in Supply A change in supply is a change in the amount of a good supplied resulting from a change in something other than the price of the good. However. move up or down the supply curve to find the new quantity that will be supplied. B2-34 © 2009 DeVry/Becker Educational Development Corp. Graph C Price Price Price P2 P1 P2 P1 P2 P1 4 6 Quantity 3 5 Quantity 7 11 Quantity Individual 1's demand curve Individual 2's demand curve The market demand curve B. b. illustrate the same kind of relationship. all else equal. A change in quantity supplied is represented by a movement along the supply curve. The market demand curve for a good is the sum total of all the individual demand curves and is also downward sloping (demonstrating the inverse relationship between price and quantity demanded). It does. they have a positive correlation).. . Quantity Supplied Quantity supplied is the amount of a good that producers are willing and able to produce at each and every price (at any given price). this supply curve is the microeconomics supply curve for a certain good or product and not the total demand in the economy as a whole. Change in Quantity Supplied A change in quantity supplied is a change in the amount producers are willing and able to produce resulting solely from a change in price. however. all else equal. the more sellers will produce (higher quantity). SUPPLY 1. A change in supply causes a shift in the supply curve.
B2-35 . a decrease in taxes or an increase in subsidies would increase the amount supplied at each price level. d. Changes in Production Technology For example. Changes in Subsidies or Taxes For example. O S T c. if prices are expected to decrease. Graph D: Change in Quantity Supplied Price (in $) S Price (in $) Graph E: Change in Supply S3 S1 S2 A decrease in supply P2 P1 An increase in supply X1 X2 Quantity Shifts in supply caused by external factors (other than price) Quantity Changes in price cause movements along the supply curve © 2009 DeVry/Becker Educational Development Corp. a decrease in the demand for another good supplied by a firm would cause the firm to shift its resources and increase the supply of its remaining goods. Changes in the Price or Demand for Other Goods For example. All rights reserved. e.Becker CPA Review Business Environment & Concepts 2 2. Factors that Shift Supply Curves Mnemonic: ECOST E a. the firm is willing to supply more product. This is represented by the shift in the supply curve from supply curve S1 to supply curve S2. This is represented by the shift in the supply curve from supply curve S1 to supply curve S2. an improvement in technology would cause a shift to the right of the supply curve. Changes in Price Expectations of the Supplying Firm For example. a decrease in wages paid to workers would cause a shift to the right in the supply curve because for the same total amount of production dollars. C b. the firm will supply more now at each price level to take advantage of the currently higher prices. Changes in Production Costs (Price of Inputs) For example.
namely. price (P) is $10 at equilibrium and the quantity supplied (Q) is QE.Business Environment & Concepts 2 Becker CPA Review 3. As illustrated above. 3. Graph G illustrates equilibrium price. 2. and is also upward sloping (demonstrating the positive relationship between price and quantity supplied). All rights reserved. Market Supply Market supply is the total amount of a good all producers are willing and able to produce at each and every price. 1. all else equal. The market's equilibrium price and output (quantity) is the point where the supply and demand curves intersect. Graph F Price Price Price P2 P1 P2 P1 P2 P1 4 10 Quantity 2 5 Quantity 6 15 Quantity Producer 1's supply curve Producer 2's supply curve The market supply curve C. Graph G P D $12 Price (P) 10 9 S Shortage Surplus S for example. minimum wage Equilibrium price ceiling price D QD QS QE a. by summing the quantities supplied at each price over all producers. © 2009 DeVry/Becker Educational Development Corp. MARKET EQUILIBRIUM A market is in equilibrium when there are no forces acting to change the current price/quantity combination. The interaction of demand and supply determines equilibrium price. Graph F illustrates how the market supply curve is constructed when the market contains just two producers. The market supply curve for a good is the sum total of all the individual supply curves. B2-36 . The market supply curve is derived in the same manner as the market demand curve.
Conversely. Changes in Equilibrium If supply and/or demand curves shift. as shown in Graph J. a shift left (decrease) in demand from curve D to curve D1. will result in an increase in price (from P to P1) and a decrease in market clearing quantity (from Q to Q1). If price is set above the equilibrium price. Market clearing quantity is the equilibrium quantity. Graph J Price S S1 Price Graph K S1 S P P1 D P1 P D D1 Q Q1 Quantity Q1 Q Quantity B2-37 © 2009 DeVry/Becker Educational Development Corp. the equilibrium price and quantity will change. will result in a decrease in price (from P to P1) and an increase in market clearing quantity (from Q to Q1). as shown in Graph I.Becker CPA Review Business Environment & Concepts 2 b. as shown in Graph H. the quantity demanded will be less than the quantity supplied. If price is set below the equilibrium price. a. Graph H Price S Price Graph I S P1 P D Q Q1 Quantity D1 P P1 D1 Q1 Q Quantity D b. 4. Effects of a Change in Demand on Equilibrium A shift right (increase) in demand from curve D to curve D1. will result in a decrease in price (from P to P1) and a decrease in market clearing quantity (from Q to Q1). c. Effects of a Change in Supply on Equilibrium A shift right (increase) in supply from curve S to curve S1. a shift left (decrease) in supply from curve S to curve S1. All rights reserved. will result in an increase in price (from P to P1) and an increase in market clearing quantity (from Q to Q1). the quantity demanded will exceed the quantity supplied. and a shortage will result. and a surplus will result. Conversely. assuming that prices are free to change. Market clearing is the idea that the market will "eventually" be cleared of all excess supply and demand (all surpluses and shortages). as shown in Graph K. .
(a) (b) (2) If the increase in demand is larger than the increase in supply. PRICE ELASTICITY OF DEMAND The price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price. A negative price elasticity coefficient results if the demand curve is normal. . 3. the equilibrium price will rise. Conversely. and (c) a decrease in demand and a decrease in supply. General Effects of Changes in Demand and Supply on Equilibrium (1) An increase in demand and supply results in an increase in equilibrium quantity.Business Environment & Concepts 2 Becker CPA Review c. as price goes up (positive percentage change). the effect on equilibrium price is indeterminate because an increase in demand and supply could cause an increase. Change in Supply Increase Decrease Decrease Increase Effect on Equilibrium Price Indeterminate Increase Indeterminate Decrease Effect on Equilibrium Quantity Increase Indeterminate Decrease Indeterminate Change in Demand Increase Increase Decrease Decrease III. However. A. but the effect on price is indeterminate. B2-38 © 2009 DeVry/Becker Educational Development Corp. 2. This negative price elasticity reflects the downward sloping demand curve. All rights reserved. In a normal demand curve. The effect of other complex cases such as (a) a decrease in demand and an increase in supply. the equilibrium price will fall. you should draw supply and demand diagrams for each case to verify the effects listed in the table. It is certain that the effect is an increase of equilibrium quantity (because both an increase in demand and an increase in supply cause quantity to increase). the quantity demanded goes down (negative percentage change). the price elasticity of demand is usually negative. ELASTICITY OF DEMAND AND SUPPLY Elasticity is a measure of how sensitive the demand for or the supply of a product is to a change in its price. To understand them more fully. (b) an increase in demand and a decrease in supply. Table 1 summarizes the effect of all four cases discussed above on equilibrium price and quantity. if the increase in supply is larger than the increase in demand. because it is presumed that price elasticity is negative for a demand curve. decrease. 1. can be analyzed in a similar manner. or no change (if equal changes) in equilibrium price. the absolute elasticity coefficient (positive value) is considered when elasticity problems are posed on the examination. Generally. Measuring the Price Elasticity of Demand The price elasticity of demand can be measured in two ways.
58) (120 − 100) (120 + 100) 4. suppose once again that when the price of a product increases from $100 to $120. in the pharmaceutical industry. Price Inelasticity (Demand < 1.000) (900 + 1.0 (defined as elastic).000 units to 900 units. a. b.1.0. For example.000 (old demand) = (-100) units = (10%) in Quantity 1.000 units to 900 units. the price elasticity of demand would be: ep = (Q2 − Q1 ) (Q2 + Q1 ) (P2 − P1 ) (P2 + P1 ) ep = (900 − 1.0. the price elasticity of demand would be: ep = Price Elasticity of Demand = % change in quantity demanded % change in price % Change = 900 (new demand) . The Point Method The point elasticity of demand measures the price elasticity of demand at a particular point on the demand curve.5 (Absolute Value = .5) 20 b. quantity demanded decreases from 1.0) Demand for a good is price inelastic if the absolute price elasticity of demand is less than 1. depicting that the quantity demanded stays the same no matter how price changes (e. 5.0) Demand is price elastic if the absolute price elasticity of demand is greater than 1. suppose that when the price of a product increases from $100 to $120. If price inelasticity is zero. demand is perfectly inelastic.$100 (old price) = $20 = $1 = 20% in Price $100 (old price) $100 $5 ep = Price Elasticity of Demand = (10) . The smaller the number after the minus sign. the greater the number..Becker CPA Review Business Environment & Concepts 2 a. Price Elasticity (Demand > 1. the more inelastic the demand for the good. Using the point elasticity method. © 2009 DeVry/Becker Educational Development Corp. The calculation above with a 0. Using the midpoint method. B2-39 .000 units Divided by: % Change = $120 (new price) . The Midpoint Method The midpoint method measures the price elasticity of demand between any two points on the demand curve.000) = −. When the value is greater than 1. For example.58 (Absolute Value = .g. the demand for insulin by diabetics). Note also that perfectly inelastic demand curves are vertical. or = -. All rights reserved. quantity demanded decreases from 1.5 value is an example of inelastic demand. the more elastic the demand.000 (old demand) 1.
0.Business Environment & Concepts 2 Becker CPA Review 6. a change in price will have no effect on total revenue. Price Elasticity of Demand Elastic Inelastic Unit Elastic Implied Elasticity Greater than 1 Less than 1 Equal to 1 Impact of a Price Increase on Total Revenue Total revenue decreases Total revenue increases Total revenue is unchanged Impact of a Price Decrease on Total Revenue Total revenue increases Total revenue decreases Total revenue is unchanged B2-40 © 2009 DeVry/Becker Educational Development Corp. an increase in price will result in a decrease in total revenue (negative relationship). Product demand is more elastic with more substitutes available but is inelastic if few substitutes are available. Unit Elasticity (Demand = 1. total revenue (equal to price times quantity) will decrease. an increase in price results in a decrease in quantity demanded that is proportionally smaller than the increase in price. b. the more product demand becomes elastic because more choices are available. Effects of Price Inelasticity on Total Revenue (Positive Relationship) If demand is price inelastic. As a result. As a result. c. total revenue (equal to price times quantity) will increase. Demand is unit elastic if the percentage change in the quantity demanded caused by a price change equals the percentage change in price. Effects of Price Elasticity on Total Revenue (Negative Relationship) If demand is price elastic. 7. we can determine how a change in price will affect a firm's total revenue. The longer the time period. All rights reserved. a. Effects of Unit Elasticity on Revenue (No Effect) If demand is unit elastic.0) Demand is unit elastic if the absolute price elasticity of demand is equal to exactly 1. When demand is price elastic. Total revenue is simply the price of a good multiplied by the quantity of the good sold. an increase in price will result in an increase in total revenue (positive relationship). and a decrease in price will result in a decrease in total revenue. Factors Affecting Price Elasticity of Demand a. b. Price Elasticity Effects on Total Revenue If we know the price elasticity of demand for a good. an increase in price results in a decrease in quantity demanded that is proportionally larger than the increase in price. When demand is price inelastic. d. Summary The table below summarizes the relationship between the price elasticity of demand and total revenue. 8. . and a decrease in price will result in an increase in total revenue.
PRICE ELASTICITY OF SUPPLY The price elasticity of supply is calculated the same way as the price elasticity of demand. 1. 3. the price elasticity of supply equals zero. C. Formula for Price Elasticity of Supply es = Price Elasticity of Supply = % change in quantity supplied % change in price % Change = 600 (new supply) . it may result in high elasticity if the product can be stored and does not have to be bought today.0) Supply is price inelastic if the absolute price elasticity of supply is less than 1.$10 (old price) = 1 = 10% in Price $10 (old price) 10 es = Price Elasticity of Supply = 2.0) Supply is unit elastic if the absolute price elasticity of supply is equal to 1. Unit Elasticity (Supply = 1. 5. except that the change in quantity supplied is now measured. Price Inelasticity (Supply < 1. Feasibility of customers storing the product will affect the price elasticity of supply. Factors Affecting Price Elasticity of Supply a.0) Supply is price elastic if the absolute price elasticity of supply is greater than 1. The time it takes to produce and supply the good will affect the price elasticity of supply. If supply is perfectly inelastic.0. Perfectly inelastic supply curves are vertical. CROSS ELASTICITY Cross elasticity of demand (or supply) is the percentage change in the quantity demanded (or supplied) of one good caused by the price change of another good. 4. Price Elasticity (Supply > 1.0. Ce = Cross Elasticity of Demand/Supply = % change in number of units of X demanded (supplied) % change in price of Y © 2009 DeVry/Becker Educational Development Corp. 20% =2 10% b.0. longer production time leads to lower price elasticities. which reflects that quantity supplied is insensitive to price changes.Becker CPA Review Business Environment & Concepts 2 B. All rights reserved. For example. B2-41 . For example.500 (old supply) = 100 = 20% in Quantity 500 (old supply) 500 Divided by: % Change = $11 (new price) .
PRICE CEILINGS A price ceiling is a price that is established below the equilibrium price. Negative Income Elasticity If the income elasticity of demand is negative (e. there will be a market shortage..g. This is most often accomplished by using price ceilings and price floors. but only QS will be supplied.g. Price ceilings cause prices to be artificially low. . IV. the government will intervene in a market by mandating a price different from the "market price" (causing either a surplus or a shortage).g.. All rights reserved. equilibrium) will be demanded. price cannot go above this amount) for a good (e. if the government sets a ceiling price (i. the good is an inferior good. 2.g. A. the good is a normal good. B2-42 © 2009 DeVry/Becker Educational Development Corp.e.. premium foods such as steak and lobster). If the coefficient is zero.Business Environment & Concepts 2 Becker CPA Review 1..g. A normal good is a product whose demand is positively related to income.. An inferior good is a product whose demand is inversely related to income (opposite of normal good).. the two goods are substitutes (people stop buying the higher priced goods and begin to buy the substitute). Complement Goods: Negative Coefficient If the coefficient is negative (i. INCOME ELASTICITY OF DEMAND The income elasticity of demand measures the percentage change in quantity demanded for a product for a given percentage change in income. the goods are unrelated. D. causing the demand for Product B to go up). demand decreases as income increases). an increase in the price of Product A results in a decrease in quantity demanded for Product B). demand for inferior goods decreases (e. As income goes up.e. then QD (in Graph G from page B236.e.. the commodities are complements. GOVERNMENT INTERVENTION IN MARKET OPERATIONS Sometimes. 2. $9). Hence. demand increases as income increases). 3.. Positive Income Elasticity If the income elasticity of demand is positive (e. the price of Product A goes up. As income goes up. Substitute Goods: Positive Coefficient If the coefficient is positive (i. which causes shortages to develop. demand for normal goods increases (e. Ie = Income Elasticity of Demand = % change in number of units of X demanded % change in income 1. canned vegetables or hamburger). For example. creating a greater demand than the supply available.
Economic Costs Economic costs are accounting (explicit) costs plus opportunity (implicit) costs. 2.. a market surplus will result. which represents the value of the next best alternative foregone (or not chosen). but economists view these as added costs to the organization. ECONOMIC PROFIT VS. B. PRICE FLOORS A price floor is a minimum price set above the equilibrium price.Becker CPA Review Business Environment & Concepts 2 B. b. All rights reserved. purchases of input services)..e. 1.. Price floors are minimum prices established by law. Accounting costs do not consider opportunity costs. Explicit Costs Explicit costs are documented out-of-pocket expenses (e. capital costs (interest). PROFIT A. a minimum wage set at $12). ACCOUNTING PROFIT Accounting profit equals the difference between total revenue and total accounting costs.. labor costs (wages). capital. Accounting Costs Accounting costs measure the explicit costs of operating a business (e. such as minimum wages and agricultural price supports.g.g.e. wages. ECONOMIC PROFIT Economic profit equals the difference between total revenue and total economic costs. a. Implicit Costs (Includes Opportunity Costs) Implicit costs are opportunity costs of inputs supplied by the owners (entrepreneurship. Opportunity cost is usually considered to be the profits that are lost from business because one strategy is pursued instead of another. Accounting profit is generally higher than economic profit because economic profit takes into account both explicit and implicit (opportunity) costs. no expense to the company). materials.). accountants treat entrepreneurial costs (e. and entrepreneurial costs. B. VI. TYPES OF COSTS 1.. © 2009 DeVry/Becker Educational Development Corp. COST CONCEPTS The two major concepts of costs to economists are accounting costs and economic costs. which include opportunity costs. ECONOMIC COSTS A. For example. 2. The most common economic costs are land costs (rent). which causes surpluses to develop. if the government sets a price floor (i.g. For example. A key point in economics is opportunity cost. B2-43 .. the value of a sole proprietor's time) as profits (i. equity.g. prices cannot go below this amount) for a good (e. etc. and utilities). V.
causes output to increase at a decreasing rate. land. PRODUCTION COSTS IN THE SHORT RUN Economists differentiate between the short run and the long run. entrepreneurial talent. adding additional workers to the production process. Fixed costs are the cost of acquiring the fixed resources used in production (one example is depreciation). For example. For example. all costs have the opportunity to change. PRODUCTION CONCEPTS The three main production concepts are: 1. The long run is a period of time in which all of the inputs used for production are variable. the marginal product of labor (L) is: MPL = ΔTP ΔL 3. all costs are variable. . they are dependent upon the level of production. while holding the amount of other inputs constant. output increases but at a diminishing rate. the short-run total cost structure of a firm consists of fixed costs and variable costs: 1. D. in the long run. C. PRODUCTION FUNCTION A firm's production function refers to the relationship between the firm's input of productive resources (the mnemonic "CELL": capital. Variable costs are the costs of acquiring the variable resources (such as labor). In the long run. some of the economic costs are fixed because the inputs are fixed. and labor) and its output of goods and services. FIXED AND VARIABLE COSTS Because some resources are fixed and others are variable in the short run. Total Product Total product (TP) equals the total amount of output (Q) produced. Average Product Average product (AP) equals the total product divided by the quantity of an input.unit increase in the quantity of an input employed. even capital costs. In the short run. For example. when more and more units of a input are combined with a fixed amount of other inputs. Thus. Fixed costs do not change during the production period. B. LAW OF DIMINISHING RETURNS One of the main economic concepts that governs production is the law of diminishing returns which states that. A. they are independent of the level of production. the average product of labor (L) is APL = TP / L. All rights reserved. Marginal Product Marginal product (MP) equals the change in total product resulting from a one. B2-44 © 2009 DeVry/Becker Educational Development Corp. 2.Business Environment & Concepts 2 Becker CPA Review VII. 2. The short run is a period of time in which some of the inputs used for production are fixed.
ATC = TC / Q 4. Marginal cost (MC). or incremental cost.Becker CPA Review Business Environment & Concepts 2 E. equals the change in total cost. Marginal Cost (MC) Marginal cost (incremental cost) is the change in total cost associated with a change in output quantity over a period of time. the marginal cost of the 10th unit is the total cost of producing 10 units less the total cost of producing 9 units (the difference between the total cost of each). AFC = FC / Q 2. Average Total Cost (ATC) Average total cost (ATC). Average Fixed Cost (AFC) Average fixed cost (AFC) equals total fixed costs (FC) divided by quantity (Q). COST FUNCTIONS The four major cost functions are: 1. AVC = VC / Q 3. Fixed costs do not influence marginal costs. Average Variable Cost (AVC) Average variable cost (AVC) equals total variable cost (VC) divided by quantity. or unit cost. MC = ΔTC ΔQ a. F. equals total (fixed plus variable) costs (TC) divided by quantity. resulting from a one-unit increase in quantity. b. For example. B2-45 . All rights reserved. ILLUSTRATION AND ANALYSIS OF SHORT-RUN COST CURVES Graph L Costs (dollars) MC ATC AVC Short-Run Cost Curves AFC Output (quantity) © 2009 DeVry/Becker Educational Development Corp. Marginal cost depends solely on variable costs.
D. In the long run. In the long run. Thus. 4. and diseconomies of scale will result (see Graph M). 2. all resource inputs are variable. economies of scale will cause the long-run average total cost curve (LRATC) to decline within the range of production. VIII. ATC is the sum of AFC and AVC. 3. The average fixed cost curve (AFC) decreases continually over the range of quantity produced (as output increases). Therefore. marginal costs and average costs start to increase causing average total costs to rise. Economies of scale will eventually be lost. the optimal size or number of plants is at the minimum point of the LRAC curve. average total costs are high because average fixed costs are high. Economies of scale are reductions in unit costs resulting from increased size of operations. At low levels of output. C. The short run supply curve is the marginal cost (MC) curve above the minimum point of its average variable cost curve (AVC). B. The average total cost (ATC) curve is U-shaped. As output increases. the vertical distance between the AVC curve and the ATC curve is equal to AFC.Business Environment & Concepts 2 Becker CPA Review 1. ECONOMIES OF SCALE Companies that are able to reduce per unit costs by using large plants to produce large amounts of output are said to have economies of scale. average fixed costs fall and thus average total costs fall. Factors enabling economies of scale (increases in the productivity of inputs) include: B2-46 © 2009 DeVry/Becker Educational Development Corp. To be in position to produce at the lowest possible cost means adjusting the scale of production by adjusting plant size or numbers of plants. All rights reserved. LONG-RUN COST GRAPH Graph M illustrates the long-run average total cost (LRATC) curve and the long-run marginal cost (LRMC) curves. as output continues to increase. . 5. The marginal cost curve (MC) intersects the AVC and ATC curves at their minimum points. Graph M Long-Run Costs Economies of Scale Diseconomies of Scale LRMC LRATC Quantity of Output E. However. Generally the long-run average total cost (LRATC) curve is U-shaped. PRODUCTION COSTS IN THE LONG RUN A.
Marginal Cost (MC) is the cost of producing one additional unit. All rights reserved. Average Revenue (AR) is Total Revenue (TR) divided by Total Output. the firm will continue adding units to production until it becomes unprofitable to do so (MR − MC = 0). In other words. diseconomies of scale can also cause workers to feel disassociated from the firm with a resulting lack of motivation. goods and services are produced at the lowest cost to the consumer in the long run). nor shift the market supply sufficiently to make a good more scarce or abundant. © 2009 DeVry/Becker Educational Development Corp. MARKET STRUCTURES AND PRICING Operating environments influence the strategic plan. Maximizing Short-Run Profits (MR = MC = P) It is assumed that the objective of any business is to maximize its profits. Factors causing diseconomies of scale include: 1. A large number of suppliers and customers acting independently. Following is a brief discussion of the overall market structures in which firms may operate. Marginal Revenue (MR) is the additional revenue brought in by producing one additional unit of output. For example. Therefore. No barriers to entry because firms exert no influence over the market or price (thus. competitive firms must produce at the output rate where Price = Marginal Revenue = Marginal Cost (or P = MR = MC). In a perfectly competitive market. c. To do this. the condition for maximizing profit is: MR=MC. no individual firm can influence the market price of its product. 3. 2. A. 2. b.Becker CPA Review Business Environment & Concepts 2 1. Diseconomies of scale are increases in average costs of operations resulting from problems in managing large-scale enterprises. Attributes of perfect competition include: a. strategic plans may include maintaining the market share and responsiveness of the sales price to market conditions. B2-47 . Bottlenecks and costs of transporting materials Difficulty of supervising and managing a large bureaucracy (reasons for diseconomies of scale for the firm result almost entirely from the inefficient performance of the management function) IX. A profitmaximizing firm will continue adding units to production until the cost of producing one more unit is greater than the revenue that unit will generate. Opportunity for specialization Utilization of advanced technology Mass production is normally more efficient DISECONOMIES OF SCALE Diseconomies of scale may occur when these large firms become inefficient and are no longer cost productive. F. This is illustrated in Graphs N and O below. Introduction Under perfect competition. To maximize short-run profits. a firm must find that price-quantity combination that will produce the largest spread between its revenues and its costs. Very little product differentiation (homogeneous products). PERFECT (PURE) COMPETITION 1. 2.
Firms are Price Takers Note that although the industry (market) demand curve slopes down.. P > AVC) because it will still cover all of its variable costs and some of its fixed costs. If price is less than ATC at the profit maximizing level of output (i. b. B2-48 © 2009 DeVry/Becker Educational Development Corp. 6. economic profits will be negative (i. under conditions of perfect competition. Advantages Derived from Perfect Competition a. 4. thus. (In a monopolistic market. the firm should continue to operate in the short run as long as price is greater than average variable costs (i. thus. Operating at a Loss (P > AVC) In the short run.. As illustrated in Graph O. In the long run. P = MC = Minimum ATC).e. utility is maximized. The entry and exit of new firms ensures that economic profits are zero in the long run and." discussed below. the monopoly firm sets prices and is a "price setter. All rights reserved. where MR = MC). If abnormal profits exist. Q1 is the profit-maximizing level of output of an individual firm.e. firms may operate at a loss. thus. Because the price of an individual firm's output is the same regardless of how much it produces. the firm is a "price taker" (i. However. .e.e. each firm has a horizontal demand curve at the equilibrium price for the industry.. that firms earn a normal rate of return.e. cannot change the price itself). The market maintains a lower price and larger quantity than in any other market structure.. economic profits are zero because firms produce where price equals minimum average total cost.Business Environment & Concepts 2 Becker CPA Review The Profit Maximizing Price and Output for a Firm Operating in a Perfectly Competitive Market Environment Graph N The Whole Industry $/Unit S $/Unit P=MC=MR Graph O One Firm MC ATC P=MR Total Profit P P ATC D Q Quantity of Output Q1 Quantity of Output P is the price at which all firms in the industry sell their product in the short run and Q is industry output. Long-Run Profits with Perfect Competition The long-run equilibrium position for a competitive firm is where price equals marginal cost equals minimum average total cost (i. which equals average revenue (P = MR = AR). Each buyer that is willing to pay the market price will get as many units as the buyer desires. price equals marginal revenue. the firm’s total profit in the short-run is given by the shaded area.) 5. the firm incurs economic losses). new competitors enter and drive the price down.. 3.
2. MONOPOLY Under a monopoly.g. All rights reserved. b.. Since the firm produces where MR = MC. © 2009 DeVry/Becker Educational Development Corp. it produces at a lower output and higher price than the competitive firms and earns above-normal profits.g. strategic plans will likely ignore market share and focus on profitability from production levels that maximize profits. Assumptions and Market Characteristics of Monopoly a. A single firm with a unique product Significant barriers to market entry The ability of the firm to set output and prices (e. the firm's demand curve coincides with the industry demand curve for the product (because the firm and the industry are the same). Monopoly (e. d. the firm will maximize profits where marginal revenue equals marginal cost. Higher prices are charged for supplying less of the product.Becker CPA Review Business Environment & Concepts 2 B. the monopolist's price will be higher than marginal revenue. which was a "regulated" monopoly) represents concentration of supply in the hands of a single firm. P Graph P Profit Maximizing Price and Output of a Monopolist MC Monopoly Profit P1 ATC ATC Firm Demand = Industry Demand MR=MC Q1 MR Q MR = MC and P > MR (and MC) In pure monopoly. through patents or regulatory restrictions against competition) No substitute products (the firm's demand curve is the same as the industry's demand curve) Firm is a Price Setter Monopolies are "price setters. however." as opposed to firms in perfect competition (which are "price takers"). B2-49 . In a monopoly. c.. 1. the classic utility company.
d. If price is less than ATC at the profit maximizing level of output (i. firms may operate at an economic loss.Business Environment & Concepts 2 Becker CPA Review 3. and therefore.g. Natural Monopoly A natural monopoly exists when economic and technical conditions permit only one efficient supplier. Inefficiency of Monopoly Monopolists produce at a point where price is greater than marginal cost.e. Little Market Control by the Firm Because many firms compete in this scenario. If the situation does not change in the long run. competition to increase brand awareness and loyalty) Brand Loyalty Instead of reducing prices. soft drinks. the firms spend money to create brand loyalty (e.). 5. 1. B2-50 © 2009 DeVry/Becker Educational Development Corp. Thus.e. no one firm will be able to affect the prices charged by the other firms. etc. Numerous firms with differentiated products Few barriers to entry The ability of firms to exert some influence over the price and market Significant non-price competition in the market (e... Monopolistic competition exists when many sellers compete to sell a differentiated product in a market into which the entry of new sellers is possible (e. the economic consequence of monopoly is that less output is produced than is socially optimal. . a monopolist that operates at an economic loss will shut down. the quantity produced by a monopolist is below the socially efficient level. C. Assumptions and Market Conditions a.. 4.. product research. All rights reserved. aspirin. economic profits will be negative (i. MONOPOLISTIC COMPETITION Under monopolistic competition. 3. brand name cosmetic products). the firm incurs economic losses). there is little market control by each firm. c. Operating at a Loss In the short run. etc. monopolies are inefficient because they produce a deadweight loss to society. strategic plans may include maintaining the market share (as with pure competition) but will also likely include a plan for enhanced product differentiation and extensive allocation of resources to advertising..g.g. marketing. As a result. where MR = MC). 2. In that sense. b.
The long run equilibrium position for a monopolistically competitive firm is. Graph Q Profit Maximization Price MC ATC P ATC AVC MR Q1 Demand Quantity of Output 5..Becker CPA Review Business Environment & Concepts 2 4. In Graph Q. in the long run. the "Big Three" automotive manufacturers) dominate the sales of a product and entry of new sellers is difficult or impossible.. strategic plans focus on market share and call for the proper amount of advertising (to ensure appropriate product differentiation) and ways to properly adapt to price changes or required changes in production volume. The firm maximizes profits by producing the level of output that equates marginal revenue and marginal cost (i. more firms will enter and drive profits down to zero. firms will exit and drive profits up to zero. Zero Economic Profit in the Long Run Economic profit equals the difference between total revenue and total economic costs. the firm earns an economic profit illustrated as the shaded area. Relatively few firms with differentiated products Fairly significant barriers to entry (e. If firm profits are negative in the short run. Maximize Profits Where MR = MC The following graph illustrates the profit maximizing output level and price of a monopolistically competitive firm.e. Assumptions and Market Conditions a. to produce where MR = MC and P = ATC. D. All rights reserved. Because the firm sells a differentiated product. b. it faces a downward sloping demand curve (similar to a monopolist). OLIGOPOLY Under oligopoly.. B2-51 . An oligopoly is a market structure in which a few sellers (e.g. If profits are positive in the short run. which include opportunity costs. produce where MR = MC). monopolistically competitive firms will earn zero economic profits. c. therefore. 1. high capital cost of designing a safety tested car and building an auto plant) Strongly interdependent firms (prices tend to be fixed) © 2009 DeVry/Becker Educational Development Corp. Because there are few barriers to entry under monopolistic competition.g.
D΄ D Q4 Q5 Q1 Q3 Q2 Quantity of output per period of time The matching of price cuts and the ignoring of price increases by rival firms has the effect of making an oligopolist's demand curve highly elastic above the ruling (prevailing) price. Firms would be foolish to engage in price cutting because rivals merely match the price reduction (e. B2-52 © 2009 DeVry/Becker Educational Development Corp. the firm will operate best when marginal revenue equals marginal cost (MR = MC). b.Business Environment & Concepts 2 Becker CPA Review 2. rival firms will match the reduction. and oligopoly. rival firms will ignore the increase. Illustration of Kinked Demand Curve a. Graph R illustrates the effects of price adjustment by an oligopolist.g. D΄ $ P3 P1 P2 D If price is cut. . 2. E. Microeconomic theory holds that firms make decisions based upon marginal cost and marginal revenue (essentially ignoring fixed or sunk costs). Oligopolists face a kinked demand curve because firms match price cuts of competitors but ignore price increases. the airline industry). The following table summarizes the market assumptions and conditions underlying perfect competition. This causes the demand curves to have different slopes above and below the prevailing price.. MARKET ASSUMPTIONS AND CONDITIONS 1. illustrating that there is not a direct relationship between price and quantity at all points on the demand curve. monopolistic competition. This causes the demand curve to be kinked. All rights reserved. Graph R An Oligopolist's Kinked Demand Curve If price is raised above the prevailing level. monopoly. A kink in the demand-AR curve appears at the prevailing price. 3. Regardless of the model that represents the industry. and the firm will lose a large portion of its sales. thereby limiting the potential gain in sales.
can only adjust production so that P = MR = MC Zero economic profit Monopolistic Competition Many (Highly competitive) Small Oligopoly Few (Moderately competitive) Large High (Difficult to enter industry because of Economies of Scale) Various (Firms usually sell differentiated products) Inelastic (Firms face a kinked downward-sloping demand curve) Monopoly One (No competition) 100% of industry Insurmountable (No entry is possible) None (One firm sells only one product) Inelastic (Firm faces the entire demand curve for the product. or as little. price is set by the market. © 2009 DeVry/Becker Educational Development Corp. B2-53 . as it wants at the given market price) Firm has control over quantity produced only. price is mostly set by the market Searches for best price to maximize profits P > MR = MC in the short run Zero economic profit Differentiation of product Elasticity of demand Firm's control over price and quantity Firm has control over both the quantity produced and the price charged Firm has control over both price and quantity Searches for optimum price P > MR = MC in the short and the long run Positive economic profit Pricing strategy Does not like to engage in price competition P > MR = MC Positive economic profit Long-run profitability F. OPEC and the Central Selling Organization of De Beers).Becker CPA Review Business Environment & Concepts 2 Market Structure Characteristic Number of firms in the industry Size of firms relative to industry Perfect Competition Many (Highly competitive) Small None (Easy to enter industry) None (All firms sell the same commodity product) Perfectly elastic (Firm sells as much. Cartels Cartels are groups of firms acting together to coordinate output decisions and control prices as if they were a single monopoly (i. All rights reserved. The likely effect of a cartel is to increase price and reduce output below the socially efficient level.e. which slopes downward) Barriers to entry Low (Easy to enter industry) Some (Firms sell slightly different products that are close substitutes) Highly elastic but downward sloping (Firm can adjust quantity of products sold without affecting the price very much) Firm has control mostly over quantity produced. EFFECTS OF BOYCOTTS AND CARTELS ON PRICING AND OUTPUT 1.. firm must accept the market price Accepts market price.
b. Derived Demand Derived demand is the demand for factors of production. (Recall that marginal product (MP) is the change in total product resulting from a one-unit change in an input). if the marginal product of an input increases. the firms output) and the marginal product of the input itself. Boycotts Boycotts are organized group refusals to conduct market transactions with a target group (using only social pressure. a.e. . The primary resources from which final products are made consist of land (natural resources). Demand for Inputs Depends on Demand for Outputs The demand for any input depends on the demand for the product the input produces (i. Factors of production are bought and sold in markets just like final goods and services are bought and sold in markets. the demand for that input will also increase. X. labor (human capital). The price firms must pay for the factors of production is determined by the interaction of supply and demand in the input market. PRODUCTION AND DEMAND FOR ECONOMIC RESOURCES 1. Complementary Inputs Inputs are complementary inputs if an increase in the usage of one input results in an increase in the usage of the other input. 2. To maximize profits. and capital (non-human physical capital accumulated through past investment). B2-54 © 2009 DeVry/Becker Educational Development Corp. The effectiveness of a boycott is measured as the achieved change in the target's disputed policies (normally price). (1) (2) If the demand for a firm's output increases. THE ECONOMY AS A SYSTEM OF MARKETS A. the demand for inputs is directly related to the demand for the goods and services those inputs produce. These resources are known as factors of production. A firm's demand for inputs is derived from its decision to produce a good or service. Therefore. a. Results indicate that a boycott will be most effective when economic and image pressure on the target are high and the target's policy commitment (how firm the company is on not changing its mind) is low. Factors of Production (Resources) Businesses use resources to make final products. b. Types of Inputs a.Business Environment & Concepts 2 Becker CPA Review 2. Substitute Inputs Inputs are substitute inputs if an increase in the usage of one input results in a decrease in the usage of the other input. not legal obligation).. firms need to decide on the optimal levels of inputs to employ. Similarly. 3. the demand for the inputs used to produce that output will also increase. All rights reserved.
in the labor market. the greater the quantity of labor service demanded by employers. Relative to purely competitive labor market. Just like in any other market. For example. that firm is known as a monopsonist. If the demand for medical services increases. THE LABOR MARKET In modern economies. © 2009 DeVry/Becker Educational Development Corp. Thus. monopsony results in lower wages and lower levels of employment. wages are the price paid for labor. if a town contains a single firm. where workers independently offer skills of a given quality to employers who compete for the workers' services. The equilibrium wage is found where the demand curve for labor intersects the supply curve for labor. B2-55 . Examples (1) (2) The demand for labor is directly related to the demand for the goods and services that labor produces. 1. The lower the wage. workers sell their services to employers in labor markets. the derived demand for doctors. or wage. Illustration Graph S illustrates equilibrium in the labor market. Labor Demand and Supply Under Monopsony A monopsony occurs when there is only one employer in a market. The equilibrium wage depends on the supply of and demand for labor.Becker CPA Review Business Environment & Concepts 2 b. Much like a monopolist has market power in the product market. All rights reserved. B. The laws of demand and supply prevail in labor markets as they do in product markets. of workers. and medical equipment will also increase. Graph S The Labor Market Wage Supply of Labor w1 Demand for Labor L1 Hours per Year 2. nurses. the supply of labor and demand for labor determines the price. a monopsonist has market power in the input (labor) market.
The union may use its market power to bargain collectively for higher wages or restrict the supply of labor. the minimum wage causes unemployment. they may fall in the sector that is not unionized. Graph T Minimum Wages Wage Supply of Labor wmin w1 Minimum Wage Demand for Labor LD L1 min LS Hours per Year When the minimum wage is set at w . As a result. one unionized and the other not. 4. Effect on Unionized Workers By forming a union and acting collectively. the result is unemployment. . The effect of a minimum wage is illustrated in Graph T. or an excess supply of labor. of (Ls – LD). while wages rise in the unionized sector. workers gain market power much in the same way that a monopoly or cartel has market power. As a result. Effect on Non-Unionized Workers Unions may also affect the wages of non-unionized workers. wages in the nonunion sector may fall as the supply of labor in that sector increases. Because employment falls in the unionized sector. If the minimum wage is set above the equilibrium wage. wages of unionized workers increase. In other words. B2-56 © 2009 DeVry/Becker Educational Development Corp. Thus.Business Environment & Concepts 2 Becker CPA Review 3. As a result. b. Suppose there are two sectors in an economy. an excess supply of labor will result. As a result. Unions and Wages a. Minimum Wage Laws The use of minimum wage laws to increase the wages of low skilled labor is controversial. the quantity of labor demanded decreases from L1 to LD and the quantity of labor supplied increases from L1 to LS. if the minimum wage is above the equilibrium wage. displaced workers may seek employment in the nonunion sector. the imposition of a minimum wage increases the income of those workers who have a job. All rights reserved. but it decreases the income of workers who find themselves unemployed as a result of the imposition of the minimum wage.
long look at what drives the consumers in the marketplace. B. incremental analysis of relevant costs associated with changing the manner in which the identified activity in the value chain is accomplished can be performed. XII. Relationship between strategic planning activities: Strategic Positioning Value Chain Analysis Balanced Scorecard* * Balanced Scorecard is discussed in Chapter B5. Weaknesses. It also means that they need to take a good. value chain analysis is invaluable in assessing the ability of the firm to attain competitive advantage.Becker CPA Review Business Environment & Concepts 2 XI. VALUE CHAIN ANALYSIS Companies strive to attain competitive advantage in a variety of means. LINK VALUE CHAIN ANALYSIS TO STRATEGY Value chain analysis must be used in conjunction with the organizational objectives and goals as well as the strategic plan that the firm employs so that competitive advantage can be assessed. REQUIRED READING AT APPENDIX I As a supplement to the material above. TWO GENERAL TYPES OF FACTORS THAT INFLUENCE STRATEGY Firms use SWOT (Strengths. FACTORS THAT INFLUENCE STRATEGY When determining the effects of the market on business strategy. please read the expanded discussion of Value Chain Analysis at Appendix I. © 2009 DeVry/Becker Educational Development Corp. All rights reserved. Opportunities. A. C. Once costs have been analyzed relative to each activity. The firm will go through exercises to assess how its activities create value in the marketplace. A. Once the firm is aware of how its product is perceived. Managers must determine the flow of activities undertaken by the organization to produce a service or product and critique the value added to the customer by each link in the value chain. B2-57 . and this does not only include doing all they can to match or beat what their competitors do. a look at the overall macroenvironment in which the firm operates is essential because it can significantly assist the company in developing and choosing the best strategy to meet its goals. Firms desiring to achieve competitive advantage must focus on the needs and preferences of the buyers and then either meet or exceed their expectations. STRATEGIC TOOL Value chain analysis is a strategic tool that assists a firm in determining how important its perceived value (perceived by the buyers) is with respect to the market the firm operates in. Any strategy must consider these factors in its development. and Threats) analysis to assist in developing their appropriate strategic plans. Reduced cost or improved innovation can result.
The economy Regulations and laws Demographics of the population Technological advances and existing technology Social values Political issues Factors that Affect the Competitive Environment of the Firm A detailed discussion of the following five factors that affect the competitive environment of the firm is provided in item B. All rights reserved. (1) (2) (3) (4) (5) Barriers to market entry Market competitiveness Existence of substitute products Bargaining power of the customers Bargaining power of the suppliers B2-58 © 2009 DeVry/Becker Educational Development Corp. d. Internal Factors (Strengths and Weaknesses) Factors internal to the organization that impact strategy are sources of strengths and weaknesses and include: a.Business Environment & Concepts 2 Becker CPA Review 1. b. e. External Factors (Opportunities and Threats) Factors external to the organization are sources of opportunities in the market and threats to the firm's ability to continue with its strategic plan. a. g. f. Innovation of product lines Competence of management Core competencies (outstanding skills that are better than those of the competitors) Influence of high-level managers Capital improvements Leadership in research and development Cohesiveness of the values of the organization Marketing effectiveness Effectiveness of communication Clarity of the strategic mission 2. j. below. i. c. h. . Factors that Affect the Overall Industry and Competitive Environment of the Industry (1) (2) (3) (4) (5) (6) b.
Barriers to entry are the various "hoops" and other obstacles that firms must combat. consumer desires for improved quality and service. a. potential high profits exist in the market. technology changes. high up-front capital requirements.). b. labor issues. Advertising of Rival Firms If rival firms are apt to spend large amounts of money on advertising aimed at changing customer preferences and creating loyalty. B2-59 .Becker CPA Review Business Environment & Concepts 2 B. Firms need to be cognizant of their rivals' competitive moves and evaluate their current actions in an attempt to determine the future moves of the competition in the market. Types of Barriers to Entry Often. trade barriers. © 2009 DeVry/Becker Educational Development Corp. Unless barriers to entry exist. the firm faces a strong competitive force. A good strategic plan will position the firm so that it is always "on the look out" for changes in the forces so that it can preempt and predict the strategic moves of rival firms. input costs. The amount of overall competition the firm is faced with can only be determined after analysis of how significant of an impact the following five forces have with respect to the competitive environment of the firm.g. 1. It is also possible that the simple threat of new entrants will scare firms into keeping their prices at competitive levels. b. firms will enter until profits fall to a competitive level. Barriers to Entry The firm faces the threat of new firms entering the market in which it operates. 2. FIVE FORCES THAT AFFECT THE COMPETITIVE ENVIRONMENT (AND PROFITABILITY) OF THE FIRM (MICHAEL PORTER. etc. and the risk of retaliation by other firms is low. the impact of this competitive factor is increased. If the industry as a whole is earning a profit. along with facing the retaliation of those firms already competing in the market and the competitive cost advantages that existing firms enjoy.. supplier access. rival firms face barriers to entry in the form of government regulation. other firms will desire to enter the market. economies of scale. pre-existing customer preferences and loyalties. and other restrictions. Market Competitiveness (Intensity of Competition) The existence of competition from rival firms is often the most significant of the five forces of competition. a. 1980 AND 1985) One of the goals of a firm is to create a strategy that attempts to keep the operations of the firm away from the unnecessary and oftentimes hazardous influences of the following five forces as much as possible. learning curve issues. When New Companies Will Attempt to Enter New companies will attempt to enter the competition when barriers to entry are low. and other up-front competitive cost disadvantages. A strategic plan must be put in place so that a move in any of the forces that can have a significant impact on the operations of the firm cannot seriously jeopardize the ability of the firm to operate. respond appropriately and timely. All rights reserved. and maintain its competitive advantage. Ability of Rival Firms to Respond to Change If a firm is in competition with other firms who are all able to respond to changes in various components affecting business (e. regulation. including patents.
Alliances of Rival Firms and Suppliers Often. several equal-sized firms exist in the market. buyers have little choice of products and may be willing to pay a higher price for the products that are available. If close substitutes exist. When alliances are created. The effect is further intensified when the costs of the buyer switching to the substitute product are low. this force will have a stronger influence on the firm's competitive environment because the ability of a firm to sustain profits is significantly impacted by the maximum amount that buyers are willing to pay for a product. B2-60 © 2009 DeVry/Becker Educational Development Corp. Research and Development of Rival Firms When rival firms expend large amounts of money on research and development to improve their products or create new innovations in technology. and this could impact the firm's ability to obtain its inputs to the production process at advantageous prices and. have equal performance. buyers may have a limit on the maximum price that they are willing to pay. some firms profit from making certain moves to increase market share. e. Buyers may be quite price sensitive and change products solely based on price or they may have such brand loyalty and strong preferences that they will stay with a product regardless of price (oftentimes depending on the elasticity of demand). The strength of the relationship between the value chains of buyers and firms impacts the bargaining power that buyers have. Large Volume of a Firm's Business (High Buyer Concentration) If one group of customers makes up a large volume of the firm's business. the costs of exiting the market exceed the cost of continuing to operate. thus. and are priced at or below the price of the firm's product. All rights reserved. and the various firms employ different types of strategic plans. . reduce its competitive advantage. and quality. the bargaining power (negotiating power) of the customer will significantly impact the competitive environment of the firm.Business Environment & Concepts 2 Becker CPA Review c. and the strategy of firms should focus on pleasing this group of customers. Bargaining Power of the Customers If buyers are in the position to bargain with suppliers on the conditions of service. and large amounts of funds are expended by firms each year in this area. and this has a direct impact on the profits of the firm. they are a strong force in the competitive market in which the firm operates and will have a large impact on the competitive environment of the firm. If the firm faces heavy competition from substitute products. d. a. If few substitutes exist. This is especially true if the substitutes are readily available to consumers. Increase in Competition Competition becomes an even stronger force impacting the firm when the market is not growing fast (in contrast. customers do not have strong brand preferences. it faces issues that need to be addressed in its strategic plan. competitors are usually able to sustain profitability without having to take market share from their rivals). in fast growing markets. Marketing strategies are focused on the consumer of goods. 4. price. Existence of Substitute Products If a firm operates in a market in which substitute products are available. the impact of this competitive factor is increased. rival firms focus on developing strong alliances with suppliers. the impact of this competitive factor is increased. 3.
© 2009 DeVry/Becker Educational Development Corp. Buyer's Low Cost of Switching Products If the costs of switching from one product to another are low. the quality of its product) is excellent and crucial to the success of the firm's product and the demand for its goods from other firms is high. no substitutes are available). b. 5.. especially when those input costs are a significant part of the overall product cost. This result is intensified if the firm cannot easily change production without incurring high costs to begin producing another product. especially if the firm is not a large client of the supplier or if strategic alliances have been formed between the supplier and a competitor. Bargaining Power of the Suppliers When the bargaining power of the suppliers of inputs to the production process is high. the more the buyer will be able to compare and contrast features of a product and choose one over the other. All rights reserved.e.g. Availability of Information The more information that is available to the buyer. changes in the operations of the supplier. the firm must take a good look at its strategic plan with respect to the suppliers.. and thus the price of the input. Firm is Unable to Change Suppliers If the firm is unable to use different suppliers or cannot change its inputs (i. the impact of the effect on the competitive environment from buyers is increased. Reputation of Supplier and Demand for its Goods If the reputation of the supplier (e. The strength of the relationship between the value chains of sellers and firms impacts the bargaining power that suppliers have. d. the firm could be placed in a difficult situation. Suppliers can take profits away from a firm simply by increasing the cost of the inputs to the firm's production process. High Number of Alternate Suppliers When a large number of suppliers exist to serve the customers.Becker CPA Review Business Environment & Concepts 2 b. B2-61 . a. the bargaining power of the buyer is increased. will affect the profitability of firms. c.
the related value chain would be altered to take into account the chosen strategy. Value chain analysis (a strategic management tool that requires managers to determine the flow of activities undertaken by the organization to produce a service or product) was discussed earlier in this chapter. beat the profitability of its rivals. All parts of the buying decision are affected by the perceived value of the product (e. A. Cost Leadership Advantage The cost leadership advantage stems from the fact that the buyers of the product are better off because the firm has been able to produce and sell its product for less than its rivals. When firms desire to achieve competitive advantage with respect to products. superior service. performance measures. wide range of goods. the firm must always be sure to remain profitable and recoup the cost of the "premium" they have included with their product.g. COMPETITIVE ADVANTAGE IN GENERAL The overall competitive advantage of a firm is determined by the value the firm offers to its customers minus the cost of creating that value. Match the Price of Rivals If a firm enjoys a low-cost competitive advantage.). 2. 1. If the total costs of the firm are less than those of rival firms. less risks. In any of the following strategic alternatives. the firm has a competitive market advantage. All rights reserved. TYPES OF COMPETITIVE STRATEGIES Building a successful competitive strategy requires being able to attain some sort of competitive advantage while still holding customer loyalty and having value to the customer. b. B2-62 © 2009 DeVry/Becker Educational Development Corp.. This advantage may be used by the firm in one of two ways: a. it may be able to secure a larger part of the market as its customer base and gain market share while still maintaining the profits that are required. After the product has been differentiated. there are two basic forms of advantage that they will choose from. because it has overall lower total costs. . Differentiation Advantage (Offering Advantage) The differentiation (product differentiation) advantage stems from the fact that buyers are better off because the customer perceives the firm's product to be superior in some way to those of its rivals. etc. Therefore. it will be able to match the price of its rivals and. Build Market Share If the firm lowers the price of its product below the price of its competitors. This advantage may be used by the firm in one of two ways: a. b. timeliness of delivery. Build Market Share The firm may attempt to build market share by pricing its product below what it would charge to recoup the premium with a standard number of buyers and try to recover its costs because it captures more than an average share of the market. they are willing to pay a higher price for its uniqueness. higher quality. Increase Price The firm may increase the price of its product to the point where it exactly offsets the value the customer perceives from the product.Business Environment & Concepts 2 Becker CPA Review XIII.
Careful analysis of all the costs in the process must be made and costs must be eliminated. D. 2. 3. DIFFERENTIATION STRATEGIES (PRODUCT DIFFERENTIATION) Organizations may choose to achieve their organizational missions by creating the perception that their product is better or has a unique quality that differentiates it from competing products in the marketplace. 1. and the firm has ignored this fact. 4. They are able to do this by setting their product "aside" from the others through a unique feature (e. When Cost Leadership Strategies Work Well Cost leadership strategies work well in markets where the buyers have large amounts of bargaining power and are able to switch between competitive products without incurring significant cost. superior customer service. and customers desire those features. Firms may choose to evaluate the value chain for areas to cut costs while still maintaining the perception of maintaining the value to the consumer. 2. Also. B2-63 . COST LEADERSHIP STRATEGIES Organizations may choose to achieve their organizational missions by selling their product or service for less than any other participant in the marketplace. etc. When Cost Leadership Strategies Fail If firms focus too much on cutting costs of the current process. special taste. Create/Promote a Unique Feature in the Product When firms employ a differentiation strategy. FIVE BASIC TYPES OF COMPETITIVE STRATEGIES 1. Cost Leadership Focused on a Broad Range of Buyers Cost Leadership Focused on a Narrow Range (Niche) of Buyers Differentiation Focused on a Broad Range of Buyers Differentiation Focused on a Narrow Range (Niche) of Buyers Best Cost Provider C. Lowest Overall Costs In order to be a low cost provider. value. reducing the firm's competitive advantage) if it sees that this strategy has worked in the marketplace. 1." Any firm could easily use the same strategy (thus. the firm has lost its cost leadership competitive advantage. All rights reserved. prestige. the overall cost of a firm must be lower than other firms in the market. they desire to create a competitive advantage by focusing customer preference on their products and away from the products of competitors. quality. Firms that successfully differentiate their products are able to command higher prices. 5.). In this way. If new features exist in other products. the strategy of cost leadership is not "rocket science. they may end up overlooking technological advances that may also assist in lowering costs (especially those that the rivals have latched onto) or overlooking the fact that consumers may desire improvements to the product or may not care much anymore about the existence of a lower price in the desired product.g. Cost leaders undermine the profitability of their competitors as a means of achieving overwhelming market share. They are also successful in markets where there is heavy price competition and where firms (especially new entry firms) can influence buyers to switch to their product and then increase their base of customers simply by cutting the price of the product for a period of time..Becker CPA Review Business Environment & Concepts 2 B. if necessary. © 2009 DeVry/Becker Educational Development Corp. evaluation of budgets and benchmarks are crucial. 3. image. the firm will gain competitive advantage by either having higher overall profit margins or being able to undercut the prices of the other firms. Further.
the firm cannot succeed if it loses profit because of the higher costs of the feature in the differentiation strategy). When Differentiation Strategies Fail When a firm chooses to differentiate in an area without properly assessing the requirements of the consumer for desired features and preferences or without creating value for the consumer. E.." and this is especially important to firms whose products are not purchased frequently or are directed towards first-time or one-time buyers who are not that sophisticated in that market. etc.e. "perception is often greater than reality.. will not pay extra for unique features. unique features that are part of the differentiation strategy. quality. and are happy with paying a lower price for a more generic product. prestige. B2-64 © 2009 DeVry/Becker Educational Development Corp. Build Customer Brand Loyalty If the firm can achieve differentiation and still make a profit (i. a quality product at a reasonable price). Overall Lowest Cost in Industry is Not an Option Of course. superior customer service. 5. 2. when the product appeals to different people for different reasons. 3. the differentiation strategies can fail. it will succeed. it will succeed in achieving competitive advantage because it will build customer brand loyalty and increase sales..). Further. Therefore. a differentiation strategy can fail. If the firm is able to create a strategy that will allow it to evaluate and change its value chain so that it can achieve the lowest cost among its closest competitors while matching them on the features desired by consumers.g.e. highlighting the areas the ultimate consumer cares about (e. firms that focus too much on one area (or the wrong area) may "overdo it" and end up creating a product whose value does not exceed the higher price that must be charged for the feature. a firm employing a best cost strategy cannot have the overall lowest cost in the entire industry or it could not compete profit-wise because of the special. If a firm is in a market where customers do not care about differentiation. 4. When Best Cost Strategies Work Well Best cost strategies work well when generic products are not acceptable to the varied needs and preferences of the buyers but the buyers are still sensitive to the value that they are receiving for the money they are spending and the overall price they are paying. All rights reserved. Remember. . Perception is Often Greater than Reality Firms with differentiation strategies will evaluate their value chains and perhaps put more money into research and development and innovation and focus on heavy marketing of their "superior products" to customers. and when the firms who are competing in the market choose different features with which to differentiate their products.Business Environment & Concepts 2 Becker CPA Review 2. When Differentiation Strategies Work Well Differentiation strategies work well when customers are able to see value in a product. BEST COST STRATEGIES The best cost strategy combines the cost leadership strategy with the differentiation strategy to give customers higher value for their purchase price (i. 1. the firm strives to be the low cost leader among firms in the marketplace that have comparable quality products that have been differentiated in some way. It is possible for the firm to create a perception of value that is often as significant as the real value that exists in the product.
Merger and Acquisition Firms may choose to combine with or acquire other firms in a formal process of merger or acquisition in order to obtain opportunities for cost reductions that they could not otherwise obtain. the focus/niche strategies can fail. When Focus/Niche Strategies Fail When other firms see that the niche has been successful for those serving it. While all of this can be beneficial for firms. or a niche. Rather than having to address the needs and preferences of a broad range of consumers. 2. these firms are able to focus on market niches where consumers have specialized needs and preferences. B2-65 . thus causing consumers to buy the standard products on the market and stop buying the niche product that the firm offers.. likely reducing the firm's profits and its competitive advantage. to obtain technological knowledge of others that they do not currently have. this strategy may not work well. expand. and that provided that few firms are focusing in an area where others cannot compete in price or are not currently addressing with a particular feature. to combine research and development activities for efficiency and effectiveness. It often becomes difficult to attain the proper "middle" ground in the marketplace. FOCUS/NICHE STRATEGIES Firms with cost leadership or differentiation strategies may choose to focus their chosen strategy on a select small group of consumers. If the firm is not easily responsive to change (flexible) for whatever reason.e. and provided the firm has the proper resources to adequately serve the needs of the niche group. © 2009 DeVry/Becker Educational Development Corp. The firm also faces a risk that those consumers in the current niche may find that they actually prefer the features of products that the overall market desires (i. they will attempt to enter the market as competitors and take away some of the sales of the firm. and some firms may end up leaning to one side or the other and then finding themselves attempting to compete in a market where their chosen strategy does not work. preferences change or the standard products have significantly improved). All rights reserved." it faces risks of losing customers to other firms that are using cost leadership strategies or those that are specifically focused on differentiation. When Focus/Niche Strategies Work Well The focus/niche strategy works well provided the niche has a large enough demand to create a profit for the firm. OTHER TYPES OF STRATEGIES 1. 1. F. G. or to cover areas of market demand that they are not currently serving. When Best Cost Strategies Fail Because the best cost strategist plays the "middle.Becker CPA Review Business Environment & Concepts 2 3. unless the combined management is able to work together well and unless the combined operations can be run effectively together.
or to obtain information as a group that they could not obtain individually (or that may be too costly to obtain individually). Vertical Integration A firm may desire to improve its competitive advantage through vertical integration. retailers. B. please read the expanded discussion of Supply Chain Management at Appendix II. a firm may be able to be successful in achieving the desired competitive advantage. GOAL IS TO UNDERSTAND NEEDS AND PREFERENCES OF CUSTOMERS In order to attain and sustain competitive advantage. a strategy in which the firm seeks to control the value chain on the supply end (backward integration to the suppliers) and on the demand end (forward integration to consumers via distribution channels) within the same industry via integration of these processes to the firm's operations. etc. to share the cost of obtaining information on innovations in technology. All rights reserved. Cooperative/Strategic Alliances When companies desire to achieve such things as economies of scale (in marketing or production). The goal of ISCM is to better understand the needs and preferences of customers and cultivate the relationship with them. shipping. etc. it would be employing the concept of integrated supply chain management (ISCM). and the relationship between them must be evaluated and managed as goods flows through the value chain. and service providers) are able to reasonably predict the expected demand of consumers for a product and then plan accordingly for supplying that demand. When more of the competitive factors are controlled. profits must be made and consumers must have perceived value. 3. If the actual demand of the customer is met and excess supply does not sit on the market. this may end up reducing the firm's flexibility with respect to suppliers and distribution channels and force the firm to be too focused on one industry or too committed to one supplier or distribution channel. the firm will be able to minimize costs all along the supply chain (e.). supply chain operations should generally be improved. the participating firms are usually able to obtain competitive advantage by acquiring information and skills they could not obtain on their own (or were prohibited from obtaining because it was too costly. To increase value to the consumer. raw materials.Business Environment & Concepts 2 Becker CPA Review 2.g. C. production. REQUIRED READING AT APPENDIX II As a supplement to the material above. However. However. While this strategy is not as formal as a merger or acquisition. COLLABORATIVE EFFORT OF BUYERS AND SELLERS If a firm and the entire supply chain (producers. distributors. B2-66 © 2009 DeVry/Becker Educational Development Corp. customers. this strategy requires that the individual partners are able to work as a team toward a common goal and that the partners do not take the information they receive and begin to compete heavily with each other.. . SUPPLY CHAIN MANAGEMENT/INTEGRATED SUPPLY CHAIN MANAGEMENT (ISCM) A.). they may choose to form strategic alliances in a cooperative strategy. packaging. XIV. Integrated supply chain management is a collaborative effort between buyers and sellers.
the auto manufacturer must go to Bermuda and spend dollars there. Several economic theories support international trade as a means of achieving improved shareholder value. A. is not balmy and won't compare with Bermuda! In order to capitalize on resources available from that vacation destination. yet its roadways are teaming with vehicles of all types. I. The ability to trade freely between markets is often limited by the physical immobility of the resource or regulatory barriers. companies must trade outside their borders. Comparative Advantage Specialization in the production and trade of specific products produces a comparative advantage in relation to trading partners. 2. in January. B2-67 . economic or translation risk. Imperfect Markets Resource markets are often deemed to be imperfect. 1. Auto manufacturers in Detroit may seek a vacation from time to time on a sandy beach with a balmy breeze. The country predominantly specializes in tourism and uses the money it earns from its visitors to buy (import) vehicles and petroleum products. The character of those risks and their implications to both financial position and operations along with the steps an entity can take to mitigate those risks (including hedge transactions) are areas specifically identified by the content specification outline for the CPA Examination. MOTIVATIONS FOR INTERNATIONAL BUSINESS OPERATIONS Entities are encouraged to look beyond the political borders in which they were organized to maximize shareholder value. Companies and countries use their comparative advantage as a means of maximizing the value of their efforts and the value of their resources. EXAMPLE EXAMPLE © 2009 DeVry/Becker Educational Development Corp. In order to retrieve more resources. Clearly there is not opportunity to simply import the resource.Becker CPA Review Business Environment & Concepts 2 IMPLICATIONS OF DEALING IN FOREIGN CURRENCIES The introduction of foreign currency transactions to business operations adds unique concepts essential to understanding an entity's business and industry. The island nation of Bermuda produces no gasoline or vehicles. Lake Michigan is breezy but. All rights reserved. Dealing with foreign economies offers the opportunity for entities to capitalize on comparative advantages in trade or production but also exposes the entity to exchange rate fluctuations that result in potential risks frequently classified as transaction. Entities that conduct business outside the country in which they are organized are frequently referred to as multinational corporations (MNC). INTERNATIONAL BUSINESS OVERVIEW Reduced barriers to trade have created business opportunities to conduct operations in multiple countries or conduct import/export operations within the context of a traditional domestic operation. The country maximizes the number of resources it can import by specializing in tourism and buying transportation resources elsewhere.
2. Acquisitions of Existing Operations The outright purchase of foreign companies as subsidiaries serves as a means of establishing international operations. teams with Chez Brule. a U. to distribute US confections throughout France using Chez Brule's distribution network. Inc. The following terms help define different methods of organization. Franchising Entities whose marketing service or delivery strategy provides training and related service delivery resources in exchange for a fee are franchisors. 1. Inc. EXAMPLE Engulf & Devour Food products.Business Environment & Concepts 2 Becker CPA Review 3. . obligates itself to providing training and the use of unique company logos to businesses that operate in Peru.S. METHODS OF CONDUCTING INTERNATIONAL BUSINESS OPERATIONS Multinational operations are structured in any number of ways. 4. b. 3. Foreign success will promote foreign competition. a French concern. corporation.. The entity is then motivated to actually establish a business outside its boundaries to more effectively differentiate itself and compete with foreign competitors. B2-68 © 2009 DeVry/Becker Educational Development Corp. Direct Foreign Investment (DFI) a. Licensing Entities that provide the right to use processes or technologies in exchange for a fee are engaged in licensing activities. B.S. corporation. 5. Establishing New Foreign Subsidiaries The startup of a subsidiary operation within the borders of a foreign country serves as a means of establishing international operations. EXAMPLE Wireless. International Trade Import/export operations characterize the use of purely international trade as a means of conducting international business. corporation.S. Product cycle theory anticipates that domestic success will result in domestic competition that will encourage the export of products or services to meet foreign demand and maintain efficient use of capacity. All rights reserved. EXAMPLE Flip-a-burger. Product Cycle Product manufacture or delivery is subject to a definable cycle that will start with the initial development of the product to meet needs in domestic markets. Joint Ventures Joint ventures (defined on page B1-4) take advantage of comparative advantage of one ore both of the venturers in marketing or delivering a product.. obligates itself to establishing and maintaining cellular telephone systems in Mexico in exchange for a licensing fee to use its technology. a U. a U.
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INHERENT RISKS OF INTERNATIONAL BUSINESS OPERATIONS The issues associated with conducting international business operations are generally categorized in the following manner. 1. Exchange Rate Fluctuation Exchange rate risks are generally divided into the following three categories: a. b. c. 2. Transaction risk Economic risk Translation risk
Foreign Economies Operation within foreign economies carries with it the risk of functioning within the general health or weakness of a particular economy. Domestic economies may be booming while international economies are suffering and acting as a drag on overall performance.
Political Risk The potential of unstable political environments that are potentially disruptive, corrupt, or destructive amplifies the risk of doing business outside domestic borders. Ultimately, political climates or actions can disrupt cash flows.
EXCHANGE RATE RISK: FACTORS AND EXPOSURE CATEGORIES Business transactions are typically denominated and valued in terms of money. Currency or money is the medium of exchange. Within domestic environments, a single currency defines the value of assets, liabilities, and operating transactions. In international settings, the values of assets, liabilities, and operating transactions are established not only in terms of the single currency but also in relation to other currencies. The relationship between currencies is not always stable and, therefore, creates exchange rate risk. A. FACTORS INFLUENCING EXCHANGE RATES Circumstances that give rise to changes in exchange rates are generally divided between trade-related factors (including differences in inflation, income, and government regulation) and financial factors (including differences in interest rates and restrictions on capital movements between companies). 1. Trade Factor: Relative Inflation Rates When domestic inflation exceeds foreign inflation, holders of domestic currency are motivated to purchase foreign currency to maintain the purchasing power of their money. The increase in demand for foreign currency will force the value of the foreign currency to rise in relation to the domestic currency, thereby changing the rate of exchange from domestic to foreign currency. Assume the United States dollar is relatively stable while the Mexican peso is suffering from sudden inflationary pressures. As the Mexican peso buys less in the domestic Mexican economy, Mexicans and their banking institutions seek the safe haven of the United States dollar to maintain the purchasing power of their liquid resources. The demand for United States dollars created by Mexicans buying them with Mexican pesos makes the United States dollar more valuable in terms of the peso and drives up the exchange rate. The United States dollar commands more pesos in an exchange of currency.
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Trade Factor: Relative Income Levels As income increases in one country relative to another, exchange rates change as a result of increased demand for the currency in the country where income in increasing.
The income level in the United States increases significantly in the second quarter. Americans flock to Mexico City on vacation to buy piñatas. The increased supply of American dollars seeking to buy pesos to purchase Mexican goods causes the value of the American dollar to fall in relation to a stated number of pesos. The exchange rate is thus impacted by relative income levels and the associated demand for foreign currency created by new domestic income. 3. Trade Factor: Government Controls Various trade and exchange barriers that artificially suppress the natural forces of supply and demand will impact exchange rates.
A tariff on imported piñatas would have the impact of discouraging the purchase of imports, thereby reducing demand for the peso and maintaining the exchange rate. 4. Financial Factors: Relative Interest Rates and Capital Flows Interest rates create demands for currency by motivating either domestic or foreign investments. The forces of supply and demand create changes in the exchange rate as investors seek fixed returns. The impact of interest rates is directly impacted by the volume of capital that is allowed to flow between countries. Assume that guaranteed returns on institutional investments in Mexico skyrocket in the third quarter while interest rates in the United States remain low. American investors find the opportunity to earn high returns in Mexican banks irresistible. The demand for pesos increases as American investment increases. The exchange rate changes as the peso commands more United States dollars.
Summary Chart: Circumstances That Impact Exchange Rates Trade Related Factors Relative Inflation Rates Relative Income Levels Government Controls (Trade Restrictions) Financial Factors Relative Interest Rates Capital Flow Demand/ Supply of Currency Exchange Rate Demand for Securities Demand/ Supply of Currency
Demand for Goods
THEORIES EXPLAINING EXCHANGE RATE RISK Several theories are used to explain the dynamic relationship between inflation rates and interest rates in the determination of currency exchange rates. These theories include the purchasing power parity theory, the International Fischer effect, and the interest rate parity theory. 1. Purchasing Power Parity Theory The purchasing power parity theory generally suggests that the price of identical goods sold in separate economies are identical when measured in a common currency. Exchange rates will constantly adjust to ensure purchasing power parity (equality).
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Absolute Form The absolute form of the purchasing power parity theory is referred to as the "law of one price." The absolute form asserts that identical goods sold in separate economies will command equal prices when denominated in a common currency. Differences are self-adjusting.
Relative Form The relative form holds to the basic theory of the absolute form but accounts for transportation and government regulation (such as tariffs and quotas) as determining factors and acknowledges that the price of identical items in different countries will not necessarily be absolutely equal even when measured in a common currency. The rate of incremental change in the exchange rate should be approximately equal assuming no change in the market imperfections associated with government regulation and transportation costs.
International Fischer Effect The International Fischer effect explains the fluctuation in exchange rates through analysis of interest rates. Interest rates are viewed as a compound measurement of both financing costs and expected inflation that more accurately explains exchange rate changes. a. Interest Rate Components Interest rates are deemed to include a real risk-free rate of return and an additional component that accounts for inflation. b. Inflation Rates Changes in inflation derived from the International Fischer effect pinpoint the anticipated fluctuation in exchange rates.
Interest Rate Parity Theory The interest rate parity theory holds that foreign and domestic interest rates will reach equilibrium once covered interest arbitrage is no longer possible. a. Covered Interest Arbitrage Covered interest arbitrage is a currency swap in which the counterparties exchange currencies at both the spot and forward rates simultaneously (see Glossary for definitions of spot and forward rate). In other words, the party engaging in covered interest arbitrage for an investment exchanges its domestic currency for a foreign currency to make the investment and also at the same time enters into a forward contract to sell an equal amount of the foreign currency to coincide with the maturity of the investment (and the attendant proceeds of the investment). The swap restores currency exposures to the original position without a currency gain or loss, making this a way to adjust exposure to a narrowing or widening of interest rate differentials. Covered interest arbitrage also ensures interest rate parity because this relationship prevents speculators from profiting by borrowing in a low interest rate country and simultaneously lending in a high interest country and hedging the currency risk. b. Interest Rate Parity Theory The difference between forward contract prices represents the difference in interest rates in effect in each country and thereby accounts for exchange rate differences.
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000. If the exchange rate is $. Standard Deviation Over Time Currency variability may be estimated by computing the standard deviation of monthly exchange rates to the average exchange rate over multiple periods and selecting. a U. TRANSACTION EXPOSURE: DEFINITION AND MEASUREMENT Exchange rate risk is defined. judgmentally.75 to each Canadian dollar. 2.000 inflow. Standard Deviation Currency variability may be estimated by computing the standard deviation of monthly exchange rates to the average exchange rate over a single period. Currency Correlation (Multiple Foreign Currencies) Currency correlation scenarios anticipate the settlement of future transactions in multiple foreign currencies.000 and $1.75). a.000 (C$2. EXAMPLE Seattle Import/Export.S. 3. import/export company imports commodities from Canada that it pays for in Canadian dollars and exports commodities to Canada for which it receives Canadian dollars. General Measurement of transaction exposure is generally done in two steps: a. by transaction exposure.000 over the same period. Project foreign currency inflows and foreign currency outflows. The higher the degree of correlation.Business Environment & Concepts 2 Becker CPA Review C.000.500.70 and $. Transaction exposure is defined as the potential that an organization could suffer economic loss or experience economic gain upon settlement of individual transactions as a result of changes in the exchange rates.000 to Canada over the next year while importing C$8. between $.000. the expected variability in exchange rates is more difficult. the net exposure in Canadian dollars is a C$2. Estimate the variability (risk) associated with the foreign currency.000. . b. All rights reserved. in part.000.80. b.400. Currency Variability (Single Foreign Currency) While the projected net inflow or outflow of a foreign currency may be determined from a budget or business plan. Transaction exposure is generally measured in relation to currency variability or currency correlation. a. the most likely exchange rate. then the net exposure in United States dollars is $1. The degree of transaction exposure is determined statistically by the degree to which the movement of exchange rates of multiple foreign currencies correlate. If Seattle Import/Export anticipated that it would export C$10. 1. If the rate is anticipated to fluctuate five cents. the total fluctuation exposure would be expected to be between $1.600.000 × . 4. Value-at-Risk The value-at-risk method computes the maximum one day loss based on exchange rate fluctuations using both variability and correlation measurements. B2-72 © 2009 DeVry/Becker Educational Development Corp. the greater the possibility that changes in exchange rates (either favorable or unfavorable) will compound and increase the risk of exchange rate fluctuation.
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ECONOMIC EXPOSURE: DEFINITION AND MEASUREMENT In addition to transaction exposure, exchange rate risk is defined, in part, by economic exposure. Economic exposure is defined as the potential that the present value of an organization's cash flows could increase or decrease as a result of changes in the exchange rates. Economic exposure is generally defined through local currency appreciation or depreciation and is measured in relation to organization earnings and cash flows. 1. Currency Appreciation and Depreciation Currency appreciation and depreciation refer to the strengthening (appreciation) or weakening (depreciation) of a currency in relation to other currencies. a. Impact of Currency Appreciation As a domestic currency appreciates in value or becomes stronger, it becomes more expensive in terms of a foreign currency. As currency appreciates, the volume of outflows tends to decline as domestic exports become more expensive. However, the volume of inflows tends to increase as foreign imports become less expensive. b. Impact of Currency Depreciation As a domestic currency depreciates in value or becomes weaker, it becomes less expensive in terms of a foreign currency. As a currency depreciates, the volume of outflows tends to rise as domestic exports become less expensive. However, the volume of inflows tends to decline as foreign imports become more expensive. The economic exposure created by domestic currency appreciation or depreciation with respect to a foreign currency depends upon the net inflow or outflow of foreign currency and is summarized as follows: Domestic Currency
Net inflows Loss Gain Net outflows Gain Loss
Measuring Economic Exposure through Earnings Economic exposure can be measured using the sensitivity of earnings to changes in exchange rates. The approach to sensitivity analysis involves three different steps: a. b. c. Prepare an income statement computing earnings expressed in terms of the foreign currency. Apply a range of likely exchange rates to each line item of the income statement and compute earnings under each scenario. Compare the earnings amounts in relation to fluctuations in expected exchange rates to determine the sensitivity of earnings to changes in exchange rates.
Evaluation As the exchange rate increases, the foreign currency becomes more expensive in terms of the domestic currency. Profitability tends to decline because fixed costs, expressed in the foreign currency, become more expensive.
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TRANSLATION EXPOSURE: DEFINITION AND MEASUREMENT In addition to the transaction and economic exposures, exchange rate risk is defined, in part, by translation exposure. Translation exposure is defined as the potential that assets, liabilities, equity, or income of a consolidated organization that includes foreign subsidiaries will change as a result of changes in the exchange rates and defines the effect of exchange rate fluctuations on financial position and operations. Translation exposure is generally defined by the degree of foreign involvement, the location of foreign subsidiaries, and the accounting methods used and measured in relation to the impact on the organization's earnings or comprehensive income. 1. Degree of Foreign Involvement The translation exposure to exchange rate risk increases as the proportion of foreign involvement by subsidiaries increases.
Domestic International, Inc. has no foreign subsidiaries but is deeply involved in exporting to neighboring countries. Global International, Inc. has twelve foreign subsidiaries that, combined, comprise sixty-five percent of consolidated revenues. Domestic International has less translation exposure than Global International because it has no foreign subsidiaries. Domestic's international business does expose the company to exchange rate risks, however, in terms of both transaction and economic exposure. 2. Locations of Foreign Investments Measurements of financial results of foreign investments frequently occur in the foreign currency in which the investee company operates. The exposure of the parent company to translation risk is impacted by the stability of the foreign currency in comparison to the parent's domestic currency. The more stable the exchange rate, the lower the translation risk. The less stable the exchange rate, the higher the translation risk. 3. Accounting Methods The translation of financial statements reported in foreign currencies is specifically defined by the Financial Accounting Standards Board, and one of two methods is used. Each method requires that the parent company assess the functional currency of the foreign subsidiary and then apply accounting and reporting principles based on that assessment. Each method accounts for a subsidiary's financial results and represents a translation exposure to exchange rate risk. a. Temporal Method (Remeasurement Method) The temporal method assumes that the functional currency is the currency of the parent. Translation gains or losses flow through the income statement. (1) (2) The functional currency is defined as the currency in which the primary economic activities of the subsidiary are transacted. When the transactions are denominated in the foreign currency and measured in the foreign currency, but the foreign subsidiary is dependent upon the parent's domestic currency for cash flows, then the parent's domestic currency is the functional currency. Financial results of the foreign subsidiary must be remeasured into the functional currency used for reporting. Steps in remeasurement include restatement of the balance sheet using various exchange rates and restatement of the income statement using various exchange rates. Any difference between the balance sheet and the income statement is accounted for as a remeasurement gain or loss through income.
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Becker CPA Review
Business Environment & Concepts 2
The parent company's translation exposure to exchange rate gain or loss is composed of both the increase or decrease in net income as a result of exchange rates applied to income statement line items as well as the adjusting entry to determine the income necessary to balance the balance sheet through the income statement as a remeasurement gain or loss.
Current Method (Translation Method) The current method assumes that the functional currency is the currency used by the foreign subsidiary. Translation gains and losses flow through other comprehensive income. (1) When the transactions are denominated and measured in the foreign currency and the foreign subsidiary is not dependent upon the parent's domestic currency for cash flows, the subsidiary's currency (the foreign currency) is the functional currency. Financial results of the foreign subsidiary must be translated into the currency used for reporting. Steps in translation include restatement of the balance sheet using various exchange rates and restatement of the income statement using various exchange rates. Any difference between the balance sheet and the income statement is accounted for through other comprehensive income and accumulated other comprehensive income, which is a component of stockholders' equity on the balance sheet. The parent company's translation exposure to exchange rate gain or loss is composed of the increase or decrease in net income as a result of exchange rates applied to income statement line items. However, the "plug" goes to other accumulated comprehensive income on the balance sheet.
EXCHANGE RATE RISK: MANAGING TRANSACTION EXPOSURE Businesses have various methods of managing the transaction exposure associated with exchange rate risks. Generally the use of financial instruments and hedge transactions attempts to mitigate the impact of exchange rate fluctuations on individual transactions. The following discussion analyzes hedging as it relates to foreign currency transactions. A. MEASURING SPECIFIC NET TRANSACTION EXPOSURE Net transaction exposure is the amount of gain or loss that might result from either a favorable or an unfavorable settlement of a transaction. 1. Selective Hedging Hedging is a financial risk management technique in which an organization, seeking to mitigate the risk of fluctuations in value, acquires a financial security whose financial behavior is opposite that of the hedged item. Worldwide Sweet Peaches buys crates for its product for shipping from Mexico. The company incurs liabilities denominated in pesos that it satisfies in pesos bought with U.S. dollars at the time of settlement. The company incurs a significant liability in pesos at a spot rate of $.10. The company is fearful that the peso will strengthen to $.20 by the time the bill is due and thereby double its cost. Because the anticipated exchange rate (the rate at which two currencies will be exchanged at equal value) in the future of the peso is greater than the current spot rate (the exchange rate at the current date), the company will hedge its position by locking into an exchange rate that is less than the feared appreciation of the peso.
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An exchange loss will result. 1. a. they might favorably affect another. more domestic currency will be required to purchase the foreign currency and pay the payable. Should the domestic currency strengthen. All rights reserved. Accounts Receivable Application (1) B2-76 . c. Accumulate the inflows and outflows of foreign currencies by subsidiary. theoretically have no impact on income. The net transaction exposure is the aggregate exposure associated with a particular foreign currency for a particular time and is computed as follows: a. Management may elect to hedge inconsistently or selectively in order to ensure that hedge transactions are carried out with maximum effectiveness.Business Environment & Concepts 2 Becker CPA Review a. therefore. less domestic currency than originally anticipated from the sale that created the receivable can be purchased with the foreign currency received. Identifying Net Transaction Exposure Consolidated entities consider their net transaction exposure prior to considering hedge strategies. b. Accounts Payable Application (1) Accounts payable denominated in a foreign currency represent a potential transaction exposure to exchange rate risk in the event that the domestic currency weakens in relation to the foreign currency. (2) b. Compute the net impact in total. b. Net transaction exposure considers the impact of transaction exposure on the entity taken as a whole rather than individual subsidiaries. Futures hedges are denominated in standard amounts and tend to be used for smaller transactions. Hedges are likely to be effective just as often as they are likely to be ineffective if done consistently and. You will not be asked on the CPA exam to determine hedge effectiveness or ineffectiveness. Accounts receivable denominated in a foreign currency represent a potential transaction exposure to exchange rate risk in the event that the domestic currency strengthens in relation to the foreign currency. Consolidate the impact on the subsidiary by currency type. An exchange loss will result. Should the domestic currency weaken. Futures Hedge A futures hedge entitles its holder to either purchase or sell a particular number of currency units of an identified currency for a negotiated price on a stated date. 3. Adjusting Invoice Policies International companies may hedge transactions without complex instruments by timing the payment for imports with the collection from exports. © 2009 DeVry/Becker Educational Development Corp. TECHNIQUES FOR TRANSACTION EXPOSURE MITIGATION The following hedge transactions are used to mitigate exchange rate risk presented by foreign currency transaction exposure. B. Hedges can be effective or ineffective. A futures hedge contract to buy the foreign currency at a specific price at the time the account payable is due will mitigate the risk of a weakening domestic currency. depending upon the actual exchange rate at the time of settlement in comparison to the hedge price and other factors. c. 2. While exchange rate issues might adversely affect one subsidiary.
Becker CPA Review Business Environment & Concepts 2 (2) A futures hedge contract to sell the foreign currency received in satisfaction of the receivable at a specific price at the time the accounts receivable is due will mitigate the risk of a strengthening domestic currency. a. forward hedges are contracts between businesses and commercial banks and normally are larger transactions. 2. © 2009 DeVry/Becker Educational Development Corp. Money market hedges for payables satisfaction are easy to understand. Determine the amount of interest that can be earned prior to settling the payable. Accounts Payable Application (1) Accounts payable denominated in a foreign currency represent a potential transaction exposure to exchange rate risk in the event that the foreign currency strengthens. a. Accounts receivable denominated in a foreign currency represent a potential transaction exposure to exchange rate risk in the event that the domestic currency strengthens. a forward hedge would anticipate a company's needs to either buy or sell a foreign currency at a particular point in time. A forward hedge contract to sell the foreign currency received in satisfaction of the receivables at a specific price at the time the accounts receivable are due or on the monthly cycle of a particular subsidiary will mitigate the risk of a strengthening domestic currency. Forward Hedge A forward hedge is similar to a futures hedge in that it entitles its holder to either purchase or sell currency units of an identified currency for a negotiated price at a future point in time. While futures hedges tend to be used for smaller transactions. (1) (2) (3) (4) Determine the amount of the payable. Accounts Receivable Application (1) (2) 3. Discount the amount of the payable to the net investment required. While a futures hedge might hedge a particular transaction. Purchase the amount of foreign currency equal to the net investment required and deposit the proceeds in the appropriate money market vehicle. All rights reserved. A money market hedge uses domestic currency to purchase a foreign currency at current spot rates and invest them in securities timed to mature at the same time as related payables. A forward hedge contract to buy the foreign currency at a specific price at the time accounts payable are due for an entire subsidiary will mitigate the risk of a weakening domestic currency. (2) b. B2-77 . Money Market Hedge: Payables (Excess Cash) Firms with excess cash use money market hedges to lock in the exchange rate associated the foreign currency needed to satisfy payables when they come due. Money Market Hedge A money market hedge uses international money markets to plan to meet future currency requirements.
Duffy's Discount Piñatas has a receivable from a Mexican customer in the amount of 1. Purchase 961. Borrowed foreign currency amounts are converted into the domestic currency. . The current exchange rate is $.000. Determine the required investment in pesos at Mexican interest rates: 1.000 payable for $76. and U.538 pesos and convert them to $76. The current exchange rate is $. so it elects to use a money market hedge technique to expedite collection and mitigate any transaction exposure to exchange rate risk. Duffy computes that it must borrow $76. Duffy's Discount Piñatas has a payable due to its Mexican suppliers in the amount of 1.538.000. Money Market Hedge: Receivables A money market hedge used for receivables denominated in foreign currencies effectively involves factoring receivables with foreign bank loans. Duffy needs the money now.000/1.08 per peso.923. c. The current exchange rate is $. Duffy borrows the pesos from Mexican financial institutions. 2.000 pesos due in 90 days. 3. Duffy has secured the satisfaction of its current $80.538 pesos matures for 1.08).000 in 90 days. interest rates are 6%.000. Foreign currency amounts are borrowed in discounted amounts that are repaid in the ultimate maturity value of the receivable denominated in the foreign currency. b.923. Duffy will be able to meet whatever its current cash requirements are in the United States with the $76. Duffy borrows the needed amount for 90 days in the United States. Duffy performs the following steps: 1.Business Environment & Concepts 2 Becker CPA Review EXAMPLE Duffy's Discount Piñatas has a payable due to its Mexican suppliers in the amount of 1. B2-78 EXAMPLE EXAMPLE © 2009 DeVry/Becker Educational Development Corp.08 per peso and Mexican interest rates are 16%. and when the 90-day discounted note for 961.000 in excess cash and elects to use a money market hedge to mitigate transaction exposure to exchange rate risk.538 pesos with $76.923 consistent with the first money market hedge example.538 pesos × .000 pesos in 90 days.S.923 to use a money market hedge to mitigate transaction exposure to exchange rate risk consistent with the first money market hedge example but has no excess cash. 6 percent for 90 days).000. is broke and cannot wait to receive $80.923 (961. Duffy computes that it can borrow 961.000. Money Market Hedge: Payables (Borrowed Funds) Firms that do not have excess cash would follow the same basic procedure for a money market hedge on payables except that they would first borrow funds domestically and invest them internationally to satisfy the payable denominated in a foreign currency. Duffy will satisfy it with the collections from the foreign accounts receivable. Duffy has $100.08 per peso and Mexican interest rates are 16%. Mexican interest rates are 16%. All rights reserved. as usual.077 (76.923 × 1.000 pesos. Duffy has secured the satisfaction of its current $80. Duffy.000 pesos in 90 days.015. Invest pesos at Mexican interest rates and satisfy payables upon maturity of the investment.04 = 961.000 payable for $78.
B. © 2009 DeVry/Becker Educational Development Corp. and maximize the tax shield in countries with lower taxes. reduce income in countries with higher taxes. 1. even if those subsidiaries have lower rates. Transfer pricing decisions serve the purpose of minimization of local taxation while remaining within the guidelines of foreign or other host governments. INTERCOMPANY CASH TRANSFERS Intercompany cash transfers are often managed through use of leading and lagging. 2. 2. INTERCOMPANY TRANSACTIONS: RELATIVE TAX RATES Transfer prices (selling prices) in countries with higher tax rates will be reduced to optimum levels. Valuation of these transactions involve transfer pricing. Transfer prices should be set up to maximize consolidated benefit. All rights reserved. A. B2-79 .Becker CPA Review Business Environment & Concepts 2 IV. Weak Cash Position Subsidiaries with weak cash position tend to follow a "lagging" transfer policy where they would pay richer subsidiaries long after obligations were incurred as a means of preserving cash. TRANSFER PRICING International businesses will likely transact businesses between the subsidiaries that cross political boundaries or between the domestic parent and foreign subsidiary. 1. Transfer selling prices in countries with higher taxes increase the tax burden but also increase the tax protection afforded to foreign subsidiaries operating in other countries. Strong Cash Position Subsidiaries with strong cash positions tend to follow a "leading" transfer policy and pay other subsidiaries in advance.
the value starts with the suppliers who provide the raw materials for the production process. continues further with the value created by the customers. B2-80 © 2009 DeVry/Becker Educational Development Corp. In this view. what are the sources of differentiation and what are the related costs?) when the customer perceives that the firm's product is superior to those of its rivals. development of the technology used. finance. accounting. and it is an ongoing process used with strategic thinking. B. When firms must assess every part of the value chain to allow them to provide their customers with maximum value.g. MICHAEL PORTER'S WORK IN 1985 In 1985. taking orders for the product. Support Activities Support activities are those activities that are performed by the support staff of an organization (e. the manufacturing process. two major categories of business value activities exist: 1. .g. All rights reserved... handling the raw materials. and the support of the product that exists after the sale is made (e. They indicated that the firm itself is a part of the overall value chain of the industry. and then ends with the disposal and recycling of the materials. management of employees. etc. the delivery of the products through distribution channels. purchasing of the materials and supplies. 2.Business Environment & Concepts 2 Becker CPA Review APPENDIX I Homework Reading Topic: Market Influences on Business Strategies Expanded Discussion of Value Chain Analysis I. INTERNAL COSTS ANALYSIS In order to determine the internal value-creating ability of a firm. A. APPROACH OF VALUE CHAIN ANALYSIS Value chain analysis is part of an overall strategic plan. strategic planning. II. SHANK'S AND GOVINDARAJAN'S WORK IN 1993 John Shank and V. Michael Porter first suggested the idea of value chain analysis so that the firm could assess how the perceived value of the customer grows along the "chain" of activities that the firm goes through to bring its product to the marketplace. Three major forms of analysis are performed.g. advertising the product.). VALUE ACTIVITIES A.. the sources of profit and costs of the internal activities within the firm must be analyzed. Govindarajan took a look at the value chain in an even broader sense than Michael Porter. and servicing the product after it is sold). Primary Activities Primary activities are those that are involved with the direct manufacture of products. According to Porter. B. they must determine the parts of the value chain that will provide them with the largest amount of competitive advantage. INTERNAL DIFFERENTIATION ANALYSIS The firm may analyze its ability to create value through differentiation (e. continues with the firm and its strategic plan.
B. A. manufacturing. that value not only benefits the specific activity in the chain but also benefits other activities. STEPS IN VALUE CHAIN ANALYSIS Considering all of the above introductory material regarding value chain analysis. 2. B2-81 . Remember. All rights reserved. VERTICAL LINKAGE ANALYSIS Analyzing the vertical linkage of the firm means understanding the activities of the suppliers and buyers of the product (i.e. Value activities are generally those processes that are involved with designing. Often the greatest value and competitive advantage stems from the information obtained from this analysis because the activities that create the most and least amount of value can be determined. in-house customer service departments handle customer complaints in an efficient and courteous manner that establishes organizational responsiveness to the customer and creates loyalty. Inhouse customer service can also be alert for patterns of complaints and can influence product design. Identify Opportunities for Added Value Identification of activities that add value to the customer follows from our review of competitive advantage. all links from the sources of the raw materials through the recycling and disposal of the product after use) and determining where value can be created external to the firm's operations. Each step of the value chain should produce some value. Product innovation for those organizations depending on differentiation and reduced prices for those organizations focused on cost leadership will be the work product of this phase of value chain analysis. Opportunities to add value depend on our overall strategy. three general "steps" emerge. 4. the ultimate consumer actually ends up paying for the profit margins that exist all along the value chain. Identify Opportunities for Reduced Cost Analysis of the cost drivers should show where the organization is not competitive. while firms with differentiation strategies will look at opportunities for innovation. C. In some cases. Exploit Linkages Among Activities in the Value Chain Analysis of the value chain might also show synergies or connections that can be used to create greater efficiencies or greater value. Elimination or outsourcing of those items for which the organization is not cost competitive is generally proposed from this step in value chain analysis. IDENTIFY COST DRIVERS ASSOCIATED WITH EACH ACTIVITY Cost drivers represent factors that increase total cost. For example. DEVELOP A COMPETITIVE ADVANTAGE BY REDUCING COST OR ADDING VALUE The final step in value chain analysis is to study the cost drivers associated with each activity in the value chain from a specific perspective. Identify Competitive Advantage Firms with cost leadership strategies will look at cost saving opportunities. Organizations might also identify those areas in which outsourcing is valuable. and delivering a good or service. IDENTIFY VALUE CHAIN ACTIVITIES Organizations must identify value activities performed as part of their business. 3. III. 1. preparing..Becker CPA Review Business Environment & Concepts 2 C. © 2009 DeVry/Becker Educational Development Corp. Identification of cost drivers assists the organization in determining those areas in which it has a competitive advantage.
How Core Competencies are Created Core competencies are the glue that allows a firm to work as a team and to transfer good ideas from one product or segment of a business to another. Can a large amount of markets be accessed?). 4. and sustain new types of competitive advantage and profits while another firm always seems to follow or why some firms are always able to come up with the best innovations while others attempt to copy them. . quality physical resources. They also play a significant role with respect to the market influence on business strategy. segmentation analysis.e. impact the competitive environment of a firm. so they are listed here for introductory purposes only. and superior technology and is also able to integrate them appropriately.. is often helpful. learn new things (e. These five forces assist the firm in determining what makes a firm more profitable compared to another firm. b. Increase perceived customer value. (Vertical integration is also discussed later in this chapter as a possible strategy for firms to follow. which takes a look at the competitive advantages that exist in the various segments. Reduce the threat that competitors may copy the product. Barriers to market entry Market competitiveness Existence of substitute products Bargaining power of the customers Bargaining power of the suppliers CORE COMPETENCIES ANALYSIS While industry structure analysis assists in determining what it is that makes one firm more profitable than another. All rights reserved. 1. c.) When vertical integration exists within a firm and when analysis of the industry structure and the core competencies varies among the activities in the value chain. B. 3. They will each be discussed in detail later in this chapter. B2-82 © 2009 DeVry/Becker Educational Development Corp. Identifying Core Competencies A competency is deemed a core competency if it has the ability to: a.g. and reduce inherent risks is increased. 1. 2. and Provide leverage (i. three types of strategic frameworks have proven to be useful for value chain analysis. INDUSTRY STRUCTURE ANALYSIS Michael Porter's work in 1980 and 1985 identified five forces that influence profitability (either of an industry or a market) of the firm and. STRATEGIC FRAMEWORKS IN VALUE CHAIN ANALYSIS Although value chain analysis is hardly a science. 2. thus. thus increasing the firm's competitive advantage. attain. 5. A. a firm is vertically integrated. it does not focus on why one firm is able to create. best practices). C. Analysis of the core competencies of a firm answers these questions and attempts to reveal what it is within the firm that enables it to create advantage. SEGMENTATION ANALYSIS Sometimes.. from supplying the raw materials to distribution to the ultimate consumer. When a firm has a solid foundation in excellent employees.Business Environment & Concepts 2 Becker CPA Review IV. which means that it is involved in almost every aspect of the firm's value chain. the ability of the firm to adapt to change. work as a team.
GLOBAL COMPETITIVE ADVANTAGE AND VALUE CHAIN ANALYSIS Along with his "five forces" that impact the profits and competitive environment of an industry (1980 and 1985). it may help the nation fare better with regard to global competitive advantage (unless the costs are prohibitively high). currency fluctuations. If other rival firms who are competitive in the international environment exist. Porter indicated four major factors that impact global competitive advantage (to be considered along with the risks of the political environment of the nation. All rights reserved. the nation's competitive advantage is increased. B. the nation will fare better with regard to global competitive advantage. along with the laws of the nation that regulate the formation of companies and how intense the rivalry is with respect to competing firms within the nation. © 2009 DeVry/Becker Educational Development Corp. it will fare better with regard to global competitive advantage. CONDITIONS OF DOMESTIC DEMAND If the nation's domestic demand for the product is high.): A. inflation rates. CONDITIONS OF THE FACTORS OF PRODUCTION If the nation has a strong set of factors of production (e. which can negatively impact the overall customer value.. When the various parts of the value chain (and thus the value-creating processes) exist in different parts of the world. AND RIVALRY The practices of a nation with respect to how companies are managed and organized. B2-83 . etc.Becker CPA Review Business Environment & Concepts 2 V. tax regulations. C. FIRM STRATEGY. STRUCTURE. in his work in 1990.g. Michael Porter focused on the competitive forces that exist globally in an effort to study the ability of a nation to attain and sustain worldwide competitive advantage. RELATED AND SUPPORTING INDUSTRIES If suppliers of material inputs exist within the nation. a skilled labor force) that are required in a given industry. social values. this often poses problems of costs of transportation and lack of control and communication. D. all influence the ability of the nation to attain and sustain competitive advantage.
4. 7. 2. 10. 6. 7. it is necessary to procure the resources required to meet it and to manage the infrastructure that exists for the sources. 5.. which is essentially the entire supply chain. Selecting vendors Obtaining vendor feedback and certification Overseeing and obtaining proper vendor contracts Collecting and processing vendor payments Ordering. According to the Supply Chain Council.e. which attempted to create a generic model for any organization to use in order to look at the activities of the organization from the "supplier of the supplier" (the ultimate supplier) to the "customer of the customer" (the ultimate customer). this process deals with the following types of activities: 1. 3. core activities of SCOR). SUPPLY CHAIN OPERATIONS REFERENCE (SCOR) MODEL The SCOR Model was developed by the Supply Chain Council. According to the Supply Chain Council. B. 6. Determining the demand requirements Assessing the ability of the suppliers to supply resources Planning the inventory levels Planning the distribution of inventory Planning for the purchase of raw materials Assessing capacity concerns and capabilities Identifying viable distribution channels Configuring the supply chain Managing the product's life cycle Making make/buy decisions SOURCE Once demand has been planned.Business Environment & Concepts 2 Becker CPA Review APPENDIX II Homework Reading Topic: Market Influences on Business Strategies Expanded Discussion of Supply Chain Management I. and storing inputs to the production process Overseeing the quality assurance process Assessing vendor performance B2-84 © 2009 DeVry/Becker Educational Development Corp. inspecting. 3. 9. 2. The SCOR Model assists a firm in mapping out its true supply chain and then configuring it to best fit the needs of the firm and consists of four key management processes (i. 4. . examples of activities associated with "plan" are: 1. PLAN The process of planning consists of developing a way to properly balance aggregate demand and aggregate supply within the goals and objectives of the firm and plan for the necessary infrastructure. A. All rights reserved. 5. 8.
Managing the production process Implementing changes in engineering Requesting products for use in the production process Manufacturing the product Testing the product Packaging the product Releasing inventory for shipment Maintaining the production equipment and the facilities Performing quality assurance measures Scheduling production runs Analyzing capacity availability D. The following stages of supply chain management range from the least sophisticated to the most sophisticated. 9. 11. Managing of orders (e. 5. grant credit. According to the Supply Chain Council. Most are somewhere between implementing only the fundamentals of the process and having integration of the business enterprise. THE FUNDAMENTALS In this stage. 3. provide quotes.) Forecasting Pricing Managing transportation (e. and warehousing. STAGES OF SUPPLY CHAIN MANAGEMENT Not every firm implements supply chain management in the same way.g.Becker CPA Review Business Environment & Concepts 2 C. 7. © 2009 DeVry/Becker Educational Development Corp. some firms have developed extended supply chains or elaborate supply chain communities. DELIVER The "deliver" process encompasses all the activities of getting the finished product into the hands of the ultimate consumers to meet their planned demand. 9. All rights reserved. import/export issues.g.) Managing accounts receivable and collections Shipping of products Labeling of products Scheduling installation of products Delivering the inventory according to channel distribution rules II. 2. 10. truck coordination. 6. A. 4. 6. MAKE The "make" process encompasses all the activities that turn the raw materials into finished products that are produced to meet a planned demand. enter orders. 3. 4. B2-85 . freight. 8. According to the Supply Chain Council. 7. this process includes the following types of activities: 1.. However. 2. the firm is focused on its day-to-day operations and internal practices (such as standardization of operating procedures) it can employ to best manage its finished goods. 5. 8. etc. transportation issues. The firm may use spreadsheets to assist in delivering finished goods at costs that are predictable and reasonable because the main business issue it is concerned with is the cost of quality. etc. the process includes the following types of activities: 1..
but all of this hinges on whether the members of the community can cooperate within the workforce and among management and maintain a solid commitment to the established objectives of the community. management will turn its attention to consolidation of the various departments that make up operations in order to solve the firm's problems. SUPPLY CHAIN COMMUNITIES When the extended supply chain actually forms a single competitive entity. The firm will focus on the total cost of delivery. but when considered together. increase and leverage core competencies. as this process strives to integrate the supply chains of many operations. C.. III. profitable growth. and create new types of vertical integration. The main business issue of this stage is slow. and it is very concerned about customer service. Examples of benefits derived from implementing supply chain management include: A. B2-86 . goal congruence is essential). The community may be able to attain significant economies of scale. While the other stages focus on the operational side of the supply chain. C. improvements in various aspects and activities along the supply chain can provide areas of cost savings for the firm. and responding to customer needs. this stage directs its attention toward creating market leadership through working with partners to form strategic initiatives to assist in bringing new forms of value to the customer.e. not just those internally. the quantification of the benefits derived from such actions is not easily obtained. For this stage to be successful. management requires a quantified benefit before it will embark on any new type of plan. The firm will seek to achieve communication at the cross-functional level for on-time and complete delivery of its product. Networks play a large role in this stage. the firm could enjoy a significant positive impact on its profitability and competitive advantage. B. it is essential that the people involved are able to work well as a team and eliminate bias so that they are all aligned with the goals of the firm (i. Reduced costs in inventory management Reduced costs in warehousing Optimization of the distribution network and facility locations Enhanced revenues © 2009 DeVry/Becker Educational Development Corp. By themselves. While it is generally accepted that the coordination and integration of goods being brought to market is a valid business endeavor. D. which all work together with cross-functional purposes (rather than simply cross-functional communication) towards the main business issue of the cost of customer service. CROSS-FUNCTIONAL TEAMS In this stage. firms may see potential for increased profits by unifying the supply chain and forming mutual objectives. The need for those involved to be able to work as a unified team without bias is even more essential. E. D. management will move away from simple consolidation of its operations to an internally-integrated supply chain. All rights reserved. BENEFITS OF IMPLEMENTING SUPPLY CHAIN MANAGEMENT Typically. EXTENDED SUPPLY CHAIN If integration of the supply chain moves external to the firm. INTEGRATED ENTERPRISE In this stage. being profitable. However. this is significantly more difficult to implement than the previous four stages. and the extended supply chain may plan with point-of-sale tools and implement with customer management systems. The main business issue the firm is concerned with at this stage is unreliable order fulfillment. a synchronized supply chain community is formed.Business Environment & Concepts 2 Becker CPA Review B. and integrated supply chain management is no exception. and the main business issue facing the firm is creating networks of preferred suppliers.
2. After the company has chosen how it will best serve its customers. 3. 4. I. B. Establish an information and communication network for ISCM. B. J. V. E. IV. Translate the ISCM strategy into actions. This is essential to the ability of the firm to increase its market share and protect profits. Assess the opportunities in the supply chain. EFFICIENCY AND RESPONSIVENESS The supply chain of a firm must be both responsive to the changing needs of customers and allow the firm to do so in an efficient manner. H. All rights reserved. B2-87 STEPS TO ALIGN THE SUPPLY CHAIN AND THE BUSINESS STRATEGY © 2009 DeVry/Becker Educational Development Corp.Becker CPA Review Business Environment & Concepts 2 E. K. create value along the supply chain to achieve the planned goals. Improved service times Strategic shipment consolidation Reduced cost in packaging Improved delivery times Cross-docking (the minimization of handling and storage costs while receiving and process of goods in the shortest time possible) Identification of inefficiencies in supply chain activities Integration of suppliers Management of suppliers GENERAL STEPS IN IMPLEMENTING INTEGRATED SUPPLY CHAIN MANAGEMENT Although there is no set method for which to implement integrated supply chain management because there are so many variables in operational and strategic plans. C. C. 2. 1. Production Inventory Location Transportation Information Understand the markets the firm operates in and the customers it services. . F. A. Create an optimum organizational structure for ISCM. F. ALIGNING THE SUPPLY CHAIN AND BUSINESS STRATEGY A firm must be able to manage its supply chain in a way that is aligned with its business strategy. FIVE SUPPLY CHAIN DRIVERS 1. Develop a strategy for ISCM. which is directed at serving the needs of the consumers of the firm's product. Identify the core competencies of the firm and how the firm will use these to best serve its customers. 5. 3. the general steps a firm would follow are: A. G. D. L. Develop a vision for ISCM.
While the basic principles associated with hedge transactions are the same. the business will exercise its option. B2-88 © 2009 DeVry/Becker Educational Development Corp. However. I. All rights reserved. instead of requiring a commitment to a transaction. ADVANCED TECHNIQUES FOR MITIGATING TRANSACTION RISK AND EVALUATING STRATEGY A. Currency Option Hedges: Payables A call option (an option to buy) is the currency option hedge used to mitigate the transaction exposure associated with exchange rate risk for payables. . Similar to a futures contract or forward contract. the currency option hedge gives the business the option of executing the option contract or purely settling its originally negotiated transaction without the benefit of the hedge. The following outline deals with the option contracts. the decisions made by management are influenced by the character of the transaction to be hedged and the instrument used. While premiums are used to compute any net savings associated with option transactions. the business will allow the option to expire. 1. if the option price is less than the exchange rate at the time of settlement. and assessment techniques for evaluating the effectiveness of hedge strategies. The business evaluates the relationship between the option price and the exchange rate at the settlement date. the business plans to buy a foreign currency at a low rate in anticipation of the foreign currency strengthening in comparison to the domestic currency in order to ensure that it can settle its liability at predicted value. b. longer term transactions. If the option price is more than the exchange rate at the time of settlement. a. Generally. they are a sunk cost and are irrelevant to the decision to exercise the options. non-transactional risks.Business Environment & Concepts 2 Becker CPA Review APPENDIX III Homework Reading Implications of Dealing in Foreign Currency Mitigating risks associated with foreign currency transactions can be highly complex. CURRENCY OPTION HEDGES Currency option hedges use the same principles as forward hedge contracts and money market hedge transactions. The business has the option (not the obligation) to purchase the security at the option (strike) price. depending on which result is most favorable.
085 Settlement Cost for 1. however.000 [(.08.Becker CPA Review Business Environment & Concepts 2 Gearty International owes its Mexican supplier 1.08 Premium $.000.000 net savings. If the option price is less than the exchange rate at the time of settlement. computed as follows: EXAMPLE Spot Rate At Settlement $. Generally.000 pesos $ 100. Remember.085 Settlement Cost for 1.08.000 (85.000 pesos due in 30 days.000.000) Gearty will likely buy pesos at the spot rate regardless of the loss associated with the premium. The business evaluates the relationship between the option price and the exchange rate at the settlement date. that the premium is not included in the decision to exercise the option. the business will exercise its option. If Gearty is incorrect in its assessment of international exchange rates and the exchange rates stay constant at $.08) * 1. If Gearty is correct in its assessment of international exchange rates and the exchange rate at the time of the settlement (the spot rate) increases as predicted. 2. Gearty International pays a $. The gross savings of $20.08.000. they are a sunk cost and are irrelevant to the decision to exercise the options.005 premium. a. if the option price is more than the exchange rate at the time of settlement.000 and is paid regardless of whether the option is exercised. computed as follows: Spot Rate At Settlement $.000 85. is $5. then the company will allow its option to expire because exercising the option would actually be equal to simply settling the transaction at the spot rate. © 2009 DeVry/Becker Educational Development Corp.000 pesos $ 80.000 Gearty's consideration for the option. All rights reserved. Although the peso is currently exchanged for the US dollar at $.10.000. the company is fearful that the Mexican peso will strengthen in comparison to the dollar before the settlement to as much as $.005 Total Option $. Currency Option Hedges: Receivables A put option (an option to sell) is the currency option hedge used to mitigate the transaction exposure associated with exchange rate risk for receivables.000 premium to reflect a $15.005 Total Option $. Similar to a futures contract or forward contract. While premiums are used to compute any net preserved values associated with option transactions.000 net savings.10 – .000 pesos] is reduced by the $5. the $.000) $ 15.10 Net savings Option Price $. the business will allow the option to expire. B2-89 .005 premium to secure a call option to buy 1.000 pesos in 30 days for $. b. the business plans to sell a foreign currency at a high rate in anticipation of the foreign currency weakening in comparison to the domestic currency in order to ensure that it can capitalize on receivable collections at a stable or predicted value.000.08 Premium $.08 Loss Option Price $. Gearty will exercise its option to achieve a $15.000 ($ 5. The business has the option (not the obligation) to sell the collected amount of the foreign currency from the receivable at the option (strike) price.
.000 pesos in 30 days for $. Gearty International pays a $.000 preserved receivable value.005 premium to secure a put option to sell 1.000 pesos due in 30 days from its Mexican customer.000.08 Loss Option Price $. the company is fearful that the Mexican peso will weaken in comparison to the dollar before the settlement to as little as $.06) * 1. then it will allow their option to expire since to exercise the option would actually be equal to simply settling the transaction at the spot rate. computed as follows: Spot Rate At Settlement $.075 Settlement Cost for 1.000 75. that the premium is not included in the decision to exercise the option.000) Gearty will likely sell pesos at the spot rate regardless of the loss associated with the premium.000 and paid regardless of whether the option is exercised. If Gearty is incorrect in its assessment of international exchange rates and the exchange rates stay constant at $. is $5.000 in asset value.000. If Gearty is correct in its assessment of international exchange rates and the exchange rate at the time of the settlement (the spot rate) decreases as predicted.000 ($ 5. computed as follows: Spot Rate At Option Settlement Price $.005 Total Option $.000 premium paid to reflect a net $15.08.000.000 pesos] is reduced by the $5.000. however.000 Gearty's consideration for the option.000 75.Business Environment & Concepts 2 Becker CPA Review Gearty International is owed 1. The gross value "preserved" of $20.000 $ 15. Although the peso is currently exchanged for the US dollar at $.06.000 [(.000. the company will exercise its option to achieve a net preservation of $15. the $. Remember.075 Settlement Cost for 1.08.08 – .000 pesos $ 60.005 premium.08. All rights reserved. B2-90 © 2009 DeVry/Becker Educational Development Corp.08 Premium $.06 $.000 pesos $ 80.005 Total Option $.08 Net preserved value EXAMPLE Premium $.
000. there is no exposure to the risk because collection of the value booked as a receivable is assured by the option to purchase dollars at a prenegotiated rate with the foreign currency collected. The formulas take the difference between the nominal cost of hedging and the cost of not hedging to derive the additional cost of a hedge in comparison to the charges already incurred before the hedge. ASSESSING HEDGING STRATEGY EFFECTIVENESS The business decision to hedge or not to hedge using forward contracts may be evaluated using the formula for the real cost of hedging payables and the real cost of hedging receivables. If the exchange rate increases. To ensure that the company is able to settle (collect) its accounts receivable in an amount equal to the balance sheet value (expressed in its domestic currency). B. B2-91 . To ensure that the company is only required to settle (pay) its accounts payable in an amount equal to the balance sheet obligation (expressed in its domestic currency). there is no exposure to the risk because payment of the value booked as a liability is assured by the option to purchase the foreign currency in which the liability is denominated at the rate prenegotiated in the option contract.000. If the exchange rate declines. the company would purchase a call option to buy the amounts needed at the spot rate.Becker CPA Review Business Environment & Concepts 2 Using Foreign Currency Options to Mitigate Exchange Rate Risk Balance Sheet Date Assets Liabilities Exchange Rate Increases Spot Rate at Balance Sheet Date Spot Rate at Balance Sheet Date Purchase call option to buy foreign currency at balance sheet spot rate to limit cash outflows at settlement Mitigate Cash Flow Risks Preserve Fair Value of Asset Purchase put option to sell foreign currency at balance sheet spot rate to guarantee value of settlement. it is at risk for declines in the exchange rate or strengthening of the domestic currency in relation to the foreign currency. Exchange Rate Decreases The foregoing chart illustrates the relationship between exchange rate risk and monetary assets and liabilities and hedge strategies used to mitigate risk. The nominal cost of hedging a foreign currency is the known exchange rate for the currency times the underlying. Costs of Hedging or Not Hedging a. If the company owns accounts receivable in a foreign currency. the company would purchase a put option to sell the amounts collected at the spot rate. a monetary liability. All rights reserved. 1.75. If the company owes accounts payable in a foreign currency.000 is known to be $750. it is at risk for increases in the exchange rate or weakening of the domestic currency in relation to the foreign currency. © 2009 DeVry/Becker Educational Development Corp. a monetary asset. The nominal cost of hedging C$1. EXAMPLE Assume the cost of the Canadian dollar is $.
000.Business Environment & Concepts 2 Becker CPA Review b.000 $735.70. The real cost of hedging payables indicates that the company will pay $15. .000 as follows: Possible Rates .8.65. Real Cost of Hedging Receivables The real cost of hedging receivables is expressed in the following formula: a. The nominal cost of not hedging a foreign currency represents the expected value of a transaction settlement given a range of exchange rates and associated probabilities. 3. b.000. while positive results indicate that the business should not hedge the transaction. We would compute the nominal cost of not hedging a planned C$1.50 .000 C$1.50 probability of falling to . and a .000 $350. a .75.65 . Assume the cost of the Canadian dollar is $. RCHr = NRr − NRHr Terms are defined as follows: RCHr real cost of hedging receivables NRr nominal domestic revenues received without hedging NRHr nominal domestic revenues received from hedging B2-92 © 2009 DeVry/Becker Educational Development Corp.40 probability of rising to . the real cost of hedging payables with the stated exchange rate is as follows: EXAMPLE RCHp = NCHp − NCp RCHp = $750.000 EXAMPLE Nominal Cost of Not Hedging 2.000 less if it does not hedge.000 − $735.000.70 .40 Domestic Value C$1.10 probability of falling to $.000 $320. Assuming the results of the previous two concept examples.000 Nominal Cost of Not Hedging $ 65.000 The business should not hedge.80 Probability .000 C$1. Negative results indicate that the business should enter into a hedge transaction.000. and we anticipate that the exchange rate has a .10 .000 RCHp = $15. b. RCHp = NCHp − NCp Terms are defined as follows: RCHp real cost of hedging payables NCHp nominal cost of hedging payables NCp nominal cost of payables without hedging c. Real Cost of Hedging Payables The real cost of hedging payables is expressed in the following formula: a. All rights reserved.
Assuming the results of the previous concept examples. Financial Intermediaries Typically financial intermediaries are contacted to broker or match firms with currency needs. Two Firms Two firms with coincidental needs for international currencies may agree to swap currencies collected in a future period at a specified exchange rate. 1. long-term forward contracts deal with the same issues as any other forward contracts. payables or receivables) may not be known precisely prior to the execution of the futures. 2.Becker CPA Review Business Environment & Concepts 2 c. 2. or money market hedge.000 The business should hedge. To avoid the potential of overhedging. the real cost of hedging receivables with the stated exchange rate is as follows: RCHr = NRr – NRHr EXAMPLE RCHr = $735. If the business hedges too much. Negative results indicate that the business should enter into a hedge transaction. Logically. forward. the same fact pattern applied to a liability and an asset produce equal and opposite results.. Long-term forward contracts are set up to stabilize transaction exposure over long periods. C. © 2009 DeVry/Becker Educational Development Corp. Uncertainty The amount of hedged transactions (e. The two entities essentially swap their currencies in an exchange negotiation completed years in advance of their receipt of the currencies.000 − $750. Long-Term Forward Contracts Mechanically.000 less if it does not hedge.g. All rights reserved. a.000 RCHr = −$15. B2-93 . while positive results indicate that the business should not hedge the transaction. D. Longer-term hedges expand the gap between the exchange rate for the hedged item and the hedge itself thereby maximizing the savings or value of the hedged item. OTHER TECHNIQUES FOR TRANSACTION EXPOSURE MITIGATION: LONG-TERM TRANSACTIONS The following hedge transactions are used to mitigate exchange rate risk presented by transaction exposure. b. LIMITATIONS ON HEDGING 1. the company should only hedge the minimum amount known to be due or payable. Continual Short-Term Hedging Consistent short-term hedging can be ineffective over time because it mirrors the current trends of the market. Currency Swaps Transaction exposure associated with exchange rate risk for longer-term transactions can be mitigated with currency swaps. The real cost of hedging receivables indicates that the business will likely receive $15. the company is said to be overhedged. Long-term purchase contracts may be hedged with longterm forward contracts.
Leading and Lagging Leading and lagging represent transactions between subsidiaries or a subsidiary and a parent. Hedging one instrument's risk with a different instrument by taking a position is a related derivatives contract. E. .Business Environment & Concepts 2 Becker CPA Review 3. the use of organization-wide solutions related to the entity itself and related reporting requirements are included in the approach. A. Pete's Primo Piñatas would suffer economic losses as a result of their economic exposure to exchange rate risk. OTHER TECHNIQUES FOR TRANSACTION EXPOSURE MITIGATION: ALTERNATIVE HEDGING TECHNIQUES The following hedge transactions are used to mitigate exchange rate risk presented by transaction exposure. If the peso were to strengthen in relation to the dollar. A substantial decline in the value of one currency would not impact the overall dollar value of the firm if the currency represented only one of many foreign currencies. Generally. 1. All rights reserved. 2. 3. The extent to which revenues and expenses are denominated in different currencies could seriously impact the profitability of an organization and represents economic exposure. The company exports nearly 80 percent of its product to the United States and receives revenues denominated in United States dollars from upscale Mexican theme party planners. Currency Diversification The simplest hedge for long-term transactions is to diversify foreign currency holdings over time. This is often done when there is no derivatives contract for the instrument being hedged or when a suitable derivatives contract exists but the market is highly illiquid. The company's expenses paid to local suppliers are denominated in the peso. The entity that is owed may bill in advance if the exchange rate warrants (leading) or possibly wait until the exchange rate is favorable before settling (lagging). EXCHANGE RATE RISK: MANAGING ECONOMIC AND TRANSLATION EXPOSURE Businesses have various methods of managing the economic and translation exposure associated with exchange rate risks. Parallel Loan Two firms may mitigate their transaction exposure to long-term exchange rate loss by exchanging or swapping their domestic currencies for a foreign currency and simultaneously agreeing to re-exchange or repurchase their domestic currency at a later date. B2-94 EXAMPLE © 2009 DeVry/Becker Educational Development Corp. Cross-Hedging The technique known as cross-hedging involves those transactions that cannot be hedged. II. ASSESSING ECONOMIC EXPOSURE Economic exposure is defined by the degree to which cash flows of the business can be impacted by fluctuations in exchange rates. Pete's Primo Piñatas manufactures piñatas in Mexico. then imported revenues could be significantly less than domestic expenses.
international companies can perform a country risk analysis to fully assess the degree of their exposure. 1. Higher interest rates in the foreign country are indicators of slower economic growth and reduced demand. COUNTRY RISK ANALYSIS: FOREIGN ECONOMY CONSIDERATIONS The state of the foreign economy in which the multinational company operates is highly significant to risk evaluation. Increases in Expenses A company anticipating a depreciating foreign currency may elect to increase reliance on those suppliers to take advantage of paying for raw materials or supplies with cheaper currency.Becker CPA Review Business Environment & Concepts 2 B. Foreign Demand A multinational corporation exporting to a foreign country is vitally concerned with demand within that country. Although very little can be done to fully mitigate this risk exposure. b. Unsatisfactory evaluation of country risk could either result in divestiture of foreign operations or avoidance of development of foreign operations in a particular country. b. Restructuring Economic exposure to currency fluctuations can be mitigated by restructuring the sources of income and expense to the consolidated entity. All rights reserved. a. Demand is directly affected by the health of the economy of the county in which it operates. III. 2. Lower interest rates in the foreign country may be indicative of increased growth and demand. Decreases in Sales A company fearful of a depreciating foreign currency used by a foreign subsidiary may elect to reduce foreign sales to preserve cash flows. Characteristics of Restructuring and Economic Exposure Restructuring tends to be more difficult than ordinary hedges. b. 2. © 2009 DeVry/Becker Educational Development Corp. FOREIGN ECONOMIES AND POLITICAL RISK International business is subject to the generalized risk of operating within a foreign economy and to changes in the political climate. 1. B2-95 . A. Interest Rates a. a. Economic exposures to exchange rate fluctuations are viewed as more difficult to manage than transaction exposures. Weakening demand may cause the foreign government to implement tariffs or other regulatory measures that reduce foreign penetration. Measures to reduce foreign penetration may either require curtailment of foreign operations or export of goods produced by the multinational inside the foreign country instead of selling within the foreign country. TECHNIQUES FOR ECONOMIC EXPOSURE MITIGATION Economic exposures typically relate to organization-wide issues and can usually only be mitigated with organization-wide approaches that involve restructuring and adjustments to the business plan.
B. Weak local currency reduces demand for imported goods. Strong local currency increases demand for imported goods. 5. . 4. 3. Although expropriation of productive resources represents the most extreme political risk. All rights reserved. Bureaucracies and related inefficiencies or barriers to trade Corruption Host government attitude toward foreign firms Attitude of consumers toward foreign firms Inconvertibility of foreign currency War B2-96 © 2009 DeVry/Becker Educational Development Corp. 4. 6. b. other features of political risk must also be considered including: 1. Exchange Rate a.Business Environment & Concepts 2 Becker CPA Review 3. Inflation Higher local inflation and reduced purchasing power makes imported goods more expensive and reduces local demand for them. COUNTRY RISK ANALYSIS: POLITICAL RISK CONSIDERATIONS Political risks represent non-economic events or environmental conditions that are potentially disruptive to financial operations. 2.
Accounting Costs Accounting Profit Aggregate Demand (AD) Aggregate Supply (AS) Average Fixed Cost (AFC) Average Product (AP) Average Revenue (AR) Average Fixed Cost (AFC) Average Total Cost (ATC) Average Variable Cost (AVC) Balanced Budget Best Cost Strategy Boycott Budget Deficit Budget Surplus Business Cycle Cartel Comparative Advantage Competitive Strategies Complements Consumer Price Index (CPI) Constant Returns to Scale Contractionary Monetary Policy Core Competency Cost Leadership Strategy Cost Push Inflation Country Risk Covered Interest Arbitrage Cross Elasticity of Demand Cross Elasticity of Supply Cross Hedging Currency Appreciation Currency Depreciation Currency Variability Current Method Cyclical Unemployment Deflation Demand Curve Demand Pull Inflation © 2009 DeVry/Becker Educational Development Corp. All rights reserved. Depression Derived Demand Differentiation Strategy Discount Rate Diseconomies of Scale Disposable Income Economic Costs Economic Exposure Economic Profit Economies of Scale Expenditure Approach Explicit Costs Exchange Rate Exchange Rate Risk Expansionary Monetary Policy External Factors Factors of Production Federal Reserve (Fed) Final Products Fiscal Policy Fischer Effect Frictional Unemployment Forward Exchange Rate Forward Hedge Full Employment Functional Currency Futures Hedge GDP Deflator Gross Domestic Income (GDI) Gross Domestic Product (GDP) Gross National Product (GNP) Hedge Transaction Implicit Costs Income Approach Income Elasticity of Demand Industry Structure Analysis Inferior Good Inflation Interest Arbitrage B2-97 .Becker CPA Review Business Environment & Concepts 2 BUSINESS ENVIRONMENT & CONCEPTS 2 Terminology Definitions of the following terms that relate to topics presented in this lecture are provided in the comprehensive glossary located at the end of this textbook.
. All rights reserved.Business Environment & Concepts 2 Becker CPA Review Interest Rate Parity Internal Factors International Fischer Effect Kinked Demand Curve Lagging Indicator Law of Demand Law of Diminishing Returns Law of Supply Leading Indicator Long Run Long-Run Aggregate Supply (LRAS) M1 M2 M3 Marginal Cost (MC) Marginal Product (MP) Marginal Propensity to Consume (MPC) Marginal Revenue (MR) Marginal Revenue Product (MRP) Market Demand Market Equilibrium Market Supply Monetary Assets and Liabilities Monetary Policy Money Market Hedge Money Supply Monopoly Monopolistic Competition Monopsony Multiplier Effect National Income National Income Accounting Natural Rate of Unemployment Natural Monopoly Natural Rate of Unemployment Net Domestic Product Net National Product Niche Strategy Nominal GDP Nominal Interest Rate Non-Monetary Assets and Liabilities Normal Good Oligopoly Open Market Operations Opportunity Cost Options Hedge Parallel Loan Perfect Competition Personal Income Phillips Curve Price Ceiling Price Floor Price Elastic Demand Price Elasticity of Demand Price Elasticity of Supply Price Inelastic Demand Price Inelastic Supply Price Searcher Price Setter Price Taker Production Function Production Possibilities Curve Profit Purchasing Power Parity Quantity Demanded Quantity Supplied Real GDP Real Interest Rate Recession Reporting Currency Required Reserves Ratio (RRR) Seasonal Unemployment Short Run Spot Rate Structural Unemployment Substitutes Supply Curve Supply Shock Temporal Method Total Cost (TC) Total Fixed Cost (TFC) Total Output (Q) Total Variable Cost (TVC) Total Product Total Revenue (TR) Transaction Exposure Translation Exposure Unemployment Rate Unit Elastic Demand Value at Risk Value Chain Analysis Vertical Integration B2-98 © 2009 DeVry/Becker Educational Development Corp.
9. 18. 13.Becker CPA Review Business Environment & Concepts 2 BUSINESS ENVIRONMENT & CONCEPTS 2 Class Questions Answer Worksheet MC Question Number First Choice Answer Correct Answer NOTES 1. 4. 10. Grade: Multiple-choice Questions Correct / 18 = __________% Correct Detailed explanations to the class questions are located in the back of this textbook. B2-99 . 8. 2. 15. 5. 12. 14. 3. © 2009 DeVry/Becker Educational Development Corp. 16. 11. All rights reserved. 17. 6. 7.
All rights reserved.Business Environment & Concepts 2 Becker CPA Review NOTES B2-100 © 2009 DeVry/Becker Educational Development Corp. .
953 billion. b. 2. CPA-03291 Which of the following is not likely to cause a rightward shift in the aggregate demand curve? a. $ 5. d. d. Structural. A shift left in the aggregate supply curve. An increase in the general level of confidence about the economic outlook. B2-101 . 3. A shift right in the aggregate supply curve. $6. $6. c. Cyclical. Natural. CPA-03396 Assume the following data for the U. The most plausible explanation for this is: a. b. A shift right in the aggregate demand curve. Frictional. $6. b. An increase in wealth.040 billion $ 262 billion $ 183 billion $ 975 billion $ 5 billion Based on this information. CPA-03404 What type of unemployment is shown when individuals do not have the qualifications or skills necessary to fill available jobs? a. c.215 billion. $7. economy in a recent year: Personal consumption expenditures Exports Government purchases of goods/services M1 Imports Gross private domestic investment Open market purchases by Federal Reserve a. CPA-03307 Suppose real GDP is rising while the overall price level is falling. A shift left in the aggregate demand curve. c. An increase in government spending. © 2009 DeVry/Becker Educational Development Corp. GDP for the year in question? 4. d.Becker CPA Review Business Environment & Concepts 2 CLASS QUESTIONS 1.S.691 billion.958 billion.015 billion $ 106 billion $ 1. d. An increase in the level of real interest rates. b. c.S. which of the following was the U. All rights reserved.
15% 2% 50% 5% 8. b. Maximum price above the equilibrium price. c. c. B2-102 © 2009 DeVry/Becker Educational Development Corp. d. Minimum price below the equilibrium price. Various levels of the organization will implement strategic plans differently. 7. b. The price of cars decreases. 10. d. d. 9. A continuous decline in the overall price level. The price of gasoline increases. b. The money supply to decrease and interest rates to rise. d. d. CPA-03667 Which one of the following changes will cause the demand curve for gasoline to shift to the left? a. CPA-03395 An increase in the discount rate would cause: a.Business Environment & Concepts 2 Becker CPA Review 5. The money supply to increase and interest rates to fall. d. . The supply of gasoline decreases. When the price of a particular good falls. Maximum price below the equilibrium price. c. 6. b. The money supply to increase and interest rates to rise. CPA-03471 Which of the following is not true regarding strategic plans? a. The price of cars increases. CPA-03670 The competitive model of supply and demand predicts that a surplus can only arise if there is a: a. A continuous rise in the overall price level. b. CPA-03412 If the nominal interest rate is 10% and the rate of inflation is 5%. All rights reserved. The process of strategic planning begins with the creation of the plan. Strategic plans will vary by segment based on the characteristics of the segments. CPA-03411 Deflation is best defined as: a. c. c. The money supply to decrease and interest rates to fall. A continuous decline in real GDP. Continual re-evaluation and revision of strategic plans is necessary. c. Minimum price above the equilibrium price. b. the real interest rate is: a.
d. 0. CPA-03479 Under pure competition. b. c. Maintaining the market share and being responsive to market conditions related to sales price. c. Maintaining the market share and planning for enhanced product differentiation. CPA-03497 Elasticity of demand or supply is: a. strategic plans focus on: a. Maintaining the market share. and adapting to price changes or required changes in production volume. 14.00 0. and adapting to price changes or required changes in production volume. A measure of how flexible the demand or supply of a product is when preferences change. b. All rights reserved. c.00 13. CPA-03708 As the price for a particular product changes. Profitability from production levels that maximize profits. B2-103 .20 10. CPA-03493 Under oligopoly. ensuring product differentiation. Maintaining the market share and planning for enhanced product differentiation. the quantity of the product demanded changes according to the following schedule: Total Quantity Demanded 100 150 200 225 230 232 Price per Unit $50 45 40 35 30 25 The price elasticity of demand for this product when the price decreases from $50 to $45 is: a. Profitability from production levels that maximize profits. © 2009 DeVry/Becker Educational Development Corp. b.Becker CPA Review Business Environment & Concepts 2 11. A measure of how flexible the firm is with respect to responding to the needs of the consumers. A measure of how sensitive the demand for or supply of a product is to a change in its price. strategic plans focus on: a. c. 12. Maintaining the market share. ensuring product differentiation. b. Maintaining the market share and being responsive to market conditions related to sales price.10 5. d. A measure of how well a firm's strategic plan is able to adapt to changes in demand or supply. d. d.
d. b. B2-104 © 2009 DeVry/Becker Educational Development Corp. d. 18. If the total costs of a firm are less than those of close rivals. b. Market competitiveness. . c. 17. b. d. Customers are able to see (or perceive) a value in the firm's product compared to products of other firms.Business Environment & Concepts 2 Becker CPA Review 15. A strategy in which the firm attempts to gain competitive advantage by seeking to control the entire value chain (or a portion of it) within the same industry. c. A process in which the firm focuses on predicting the expected demand of consumers and then plans accordingly for it. The firm's product appeals to different people for different reasons. The two major forms of competitive advantage are differentiation and cost leadership. and its rivals are consistently able to effectively respond to changes in consumer preferences by making strategic moves in an effort to win over the buyers and gain competitive advantage. Which of the five forces that affect the competitive environment and profitability of a firm does this best demonstrate? a. All rights reserved. Barriers to entry. CPA-03602 Which of the following statements regarding competitive advantage is not correct? a. Cost leadership advantage may best be obtained by a firm when a firm builds market share or matches the price of its rivals. 16. The value of the firm's premium does not exceed its cost. d. An alliance with another firm that allows for economies of scale and sharing of costs in a less than formal manner. Differentiation advantage may best be obtained by a firm when a firm builds market share or decreases its price. Bargaining power of customers. b. CPA-03620 Vertical integration is: a. CPA-03609 When do differentiation strategies fail? a. c. then the firm has a competitive market advantage. Existence of substitute products. A formal process in which two or more firms combine to provide for cost reductions they could not otherwise obtain on their own. The various rival firms have chosen different features on which to differentiate their products. CPA-03583 A firm is in heavy competition with a rival firm. c.
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