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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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3. Business cycles are typically comprised of: 1. SUMMARY COMPOSITION OF BUSINESS CYCLES As noted above. leading to higher costs and a higher overall price level. At the peak of a business cycle. firm profits typically begin to stabilize as the demand for goods and services begins to rise. 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. Contractionary Phase A contractionary phase is characterized by falling economic activity and growth and follows a peak. Expansionary Phase An expansionary phase is characterized by rising economic activity (real GDP) and growth. 2. Real GDP per capita is typically used to compare standards of living across countries or across time. At this point of the business cycle. . During a recovery phase. and these fluctuations are known as business cycles. It marks the end of an expansionary phase and the beginning of a contractionary phase in economic activity. Firm profits are likely to be rising during an expansionary phase as the demand for goods and services increases. firm profits are likely to be at their highest level. leading them to reduce the size of their workforce and cut costs. Firms are also likely to experience significant excess production capacity. 4. During an expansionary phase. economic activity begins to increase and return to its long-term growth trend. Peak A peak is a high point of economic activity. economic activity is characterized by fluctuations.Business Environment & Concepts 2 Becker CPA Review D. All rights reserved. Further. E. Real GDP per capita is also used to measure economic growth. and the price of goods and services is likely to be rising. firm profits are likely to be at their lowest level. Recovery Phase A recovery phase follows a trough. Firms are also likely to face capacity constraints and input shortages (raw material and labor). firm profits are likely to be falling from their highest levels. Economic growth is the increase in real GDP per capita over time. Firms are also likely to increase the size of their workforce during an expansion. economic activity is rising above its long-term growth trend. During a contractionary phase. Trough A trough is a low point of economic activity. 5.
ILLUSTRATION Graph A illustrates the business cycle. B2-5 . C. TERMINOLOGY USED IN DESCRIBING BUSINESS CYCLES A. RECESSION A recession occurs when the economy experiences negative real economic growth (declines in national output). As a result. it is likely that many firms will go out of business during a depression. during a recession. firms will experience significant excess capacity. It is characterized by a relatively long period of stagnation in business activity and high unemployment rates. B. firm profits tend to fall and many firms incur losses. As a result. resources (including labor) are likely to be underutilized and unemployment is likely to be high. due to the significant reduction in the demand for goods and services. Economists define a recession as two consecutive quarters of falling national output. During a recession. Firms are also likely to have excess capacity. All rights reserved.Becker CPA Review Business Environment & Concepts 2 II. 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. Furthermore. DEPRESSION A depression is a very severe recession.
" A. and the government are willing and able to purchase at any given price level. The x-axis is real GDP. They include the following: 1. The government routinely revises the numbers as more data becomes available. Industrial production Manufacturing and trade sales IV. Economic indicators (gathered by The Conference Board) are variables that have historically correlated highly with economic activity. Thus. economists generally agree that business cycles result from shifts in aggregate demand and/or aggregate supply. All rights reserved. They can be "leading indicators. They are also used to examine the causes of economic fluctuations." "lagging indicators. AGGREGATE DEMAND (AD) CURVE The aggregate demand (AD) curve illustrates the maximum quantity of all goods and services that households. 2. ECONOMIC INDICATORS Although business cycles tend to be irregular and unpredictable. firms. although it is often drawn as a curve. 7.Business Environment & Concepts 2 Becker CPA Review III. 6. 2. This particular "line" just happens to be drawn as a straight line. 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. LEADING INDICATORS Leading indicators tend to predict economic activity. They give signals after the fact and include the following: 1. 2. economists nevertheless attempt to predict business cycles and their severity and duration using economic indicators. 4. 3. . COINCIDENT INDICATORS Coincident indicators tend to occur coincident to economic activity. leading indicators are subject to change." or "coincident indicators. 5. A. 8. B2-6 © 2009 DeVry/Becker Educational Development Corp. Prime rate charged by banks Average duration of unemployment Bank loans outstanding C. Note that this "aggregate" demand curve is the macroeconomic demand curve of the "total" demand in the economy as a whole. B. It shows the relationship between total output (real GDP) of the economy and the price level. REASONS FOR FLUCTUATIONS While there are a variety of theories regarding the cause of business cycles. They include: 1. 3. 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).
3. ILLUSTRATION Graph B illustrates the aggregate demand and aggregate supply curves for an economy. Note that this "aggregate" supply curve is the macroeconomic supply curve of the "total" supply in the economy as a whole. Short-Run Aggregate Supply Curve The short-run aggregate supply (SRAS) curve is upward sloping. 2. the economy will typically be experiencing a recession. Y* = GDP at the potential (equilibrium) level of output. illustrating the fact that in the long-run. C. 1. When real GDP is below the potential level of output. Similarly.Becker CPA Review Business Environment & Concepts 2 B. the economy will typically be experiencing an expansion. 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. 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. if all resources are fully utilized. illustrating the fact that as the price level rises. 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. firms are willing to produce more goods and services. The position of the long-run aggregate supply (LRAS) curve determines the level of output in the long run. when real GDP rises above the potential level of output. The LRAS curve is vertical at the economy’s potential level of output. © 2009 DeVry/Becker Educational Development Corp. B2-7 . Long-Run Aggregate Supply Curve The long-run aggregate supply (LRAS) curve is vertical. This curve corresponds to the potential level of output in the economy. All rights reserved. output is determined solely by the factors of production.
2. Reduction of Supply If circumstances cause firms to reduce their supply of goods and services. economic activity will fall. they are also likely to increase the size of their workforce. if circumstances cause individuals. businesses.Business Environment & Concepts 2 Becker CPA Review D. B2-8 . Reduction in Demand If circumstances cause individuals. or economic fluctuations. economic activity will rise. Increase in Demand In contrast. 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. AND ECONOMIC FLUCTUATIONS Business cycles. 4. an increase in demand tends to cause firm profits to rise. As a result. economic activity (real GDP) will decline. As firms reduce their supply. economic activity will rise. All rights reserved. real GDP falls from Y0 to Y1. leading them to reduce the size of their workforce. leading them to increase the size of their workforce. leading to a contraction or possibly a recession. As a result. they are also likely to reduce the size of their workforce. As a result. leading to a contraction in economic activity and possibly a recession. or governments to reduce their demand for goods and services. Graphs C and D illustrate recessions caused by shifts in aggregate demand and short-run aggregate supply. As a result. 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. 1. Firms are also likely to experience a reduction in excess capacity. As firms increase their supply. This is illustrated as the leftward shift in aggregate demand. leading to a recovery or an expansion in economic activity. leading to lower unemployment. leading to higher unemployment. Increase in Supply If circumstances cause firms to increase their supply of goods and services. real GDP falls from Y0 to Y1. businesses. This is illustrated as the leftward shift in the short run aggregate supply curve. AGGREGATE DEMAND. a reduction in demand tends to cause firm profits to decline. AGGREGATE SUPPLY. 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). Firms are also likely to experience an increase in excess capacity. 3. leading to an expansionary phase of economic activity. and governments to increase their demand for goods and services. © 2009 DeVry/Becker Educational Development Corp.
b. Increase in Real Interest Rates An increase in interest rates increases the cost of capital and. Conversely. causing national output to rise. All rights reserved. B2-9 . the willingness to acquire investment and consumer goods increases and the aggregate demand curve shifts right. FACTORS THAT SHIFT AGGREGATE DEMAND The primary factors that shift aggregate demand are: 1. As a result. an increase in real interest rates causes the cost of capital to rise and shifts the aggregate demand curve to the left. Changes in Expectations about the Future Economic Outlook (Consumer Confidence) a. Thus.Becker CPA Review Business Environment & Concepts 2 E. causing a contraction and possibly a recession. causing national output to fall. 3. national output would fall. b. Changes in Wealth a. Changes in Real Interest Rates a. Increase in Wealth An increase in wealth causes the aggregate demand curve to shift to the right. Decrease in Wealth A decrease in wealth causes the aggregate demand curve to shift to the left. an increase in wealth causes the economy to expand and leads to an increase in national output (real GDP). causing national output to rise. A decrease in wealth does the opposite of an increase in wealth. 2. Confident Economic Outlook If households become confident about the economic outlook (consumer confidence increases). b. tends to reduce consumer demand for durable goods such as new cars and homes and firm demand for new plants and equipment. consumers tend to reduce current spending. shifting aggregate demand to the left and causing national output to fall. © 2009 DeVry/Becker Educational Development Corp. Uncertain Economic Outlook When the economic outlook appears more uncertain. therefore. Decrease in Real Interest Rates A decrease in real interest rates does the opposite of an increase in real interest rates. a large decline in stock prices would decrease consumer wealth and therefore shift the aggregate demand curve to the left. A decrease in real interest rates reduces the cost of capital. For example. thereby increasing the demand for investment goods and shifting the aggregate demand curve to the right.
net exports (exports minus imports) will rise. Depreciated Currencies If the currency of a country depreciates in real terms relative to the currencies of its trading partners. Decrease in Government Spending A decrease in government spending shifts the aggregate demand curve to the left.. net exports (exports minus imports) will fall. b. while foreign goods will become relatively expensive for its residents. 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. shifting the aggregate demand curve to the left and causing national output to fall. Appreciated Currencies If the currency of a country appreciates in real terms relative to the currencies of its trading partners. As a result. Changes in Consumer Taxes a. As a result. b. 6. Increase in Government Spending An increase in government spending shifts the aggregate demand curve to the right. All rights reserved. while foreign goods will become relatively cheap for its residents. the personal income tax) reduces the disposable income (gross income minus taxes) of consumers and. B2-10 © 2009 DeVry/Becker Educational Development Corp. its goods will become relatively cheap for foreigners. Changes in Exchange Rates a. Changes in Government Spending a.Business Environment & Concepts 2 Becker CPA Review 4. therefore. Increase in Consumer Taxes An increase in consumer taxes (e. causing national output to fall. its goods will become relatively expensive for foreigners. b. 5. . causing national output to fall. causing national output to rise. shifts the aggregate demand curve to the left. shifting the aggregate demand curve to the right and causing national output to rise.g.
The MPC is the change in consumption due to a $1 increase in income. © 2009 DeVry/Becker Educational Development Corp. the economy is initially in an expansionary phase. Therefore. a $1 increase in government spending results in a greater than $1 increase in real GDP. THE MULTIPLIER EFFECT The multiplier effect refers to the fact that an increase in consumer. Using the MPC. shifting the aggregate demand curve to the left and causing national output (real GDP) to fall. 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). which is below the potential level of output Y1. or government spending.Becker CPA Review Business Environment & Concepts 2 7. B2-11 . Their spending gives other households and firms income. The government can contract the economy by decreasing government spending or increasing taxes (or both). In graph F. the effect of a $1 increase in spending is magnified by the multiplier effect. 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). which in turn spend that income. and so on. The multiplier effect stems from the fact that increases in spending generate income for firms. 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. 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. firm. Because people tend to save part of their income. All rights reserved. so be aware of this terminology as well. which is above the potential level of output Y1. For example. illustrated as output level Y0. and Graph F illustrates the effect of a decrease in government spending and/or an increase in taxes (known as contractionary fiscal policy). the economy is initially in a recession. the MPC is typically less than one. illustrated as output level Y0. The multiplier effect results from the marginal propensity to consume (MPC). produces a multiplied increase in the level of economic activity.
This is illustrated in Graph D. . Supplies are Curtailed If resource supplies are curtailed (e. crop failures. Increase in Input Prices An increase in input prices (raw material prices. national output would fall. b. wages. damage to infrastructure caused by earthquakes. when discussing business cycles we focus on shifts in the shortrun aggregate supply curve. The primary factors that shift short-run aggregate supply are: 1. etc. G.Business Environment & Concepts 2 Becker CPA Review For example. b. As a result. Decrease in Input Prices A decrease in input prices causes the short-run aggregate supply curve to shift to the right. the short-run aggregate supply curve will shift to the right. causing national output (real GDP) to decline.g. 2.) the short-run supply curve will shift to the left. Therefore. etc.) causes the shortrun aggregate supply curve to shift left.8) Thus a $100 dollar increase in spending results in a $500 increase in real GDP. causing national output to increase. a large increase in oil prices (oil is a primary input in production) would shift the short-run aggregate supply curve to the left.e. Then the multiplier would be: Multiplier = 1 × $100 = $500 (1 − 0. A decrease in input prices causes the economy to expand and leads to an increase in national output (real GDP). Supplies are Plentiful If resource supplies become more plentiful. All rights reserved. an increase in input prices causes the economy to contract and leads to a decrease in national output (real GDP). EXAMPLE For example.. causing a contraction and possibly a recession.8 (i. Thus. the change in consumption due to a $1 increase in income is 80 cents) and that spending increases by $100. FACTORS THAT SHIFT SHORT-RUN AGGREGATE SUPPLY Recall that shifts in long-run aggregate supply are associated with economic growth NOT business cycles. Supply Shocks a. B2-12 © 2009 DeVry/Becker Educational Development Corp. Changes in Input (Resource) Prices a.. suppose the MPC is 0.
g... an increase in wealth or a decrease in interest rates) tend to cause firm profits to rise. 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. leading them to increase the size of their workforce. © 2009 DeVry/Becker Educational Development Corp. All rights reserved. economic events that cause aggregate demand to decrease (e. 1. For example. B2-13 . when the aggregate demand curve shifts right (an increase in aggregate demand). 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. b. and other conditions. a rise in input costs tends to reduce firm profits and cause firms to reduce the size of their workforce. firm profits tend to increase. Shifts in Aggregate Supply Economic events that shift the aggregate supply curve also affect firm profits. Shifts in Aggregate Demand Economic events that cause aggregate demand to increase (e. Example As was discussed above. a decline in consumer confidence) tend to cause firm profits to fall.g. In contrast. 2.Becker CPA Review Business Environment & Concepts 2 H. employment. firms are likely to experience a decrease in excess capacity. they also affect the business conditions of firms. In addition. a.
Business Environment & Concepts 2 Becker CPA Review ECONOMIC MEASURES AND REASONS FOR CHANGES IN THE ECONOMY I. The combined economic output of the following four sectors is called Gross Domestic Product (GDP). and (4) interest rates. . and services) Net exports (exports minus imports) B2-14 © 2009 DeVry/Becker Educational Development Corp. non-durable goods. Department of Commerce in order to monitor the health and performance of the U. Households (or Consumers) Businesses Federal. the total dollar value of all new final goods and services produced within the economy in a given time period. 1. OVERVIEW Economists and policy-makers rely on a host of economic measures or indicators to determine the overall state of economic activity. II. All rights reserved. State. when the unemployment rate is rising the inflation rate tends to be falling. both discussed in detail below) are calculated using NIPA. The two approaches to measuring GDP (expenditure approach and income approach. THE NATIONAL INCOME ACCOUNTING SYSTEM The National Income and Product Accounting (NIPA) system was developed by the U. For example. residential fixed investment. It is important to remember that these economic measures tend to move together. A. 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.S. Similarly. (3) the inflation rate. unemployment tends to be falling. The Expenditure Approach Under the expenditure approach. when real GDP is rising.S. Some of the most commonly cited economic measures are: (1) real Gross Domestic Product (real GDP). TWO METHODS OF MEASURING GDP The two methods of measuring GDP are the expenditure approach and the income approach. and Local Governments The Foreign Sector Remember that GDP was introduced on page B2-3 where nominal GDP and real GDP were discussed. economy. (2) the unemployment rate. and change in business inventories) Personal consumption expenditures (durable goods.
4 4.8 $6.5 392. interest. rent. 1. All rights reserved.6 45.314.5 4. The income approach includes business profits. 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.4 © 2009 DeVry/Becker Educational Development Corp. The aggregate expenditures approach on the left is a flow-of-product approach (at market prices). wages.7 (96. depreciation.014. Table 1 (Billions of Dollars) Expenditures Approach (Flow-of-Product) Government purchases Investment Consumption Exports (net) $1. The Income Approach The income approach accounts for GDP as the value of resource costs and incomes generated during the measurement period.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. and business taxes.8 116.698. b.9 526.Becker CPA Review Business Environment & Concepts 2 2.931.3 818.4 Aggregate Expenditure $6. B2-15 . 2.008. a.0 572. Calculate GDP through the income approach by using the following mnemonic: I P I R A T E D B.931.7 1. The income approach on the right is a flow of earnings and costs approach (valueadded items plus taxes).
. firms and excludes goods and services that are produced domestically by foreign firms. . GDP. National Income (NI) National income (NI) is NNP less indirect business taxes (e. 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. Personal Income (PI) Personal Income (PI) is the income received by households and noncorporate businesses. All rights reserved.e. NNP equals GNP minus economic depreciation. GNP because BMW is a foreign-owned company. For example.. if BMW produces cars in the U. Net National Product (NNP). B2-16 © 2009 DeVry/Becker Educational Development Corp. This depreciation is not accounting depreciation. the expenditure necessary to maintain production capacity (or "depreciation" to accountants). which is allocation of costs to accounting periods. GNP differs from GDP because GNP includes goods and services that are produced overseas by U. It is the amount of income households have available either to spend or save. 1. 2. but it is not counted as part of U. 5. there are several other noteworthy measures. losses in the value of capital goods due to age and wear). sales tax). that production is counted as part of U..S. National Income (NI). and Disposable Income (DI).S. Specifically. 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.S. 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. Disposable Income (DI) Disposable Income (DI) is personal income less personal taxes. It measures the income received by all factors of production within a country.Business Environment & Concepts 2 Becker CPA Review C. Personal Income (PI). Gross National Product (GNP). These measures are calculated by making specific deductions and additions to GDP and include: Net Domestic Product (NDP). 4.g. Thus. OTHER MEASURES OF NATIONAL INCOME While GDP is the most common measure of national income and an economy's output and performance. Net Domestic Product Net domestic product (NDP) is GDP minus depreciation (the capital consumption allowance). 3.S.
Full Employment Full employment is defined as the level of unemployment when there is no cyclical unemployment. cyclical unemployment rises during a recession and falls during an expansion. the natural rate of unemployment is the sum of frictional. Jobs available in the market do not correspond to the skills of the work force. structural. Full employment does not mean zero unemployment. The unemployment rate can be expressed as: Unemployment Rate = Number of Unemployed × 100 Total Labor Force A. B. © 2009 DeVry/Becker Educational Development Corp. (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. 2. All rights reserved. 3. For example. The total labor force includes all non-institutionalized individuals 16 years of age or older who are either working or actively looking for work. Frictional Unemployment Frictional unemployment is normal unemployment resulting from workers routinely changing jobs or from workers being temporarily laid off. B2-17 . 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. cyclical unemployment is negative. Structural Unemployment Structural unemployment occurs when: a. the demand for labor increases and then decreases again after Christmas. and Unemployed workers do not live where the jobs are located.Becker CPA Review Business Environment & Concepts 2 III. 4. and seasonal unemployment. there is still frictional. structural. 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). Seasonal Unemployment Seasonal unemployment is the result of seasonal changes in the demand and supply of labor. It is the unemployment that arises because of the time needed to match qualified job seekers with available jobs. 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. b. TYPES OF UNEMPLOYMENT 1.) Note that to be counted as unemployed a person must be actively looking for work. Thus. When real GDP is below the potential level of output. shortly before Christmas. When the economy is operating at full employment. When real GDP is above the potential level of output. Thus. NATURAL RATE OF UNEMPLOYMENT AND THE MEANING OF FULL EMPLOYMENT 1. THE UNEMPLOYMENT RATE The unemployment rate measures the ratio of the number of people classified as unemployed to the total labor force.
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. It occurs when prices on average are increasing over time. Most economists believe deflation is a much bigger economic problem than inflation. THE LINK BETWEEN UNEMPLOYMENT AND OUTPUT (REAL GDP) The unemployment rate and national output (real GDP) tend to move in opposite directions. (The Producer Price Index (PPI) measures the overall cost of a basket of goods and services typically purchased by firms. When the demand for goods and services increases (when real GDP is rising). a.Business Environment & Concepts 2 Becker CPA Review C. During periods of deflation. the unemployment rate tends to be rising. All rights reserved. DEFINITIONS 1. firm profits are likely to be falling during periods of deflation. when real GDP is rising. Formula Using the CPI. THE PRICE LEVEL AND INFLATION A. IV. 2. firms are likely to experience significant excess production capacity. It occurs when prices on average are falling over time. firms typically need to hire additional workers to produce the additional goods and services demanded and hence the unemployment rate tends to fall. Inflation Inflation is defined as a sustained increase in the general prices of goods and services. . That is. when real GDP is falling (for example. when the economy is in a recession).) b. 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. Similarly. Consequently. the unemployment rate tends to be falling. 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. Obviously the opposite is true when the demand for goods and services decreases. 3. 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. The reason for the link between the two variables is straightforward. Deflation Deflation is defined as a sustained decrease in the general prices of goods and services.
or An increase in nominal wages. An increase in oil prices. 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. 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. All rights reserved. Decreases in taxes. Similarly. Increases in wealth. leading to inflation. a shift left in the short-run aggregate supply curve will also cause the price level to rise. 1. 3. b. b. B2-19 . A shift right in the aggregate demand curve will cause the price level to rise. a shift right in the short-run aggregate supply curve will also cause the aggregate price level to fall. CAUSES OF INFLATION AND DEFLATION Inflation and deflation are caused by shifts in the aggregate demand and short-run aggregate supply curves. leading to inflation. costpush inflation could be caused by factors such as: a. Illustrations Graphs G and H illustrate demand-pull and cost-push inflation using the aggregate demand and short-run aggregate supply curves. c. Thus. 2. demand-pull inflation could be caused by factors such as: a. Thus. 4. Cost-Push Inflation Cost-push inflation is caused by reductions in short-run aggregate supply. Increases in government spending. Similarly. Deflation Deflation is also caused by shifts in aggregate demand or short-run aggregate supply.Becker CPA Review Business Environment & Concepts 2 B. Cost-Push Inflation: A decrease in shortrun aggregate supply causes the short-run equilibrium price level to rise from P0 to P1. d. Demand-Pull Inflation Demand-pull inflation is caused by increases in aggregate demand. © 2009 DeVry/Becker Educational Development Corp. and Increases in the money supply.
OPEC and the Stagflation of the 1970s Between 1973 and 1974. As the short-run aggregate supply curve shifted left. inflation also tends to be benefit firms with large amounts of outstanding debt. Holding Monetary Liabilities During a period of inflation. national output (real GDP) began to decline.. The combination of falling national output and a rising price level is known as stagflation.g. Non-Monetary Assets and Liabilities The value of non-monetary assets (e.00 per barrel in late 1973 to $10.S. OPEC (Organization of Petroleum Exporting Countries) substantially curtailed its production of crude oil.) are fixed in dollar amounts regardless of changes in specific prices or the general price level. the price of a barrel of crude oil rose from approximately $2.e. All rights reserved. machinery.S. As the price level rises. that was particularly harsh because not only was the unemployment rate rising. those with a fixed amount of money or income (e. As a result. those with a fixed amount of debt (e. their purchasing power will be eroded). economy. Similarly. accounts receivable. .g.S. Monetary Assets and Liabilities Monetary assets and liabilities (e. cash. 2. This is the situation depicted in Graph D. the debt will be repaid with inflated dollars).. 3. land. the value of money declines. firms cut back production and the short-run aggregate supply curve shifted left.. those with home mortgages) will be aided (i.) and non-monetary liabilities will fluctuate with inflation and deflation.Business Environment & Concepts 2 Becker CPA Review C..g. firms. Holding Monetary Assets During a period of inflation. firms that lend out money at fixed interest rates are likely to be hurt by inflation. notes payable.e.00 per barrel in late 1974.. etc. retired persons) will be hurt (i. Specifically. b. Definitions a. As a result. and the aggregate price level began to rise (cost-push inflation). unemployment began to rise. rising crude oil prices represented an increase in input costs for U. 1. Thus. but the newly unemployed were facing higher prices for goods and services due to inflation! © 2009 DeVry/Becker Educational Development Corp..g. INFLATION AND THE VALUE OF MONEY Inflation has an inverse relationship with purchasing power. etc. The actions of OPEC in 197374 led to a recession in the U. EXAMPLE B2-20 This increase in the price of crude oil had a substantial effect on the U. a building.
the Federal Reserve (the Central Bank of the U.7 13. By 1932. All rights reserved. V.15% 8.7 587.8 748. orchestrated by the Federal Reserve. Specifically.1 Unemployment Rate 3. the unemployment rate.Becker CPA Review Business Environment & Concepts 2 The Great Depression and Deflation The Great Depression began with the stock market crash of October 24. the oil shocks (negative supply shocks) of the 1970s led to a situation where both unemployment and the price level were rising. the stock market crash.7 15. it does mark the beginning of the depression. As aggregate demand fell. THE PHILLIPS CURVE Inflation and unemployment are traditionally thought to have an inverse relationship in the short run. the interest rate hikes. It then increased interest rates again in early 1931. While unemployment and inflation have historically moved in opposite directions. INVERSE RELATIONSHIP BETWEEN INFLATION AND UNEMPLOYMENT A. the Great Depression was characterized by falling output (falling real GDP). shortly before the stock market crash. Table 1 Year EXAMPLE Real GDP (Billions of 1987 Dollars) 821. thereby decreasing the demand for investment goods and shifting the aggregate demand curve even further to the left.0 1929 1930 1931 1932 1933 As the table illustrates. B2-21 . The depression was caused by a number of factors including ill-timed interest rate hikes by the Federal Reserve. and the price level (as measured by the CPI) between 1929 and 1933.S. one out of every four workers was unemployed! The data suggests that the Great Depression was caused by a shift left in aggregate demand. © 2009 DeVry/Becker Educational Development Corp. Table 1 shows what happened to real GDP.) increased interest rates in an attempt to control inflation. the price level also fell and the nation experienced a period of deflation. increased the cost of capital.87% Price Level (CPI) 17. In addition. While the stock market crash was not the only cause of the great depression. as in Graph C.1 16. which shifted the aggregate demand curve to the left. The Phillips Curve illustrates the inverse relationship between the rate of inflation and the unemployment rate. The deflation that occurred can be seen by noting that between 1929 and 1933 the price level fell continuously. during the oil shocks of the 1970s the Phillips Curve broke down.3 599. In addition. It illustrates the tradeoff that exists in the short run between inflation and unemployment. the stock market crash reduced household wealth.2 13. at the height of the Great Depression.91% 23. the Dow Jones industrial average had fallen 89% from its peak in 1929.9 691. and protectionist trade policies.71% 15. 1929. rising unemployment and deflation. Specifically. Furthermore.65% 24.
. The government could also finance budget deficits by printing new money. All rights reserved. Structural deficits are not caused by temporarily low economic activity. However. B2-22 © 2009 DeVry/Becker Educational Development Corp. A. inflation tends to be low. inflation tends to be high. Cyclical Budget Deficit A cyclical budget deficit is caused by temporarily low economic activity. ILLUSTRATION OF THE PHILLIPS CURVE The Phillips Curve is illustrated in Graph I. 2. When unemployment is high. The budget deficit and the budget surplus are important indicators of the current and future health of an economy. BUDGET DEFICITS A budget deficit occurs when a country spends more than it takes in (mostly in the form of taxes). Financing Budget Deficits Budget deficits are usually financed by government borrowing. 1. Structural Budget Deficit A structural budget deficit is one that is caused by a structural imbalance between government spending and revenue. fees. Unemployment Rate VI.Business Environment & Concepts 2 Becker CPA Review B. financing budget deficits by printing money causes inflation. BUDGET DEFICITS AND SURPLUSES The budget is the federal government's plan for spending funds and raising revenues through taxation. B. For example. a cyclical budget deficit might be caused by a recession. Inflation Rate Graph I The Phillips Curve illustrates the tradeoff between inflation and unemployment. 3. which affects interest rates. and when unemployment is very low. BUDGET SURPLUSES A budget surplus occurs when government revenues exceed government spending during the year. and other means (and for borrowing funds if necessary).
Relationship Between Nominal Interest Rates and Inflation Nominal interest rates and inflation tend to move together. 2. so does the nominal interest rate. All rights reserved. then your real interest rate is only 7%. you are really only paying 7% to borrow the money! 3. 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. Real Interest Rate = Nominal Interest Rate – Inflation Rate EXAMPLE For example.Becker CPA Review Business Environment & Concepts 2 VII. © 2009 DeVry/Becker Educational Development Corp. A more accurate measure of the interest borrowers pay or lenders receive is the real interest rate. Nominal Interest Rate The nominal interest rate is the amount of interest paid (or earned) measured in current dollars. a 1% increase in the inflation rate will lead to a 1% increase in nominal interest rates. When the inflation rate increases. That is. if real interest rates do not change. It is a measure of the purchasing power of interest earned or paid. NOMINAL AND REAL INTEREST RATES 1. B2-23 . 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. When the economy experiences inflation. 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. Real Interest Rate The real interest rate is defined as the nominal interest rate minus the inflation rate. INTEREST RATES A. if you take out a loan with a 10% nominal interest rate and the inflation rate is 3%.
M1 does not typically include savings accounts or certificates of deposit (CDs).00% 0.00% 18.Business Environment & Concepts 2 Becker CPA Review Illustration: Nominal Interest Rates and Inflation (Graph J) Nominal Interest Rates and Inflation 20. M1 and M2 are the most common measures of money supply and are reported (periodically) in financial publications such as the Wall Street Journal.00% 14. 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. currency.00% 16. mutual fund accounts. All rights reserved. DEFINITION OF MONEY AND THE MONEY SUPPLY Money is the set of liquid assets that are generally accepted in exchange for goods and services.000. These include time certificates of deposit less than $100.00% 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. the nominal interest rate also increases.00% 6. M1 is defined broadly as money that is used for purchases of goods and services. M3 includes all items in M2 as well as time certificates of deposit in excess of $100. The money supply is defined as the stock of all liquid assets available for transactions in the economy at any given point in time.00% 10. Also note that around 1974/1975 the inflation rate was actually higher than the nominal interest rate implying real interest rates were negative! B. As the inflation rate increases.00% 8.00% 4. There are several definitions of money supply. . checkable deposits (accounts that allow holders to write checks against interest-bearing funds within them). B2-24 © 2009 DeVry/Becker Educational Development Corp. money market deposit accounts at banks.00% Interest Rate/Inflation Rate 12. and savings accounts. and traveler's checks.000. It typically includes coins.00% Inflation Rate 2.
Lowering the discount rate encourages borrowing by member banks and increases the money supply. All rights reserved. it decreases the money supply (i. Member banks may borrow money from the Fed to cover liquidity needs. changes in the price level. c. it increases the money supply (i. b.. Increase in the Money Supply When the Fed purchases government securities. Decrease in the Money Supply When the Fed sells government securities. a. Understanding the effects of changes in the money supply is important because changes in the money supply lead to changes in interest rates. or make investments. b. 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. B2-25 . INTEREST RATES AND THE SUPPLY OF AND DEMAND FOR MONEY 1. The Fed controls the money supply through: 1. 3. thus reducing the demand for money. Changes in the Discount Rate The discount rate is the interest rate the Fed charges member banks for short-term (normally overnight) loans. increase reserves. 2. MONETARY POLICY AND THE MONEY SUPPLY Monetary policy is the use of the money supply to stabilize the economy. puts money into circulation to pay for the securities). D. © 2009 DeVry/Becker Educational Development Corp. takes money out of circulation).e. Lowering the reserve requirement increases the money supply. b. Raising the reserve requirement decreases the money supply. Changes in the Required Reserve Ratio (RRR) The Required Reserve Ratio (RRR) is the fraction of total deposits banks must hold in reserve.. 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 Federal Reserve uses monetary policy to increase or decrease the money supply in an effort to promote price stability and full employment.e. and changes in national output (real GDP). 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. The demand for money is the relationship between how much money individuals want to hold and the interest rate.Becker CPA Review Business Environment & Concepts 2 C. The demand for money is inversely related to the interest rate—as interest rates rise. a. a.
The money supply curve is vertical since the Federal Reserve controls the supply of money (thus it is independent of the interest rate). The Money Market MS MS1 Interest Rate Equilibrium interest rate. Graph K An increase in the money supply will cause interest rates to fall. 2. Supply of Money is Fixed at a Given Point in Time As noted above. MONETARY POLICY AND ITS EFFECTS ON INTEREST RATES. VIII. © 2009 DeVry/Becker Educational Development Corp. B2-26 An increase in the money supply causes interest rates to fall. a decrease in the money supply will cause interest rates to rise. causing real GDP to rise. 4. 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.Business Environment & Concepts 2 Becker CPA Review 2. If the Fed increases the money supply. As we saw earlier. All rights reserved. Conversely. shifts in aggregate demand cause changes in the price level. Increases in desired investment and consumption cause an increase in aggregate demand. Aggregate demand shifts to the right. 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. Falling interest rates reduce the cost of capital and hence stimulate the desired levels of firm investment and household consumption. THE PRICE LEVEL. interest rates will fall. and the price level to rise. changes in the interest rate directly affect the cost of capital and thus shift the aggregate demand curve. real GDP. a. 3. EXPANSIONARY MONETARY POLICY (INCREASES IN THE MONEY SUPPLY) Expansionary monetary policy results when the Fed increases the money supply. and the unemployment rate. Finally. the unemployment rate to fall. when the Fed changes the money supply. as illustrated by the fall in interest rates from I0 to I1. The intersection of the money demand curve and the money supply line determines the interest rate. Specifically. Expansionary monetary policy affects the economy through the following chain of events: 1. and the unemployment rate. . b. A. Graph K illustrates the demand for and supply of money. 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. it causes interest rates to either increase or decrease. real GDP.
© 2009 DeVry/Becker Educational Development Corp. the Chairman of the Federal Reserve. In addition. which is below the potential level of output Y1. Specifically: 1. A decrease in the money supply causes interest rates to rise. causing real GDP to fall. By increasing the money supply. 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. CONTRACTIONARY MONETARY POLICY (DECREASES IN THE MONEY SUPPLY) Contractionary monetary policy results when the Fed decreases the money supply. and the price level to fall. The 2001 Recession and Monetary Policy After growing steadily for almost a decade. lower interest rates led to a large increase in home purchases starting in 2001 and continuing through 2002.Becker CPA Review Business Environment & Concepts 2 B. 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. All rights reserved. The effect of contractionary monetary policy is the exact opposite of expansionary monetary policy. including zero-percent financing! This helped increase consumer purchases of automobiles and overall demand for goods and services in the economy. economy experienced two consecutive quarters of negative real GDP growth implying the economy had slipped into a recession.S. the U. As the economy began to falter. As aggregate demand shifted right.S. the Federal Reserve caused interest rates to fall from I0 to I1. economy started to slow down at the end of 2000. B2-27 . the Federal Reserve began lowering interest rates by increasing the money supply. lower interest rates made it possible for the auto industry to offer attractive financing rates. Lower interest rates helped keep the economy from slipping even further into a recession. indicating a recession. The increased consumption and investment led to a shift right in aggregate demand as depicted in graph M. Alan Greenspan. Specifically. the U. Specifically. output (real GDP) is at Y0. Lower interest rates spurred new home investments and consumer consumption of durable goods such as automobiles. the unemployment rate to rise. In 2001. Aggregate demand shifts to the left. real GDP began to increase and the economy began to recover from the recession. 2. The recession of 2001 and the actions taken by the Federal Reserve are illustrated in Graphs L and M. 3. Decreases in desired investment and consumption cause a decrease in aggregate demand. 4. Rising interest rates reduce the desired levels of firm investment and household consumption. During the recession. Graph L illustrates the money market and the expansionary monetary policy of the Federal Reserve. initiated expansionary monetary policy.
identifying the critical success factors. b. however. All rights reserved. B2-28 © 2009 DeVry/Becker Educational Development Corp. 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). Generally. cash flows. mission philosophies fall into one of three basic categories that impact the overall manner in which the organization carries out its business. Hold Missions Hold missions are for organizations that maintain their current competitive position. INTRODUCTION The strategic goals of a firm are influenced by the market in which the firm operates. directed focus on planning for flexible responses for new developments in the market. identifying the strategy. mission statement. 2. and objectives of the firm. Ultimately. A. 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 corporate culture and will be discussed in detail later in this lecture. a. Organizations with build missions tend to take a long-term view and are likely to invest in significant capital projects. Organizations with harvest missions tend to have a short-term view. 1.Business Environment & Concepts 2 Becker CPA Review MARKET INFLUENCES ON BUSINESS STRATEGIES I. and are more likely to focus on net income. are less likely to invest in significant capital projects. Set the Goals of the Firm Organizations can choose any number of ways to achieve their missions. and immediate return. there are two broad and distinct paths for achieving organizational goals: cost leadership and differentiation. such as the unification of organizational and operational decisions. budgeting. however. 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. . and the overall company focus on the vision. the creation of bases for evaluation. STEPS IN STRATEGIC MANAGEMENT (STRATEGIC POSITIONING) Strategic management (positioning) normally involves defining the mission. Harvest Missions Harvest missions are for organizations that reap immediate benefits from the organization. opportunities. and analyzing those success factors by recognition of strengths. and threats. weaknesses. Build Missions Build missions are for organizations that accommodate a volume or range of work as a means of accomplishing organizational objectives. Strategic thinking encompasses a wide variety of issues with various types of benefits. goal-orientation toward the desired company achievements. Each path has its own characteristics and implications for operational planning. c.
Outstanding skills that represent strengths in relation to competitors are referred to as core competencies. d. c. Internal business process measures of success include quality measures. reduction in waste. customer satisfaction data. Strategic Analysis (SWOT) Organizations use strategic or SWOT (Strengths. As managers review these factors. Weaknesses. 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. the organization builds clarity regarding the mission. yields. Factors internal to an organization that impact strategy are the sources of strengths and weaknesses. Factors external to the organization are the sources of opportunities and threats. which may be either financial or non-financial. a. 5. These measures are generally referred to as critical success factors. and Threats) analysis to ascertain the overall strategy and critical success factors that the organization will measure. B2-29 . 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. cash flows. 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. b. etc. credit ratings. b. Define the Objectives of the Firm a. dividend growth. Examples of financial measures include sales or earnings growth. © 2009 DeVry/Becker Educational Development Corp. Financial Measures (Financial) Financial measures of success are generally derived from the financial reporting system of the organization or the marketplace. on-time delivery data. brand recognition information. and growth in the market value of the organization's stock. innovation in new products and methods. which is the ultimate focus for overall shareholder wealth maximization. 4. Decide What to Measure and Take a Baseline Measurement Organizations use various measures of success to determine the achievement of strategic objectives. consensus as to strategy. etc. cycle time computations. Financial Objectives Financial objectives are the improvement of the overall financial outcomes of a firm's strategy. critical success factors. education and training. All rights reserved. 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. Customer measures of success include market share data. and the impact of internal and external factors on the business.Becker CPA Review Business Environment & Concepts 2 3. Opportunities. etc. etc.
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. Implement the Strategic Plan In general. limited career opportunities in low-growth industries and markets will reduce the pool of talent available for management) 7. d. objectives. Respond to competitive movements and other issues. and Operating level. Evaluate and Revise the Plan as Necessary The plan must be evaluated and revised as necessary. Focus of the Plan In general. the overall vision. Strategic Plans Vary Based on Segments Strategic plans may vary for each segment of an organization based on the characteristics of that segment. 8. The plan must focus on the ways the company will: (1) (2) (3) (4) b. The plan must provide an environment and a model under which the goals and profitability of the firm can be achieved. . c. Functional level. Achieve/maintain competitive advantage. 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.g. B2-30 © 2009 DeVry/Becker Educational Development Corp. Create the Strategic Plan a. Business level. Corporate level. Conduct business operations. mission statement. The levels (from top to bottom) include: a. and strategy of the firm must be embraced and executed at various levels within the organization.. 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. All rights reserved.Business Environment & Concepts 2 Becker CPA Review 6. b. and Provide a way to address the needs and preferences of its customers.
II. d. © 2009 DeVry/Becker Educational Development Corp. 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. b.Becker CPA Review Business Environment & Concepts 2 B. e. contingency plans that are part of the strategic plan focus on the ability of the firm to change products or adapt to new markets. c. 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. 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. but understanding the fundamentals is also important to the business manager.. THE LAWS OF DEMAND AND SUPPLY Basic principles of microeconomic theory are very important on the CPA Exam. Three Questions a Firm Should Ask Itself The firm must have an on-going process of attempting to determine three things: a. and Customer preferences. B2-31 . Managers are more likely to be successful if they understand how their actions and various governmental policies or collusive actions (e. All rights reserved. cartels) affect their market and firm. or objectives become impractical or irrelevant. CHOICE OF A BUSINESS MODEL Once a strategic plan is in place. For example. A market is simply a collection of buyers and sellers meeting or communicating in order to trade goods or services. Technology. 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. b.g. 1. Crisis situations. C. 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. c. Sustaining competitive advantage is crucial to the success of a firm. 2. Regulatory laws. Competition. assumed variables prove to be faulty. 3.
For example. Definitions a. . All rights reserved. then the "demand point" will change along this demand curve. the quantity demanded decreases. b. B2-32 © 2009 DeVry/Becker Educational Development Corp. it will be used as a substitute for Coca-Cola (a similar good). if the price of Pepsi-Cola decreases. For example. as purchasing power or real income increases). As a result. Income Effect The income effect means that as prices are lowered with income remaining constant (i. people will purchase more of all of the lower priced products. b. however. 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. if the price of a product increases. all else equal. As the price of the product increases. the consumer can purchase more of all goods. It does. all else equal. c. there will be a move up the demand curve. illustrate the same kind of relationship. d. Quantity demanded is inversely related to price for two reasons: a. 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. When the assumptions regarding price or quantity change. 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). Changes in quantity demanded are shown by movements along the demand curve (D). The substitution effect exists because people tend to substitute one similar good for another when the price of a good they usually purchase increases. DEMAND 1. However.Business Environment & Concepts 2 Becker CPA Review A.. A change in demand cannot be due to a change in price. 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. a decrease in the price of a good increases a consumer's real income even when nominal income remains constant. 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). 2. 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. 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. For example. A change in demand causes a shift in the demand curve. 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.e.
. Changes in Consumer Expectations For example. if personal computer prices diminish. an increase in the number of buyers will shift the demand curve to the right.Becker CPA Review Business Environment & Concepts 2 3. Changes in Wealth For example. in the clothing industry. Changes in Consumer Tastes or Preferences for a Product For example. d. an increase in income will shift the demand curve to the right (depicted as the shift from D1 to D2). 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. e. f. people whose wealth increases may increase their demand for luxury cars. the demand curve will shift to the right (increase) for the original good. if the price of a similar good (a substitute good) increases. immediate demand will increase for that product (at the current lower price). I T E N c. B2-33 . 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). Changes in Consumer Income For example. now perceived as a bargain.g. then the demand for the original good will increase (e. 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. b. Factors that Shift Demand Curves (Factors Other than Price) Mnemonic: W R I T E N W R a. if consumers anticipate that there will be a future price increase. All rights reserved. This is also depicted as the shift from D1 to D2. Changes in the Number of Buyers Served by the Market For example.
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). c. B2-34 © 2009 DeVry/Becker Educational Development Corp. Definitions The fundamental law of supply states that price and quantity supplied are positively related (i. The higher the price received for a good. all else equal. all else equal. 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. A change in quantity supplied is represented by a movement along the supply curve. the more sellers will produce (higher quantity). When price changes. 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. they have a positive correlation). d. A change in supply cannot be due to a change in price. move up or down the supply curve to find the new quantity that will be supplied.Business Environment & Concepts 2 Becker CPA Review 4. However. It does. All rights reserved. A change in supply causes a shift in the supply curve. Market Demand Market demand is the total amount of a good all individuals are willing and able to purchase at each and every price. 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. The market demand curve is derived by summing the quantities demanded at each price over all individuals. however. 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). all else equal. b. 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. 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). SUPPLY 1.e. Graph C illustrates how the market demand curve is constructed when the market contains just two individuals. 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.. a. . illustrate the same kind of relationship.
if prices are expected to decrease. Factors that Shift Supply Curves Mnemonic: ECOST E a. This is represented by the shift in the supply curve from supply curve S1 to supply curve S2. All rights reserved. B2-35 . 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. d. O S T c. the firm will supply more now at each price level to take advantage of the currently higher prices. Changes in Price Expectations of the Supplying Firm For example. This is represented by the shift in the supply curve from supply curve S1 to supply curve S2. a decrease in taxes or an increase in subsidies would increase the amount supplied at each price level. Changes in Subsidies or Taxes For example. Changes in the Price or Demand for Other Goods For example. 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. Changes in Production Technology For example.Becker CPA Review Business Environment & Concepts 2 2. the firm is willing to supply more product. C b. e. 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. an improvement in technology would cause a shift to the right of the supply curve. Changes in Production Costs (Price of Inputs) For example.
B2-36 . All rights reserved. The interaction of demand and supply determines equilibrium price. 1. 2. Market Supply Market supply is the total amount of a good all producers are willing and able to produce at each and every price. The market supply curve is derived in the same manner as the market demand curve. © 2009 DeVry/Becker Educational Development Corp. all else equal. As illustrated above.Business Environment & Concepts 2 Becker CPA Review 3. The market supply curve for a good is the sum total of all the individual supply curves. and is also upward sloping (demonstrating the positive relationship between price and quantity supplied). minimum wage Equilibrium price ceiling price D QD QS QE a. Graph G illustrates equilibrium price. 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. by summing the quantities supplied at each price over all producers. Graph F illustrates how the market supply curve is constructed when the market contains just two producers. MARKET EQUILIBRIUM A market is in equilibrium when there are no forces acting to change the current price/quantity combination. namely. Graph G P D $12 Price (P) 10 9 S Shortage Surplus S for example. price (P) is $10 at equilibrium and the quantity supplied (Q) is QE. The market's equilibrium price and output (quantity) is the point where the supply and demand curves intersect. 3.
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. c. as shown in Graph I. assuming that prices are free to change. as shown in Graph J. 4. Conversely. Changes in Equilibrium If supply and/or demand curves shift. . Market clearing is the idea that the market will "eventually" be cleared of all excess supply and demand (all surpluses and shortages). and a shortage will result. Effects of a Change in Supply on Equilibrium A shift right (increase) in supply from curve S to curve S1. the quantity demanded will exceed the quantity supplied. will result in a decrease in price (from P to P1) and a decrease in market clearing quantity (from Q to Q1). Effects of a Change in Demand on Equilibrium A shift right (increase) in demand from curve D to curve D1. the quantity demanded will be less than the quantity supplied. the equilibrium price and quantity will change. a shift left (decrease) in supply from curve S to curve S1. Graph H Price S Price Graph I S P1 P D Q Q1 Quantity D1 P P1 D1 Q1 Q Quantity D b. All rights reserved. a.Becker CPA Review Business Environment & Concepts 2 b. If price is set below the equilibrium price. Market clearing quantity is the equilibrium quantity. as shown in Graph K. 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 H. and a surplus will result. Conversely. 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). will result in an increase in price (from P to P1) and an increase in market clearing quantity (from Q to Q1). If price is set above the equilibrium price.
because it is presumed that price elasticity is negative for a demand curve. To understand them more fully. you should draw supply and demand diagrams for each case to verify the effects listed in the table. Measuring the Price Elasticity of Demand The price elasticity of demand can be measured in two ways. B2-38 © 2009 DeVry/Becker Educational Development Corp. the equilibrium price will rise. (b) an increase in demand and a decrease in supply. or no change (if equal changes) in equilibrium price. 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. 1. Conversely. 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. decrease. PRICE ELASTICITY OF DEMAND The price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price. if the increase in supply is larger than the increase in demand. This negative price elasticity reflects the downward sloping demand curve. and (c) a decrease in demand and a decrease in supply. but the effect on price is indeterminate. Generally. the quantity demanded goes down (negative percentage change). A negative price elasticity coefficient results if the demand curve is normal. All rights reserved.Business Environment & Concepts 2 Becker CPA Review c. The effect of other complex cases such as (a) a decrease in demand and an increase in supply. 2. (a) (b) (2) If the increase in demand is larger than the increase in supply. Table 1 summarizes the effect of all four cases discussed above on equilibrium price and quantity. the absolute elasticity coefficient (positive value) is considered when elasticity problems are posed on the examination. However. as price goes up (positive percentage change). A. the price elasticity of demand is usually negative. can be analyzed in a similar manner. In a normal demand curve. 3. 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 equilibrium price will fall. the effect on equilibrium price is indeterminate because an increase in demand and supply could cause an increase. . General Effects of Changes in Demand and Supply on Equilibrium (1) An increase in demand and supply results in an increase in equilibrium quantity.
5 (Absolute Value = .0. Using the point elasticity method.000 (old demand) 1. quantity demanded decreases from 1. Price Inelasticity (Demand < 1.. the demand for insulin by diabetics).000 units Divided by: % Change = $120 (new price) . depicting that the quantity demanded stays the same no matter how price changes (e. quantity demanded decreases from 1. the price elasticity of demand would be: ep = Price Elasticity of Demand = % change in quantity demanded % change in price % Change = 900 (new demand) . suppose that when the price of a product increases from $100 to $120. All rights reserved. the more inelastic the demand for the good. Using the midpoint method.0) Demand is price elastic if the absolute price elasticity of demand is greater than 1. Price Elasticity (Demand > 1. B2-39 . For example.58 (Absolute Value = . demand is perfectly inelastic. in the pharmaceutical industry. © 2009 DeVry/Becker Educational Development Corp.5) 20 b. For example. b.000) (900 + 1.5 value is an example of inelastic demand.0 (defined as elastic). When the value is greater than 1.1. The calculation above with a 0. Note also that perfectly inelastic demand curves are vertical. The smaller the number after the minus sign. The Point Method The point elasticity of demand measures the price elasticity of demand at a particular point on the demand curve. a.58) (120 − 100) (120 + 100) 4.000) = −.0) Demand for a good is price inelastic if the absolute price elasticity of demand is less than 1. the more elastic the demand. 5. suppose once again that when the price of a product increases from $100 to $120.$100 (old price) = $20 = $1 = 20% in Price $100 (old price) $100 $5 ep = Price Elasticity of Demand = (10) .Becker CPA Review Business Environment & Concepts 2 a. the price elasticity of demand would be: ep = (Q2 − Q1 ) (Q2 + Q1 ) (P2 − P1 ) (P2 + P1 ) ep = (900 − 1. or = -.000 (old demand) = (-100) units = (10%) in Quantity 1. If price inelasticity is zero.000 units to 900 units. The Midpoint Method The midpoint method measures the price elasticity of demand between any two points on the demand curve.g. the greater the number.0.000 units to 900 units.
a. we can determine how a change in price will affect a firm's total revenue. an increase in price will result in a decrease in total revenue (negative relationship).0. the more product demand becomes elastic because more choices are available. 7. b. 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. and a decrease in price will result in an increase in total revenue. As a result. Summary The table below summarizes the relationship between the price elasticity of demand and total revenue.0) Demand is unit elastic if the absolute price elasticity of demand is equal to exactly 1. d. b. When demand is price inelastic.Business Environment & Concepts 2 Becker CPA Review 6. Unit Elasticity (Demand = 1. 8. As a result. All rights reserved. an increase in price results in a decrease in quantity demanded that is proportionally larger than the increase in price. Effects of Price Inelasticity on Total Revenue (Positive Relationship) If demand is price inelastic. an increase in price will result in an increase in total revenue (positive relationship). c. Effects of Unit Elasticity on Revenue (No Effect) If demand is unit elastic. Effects of Price Elasticity on Total Revenue (Negative Relationship) If demand is price elastic. and a decrease in price will result in a decrease in total revenue. a change in price will have no effect on total revenue. When demand is price elastic. total revenue (equal to price times quantity) will increase. Total revenue is simply the price of a good multiplied by the quantity of the good sold. Factors Affecting Price Elasticity of Demand a. . The longer the time period. 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 smaller than the increase in price. total revenue (equal to price times quantity) will decrease. Demand is unit elastic if the percentage change in the quantity demanded caused by a price change equals the percentage change in price. Product demand is more elastic with more substitutes available but is inelastic if few substitutes are available.
Unit Elasticity (Supply = 1. 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.Becker CPA Review Business Environment & Concepts 2 B. which reflects that quantity supplied is insensitive to price changes. The time it takes to produce and supply the good will affect the price elasticity of supply. Formula for Price Elasticity of Supply es = Price Elasticity of Supply = % change in quantity supplied % change in price % Change = 600 (new supply) . 4. B2-41 .500 (old supply) = 100 = 20% in Quantity 500 (old supply) 500 Divided by: % Change = $11 (new price) . longer production time leads to lower price elasticities. 20% =2 10% b. the price elasticity of supply equals zero.0) Supply is price inelastic if the absolute price elasticity of supply is less than 1. PRICE ELASTICITY OF SUPPLY The price elasticity of supply is calculated the same way as the price elasticity of demand. Price Elasticity (Supply > 1. 3.0) Supply is unit elastic if the absolute price elasticity of supply is equal to 1. Feasibility of customers storing the product will affect the price elasticity of supply.0) Supply is price elastic if the absolute price elasticity of supply is greater than 1.0. except that the change in quantity supplied is now measured. Factors Affecting Price Elasticity of Supply a. 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. For example. 1. 5. If supply is perfectly inelastic. it may result in high elasticity if the product can be stored and does not have to be bought today.$10 (old price) = 1 = 10% in Price $10 (old price) 10 es = Price Elasticity of Supply = 2. For example. C.0. Perfectly inelastic supply curves are vertical.0. All rights reserved. Price Inelasticity (Supply < 1.
Negative Income Elasticity If the income elasticity of demand is negative (e... Price ceilings cause prices to be artificially low.. equilibrium) will be demanded. 2. causing the demand for Product B to go up). demand for normal goods increases (e. canned vegetables or hamburger). $9). A. the good is a normal good. . A normal good is a product whose demand is positively related to income. premium foods such as steak and lobster). but only QS will be supplied. the good is an inferior good.. D. B2-42 © 2009 DeVry/Becker Educational Development Corp. IV. price cannot go above this amount) for a good (e.. the goods are unrelated.e. All rights reserved. there will be a market shortage... the commodities are complements.g. 2.g. As income goes up.g. If the coefficient is zero. Hence. then QD (in Graph G from page B236. creating a greater demand than the supply available. For example. GOVERNMENT INTERVENTION IN MARKET OPERATIONS Sometimes.. As income goes up. 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. Ie = Income Elasticity of Demand = % change in number of units of X demanded % change in income 1. the government will intervene in a market by mandating a price different from the "market price" (causing either a surplus or a shortage).g.g. PRICE CEILINGS A price ceiling is a price that is established below the equilibrium price.e.e. Substitute Goods: Positive Coefficient If the coefficient is positive (i. Positive Income Elasticity If the income elasticity of demand is positive (e. which causes shortages to develop. Complement Goods: Negative Coefficient If the coefficient is negative (i. demand for inferior goods decreases (e. an increase in the price of Product A results in a decrease in quantity demanded for Product B).Business Environment & Concepts 2 Becker CPA Review 1. An inferior good is a product whose demand is inversely related to income (opposite of normal good). if the government sets a ceiling price (i. the price of Product A goes up. demand decreases as income increases). the two goods are substitutes (people stop buying the higher priced goods and begin to buy the substitute). demand increases as income increases). This is most often accomplished by using price ceilings and price floors. 3.
e.g. a. a minimum wage set at $12).). a market surplus will result. equity. labor costs (wages). TYPES OF COSTS 1. VI. PROFIT A. which causes surpluses to develop.g. ECONOMIC PROFIT Economic profit equals the difference between total revenue and total economic costs. 1. which include opportunity costs. 2. Accounting costs do not consider opportunity costs. b. purchases of input services).. capital.. ACCOUNTING PROFIT Accounting profit equals the difference between total revenue and total accounting costs. Accounting Costs Accounting costs measure the explicit costs of operating a business (e. B.Becker CPA Review Business Environment & Concepts 2 B. COST CONCEPTS The two major concepts of costs to economists are accounting costs and economic costs.g. and entrepreneurial costs. ECONOMIC COSTS A. B. V. Economic Costs Economic costs are accounting (explicit) costs plus opportunity (implicit) costs. wages. The most common economic costs are land costs (rent). no expense to the company). Opportunity cost is usually considered to be the profits that are lost from business because one strategy is pursued instead of another. and utilities).. etc. capital costs (interest). Implicit Costs (Includes Opportunity Costs) Implicit costs are opportunity costs of inputs supplied by the owners (entrepreneurship. For example. B2-43 . which represents the value of the next best alternative foregone (or not chosen). Explicit Costs Explicit costs are documented out-of-pocket expenses (e.. Price floors are minimum prices established by law. such as minimum wages and agricultural price supports. ECONOMIC PROFIT VS..e. 2. © 2009 DeVry/Becker Educational Development Corp. Accounting profit is generally higher than economic profit because economic profit takes into account both explicit and implicit (opportunity) costs.. the value of a sole proprietor's time) as profits (i. materials. For example. All rights reserved. accountants treat entrepreneurial costs (e.g. prices cannot go below this amount) for a good (e. A key point in economics is opportunity cost. if the government sets a price floor (i. but economists view these as added costs to the organization. PRICE FLOORS A price floor is a minimum price set above the equilibrium price.
all costs have the opportunity to change. Fixed costs are the cost of acquiring the fixed resources used in production (one example is depreciation). land. entrepreneurial talent. The short run is a period of time in which some of the inputs used for production are fixed. A. while holding the amount of other inputs constant. in the long run. B2-44 © 2009 DeVry/Becker Educational Development Corp. Marginal Product Marginal product (MP) equals the change in total product resulting from a one. Average Product Average product (AP) equals the total product divided by the quantity of an input. . they are independent of the level of production. the average product of labor (L) is APL = TP / L. PRODUCTION FUNCTION A firm's production function refers to the relationship between the firm's input of productive resources (the mnemonic "CELL": capital. For example. LAW OF DIMINISHING RETURNS One of the main economic concepts that governs production is the law of diminishing returns which states that. C. they are dependent upon the level of production. B. Fixed costs do not change during the production period. all costs are variable.unit increase in the quantity of an input employed. In the short run. 2. FIXED AND VARIABLE COSTS Because some resources are fixed and others are variable in the short run. PRODUCTION COSTS IN THE SHORT RUN Economists differentiate between the short run and the long run.Business Environment & Concepts 2 Becker CPA Review VII. adding additional workers to the production process. For example. the short-run total cost structure of a firm consists of fixed costs and variable costs: 1. The long run is a period of time in which all of the inputs used for production are variable. Variable costs are the costs of acquiring the variable resources (such as labor). 2. causes output to increase at a decreasing rate. Thus. All rights reserved. and labor) and its output of goods and services. For example. PRODUCTION CONCEPTS The three main production concepts are: 1. the marginal product of labor (L) is: MPL = ΔTP ΔL 3. In the long run. when more and more units of a input are combined with a fixed amount of other inputs. D. even capital costs. output increases but at a diminishing rate. Total Product Total product (TP) equals the total amount of output (Q) produced. some of the economic costs are fixed because the inputs are fixed.
equals total (fixed plus variable) costs (TC) divided by quantity. 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.Becker CPA Review Business Environment & Concepts 2 E. 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. COST FUNCTIONS The four major cost functions are: 1. or incremental cost. ATC = TC / Q 4. Fixed costs do not influence marginal costs. MC = ΔTC ΔQ a. AFC = FC / Q 2. resulting from a one-unit increase in quantity. equals the change in total cost. All rights reserved. B2-45 . Marginal cost (MC). Marginal cost depends solely on variable costs. Average Total Cost (ATC) Average total cost (ATC). AVC = VC / Q 3. F. For example. Average Fixed Cost (AFC) Average fixed cost (AFC) equals total fixed costs (FC) divided by quantity (Q). or unit cost. b. Average Variable Cost (AVC) Average variable cost (AVC) equals total variable cost (VC) divided by quantity. 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).
as output continues to increase. The average total cost (ATC) curve is U-shaped. 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. In the long run. Therefore. Economies of scale will eventually be lost. In the long run. . 5. All rights reserved. Thus. economies of scale will cause the long-run average total cost curve (LRATC) to decline within the range of production. LONG-RUN COST GRAPH Graph M illustrates the long-run average total cost (LRATC) curve and the long-run marginal cost (LRMC) curves. all resource inputs are variable. Graph M Long-Run Costs Economies of Scale Diseconomies of Scale LRMC LRATC Quantity of Output E. 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. The marginal cost curve (MC) intersects the AVC and ATC curves at their minimum points. marginal costs and average costs start to increase causing average total costs to rise. PRODUCTION COSTS IN THE LONG RUN A. Factors enabling economies of scale (increases in the productivity of inputs) include: B2-46 © 2009 DeVry/Becker Educational Development Corp. VIII. average total costs are high because average fixed costs are high. and diseconomies of scale will result (see Graph M). D. 2. The short run supply curve is the marginal cost (MC) curve above the minimum point of its average variable cost curve (AVC). the vertical distance between the AVC curve and the ATC curve is equal to AFC. Economies of scale are reductions in unit costs resulting from increased size of operations. the optimal size or number of plants is at the minimum point of the LRAC curve. average fixed costs fall and thus average total costs fall. However.Business Environment & Concepts 2 Becker CPA Review 1. At low levels of output. 4. C. The average fixed cost curve (AFC) decreases continually over the range of quantity produced (as output increases). 3. ATC is the sum of AFC and AVC. As output increases. Generally the long-run average total cost (LRATC) curve is U-shaped. B.
Becker CPA Review Business Environment & Concepts 2 1. nor shift the market supply sufficiently to make a good more scarce or abundant. Average Revenue (AR) is Total Revenue (TR) divided by Total Output. In other words. competitive firms must produce at the output rate where Price = Marginal Revenue = Marginal Cost (or P = MR = MC). F. Diseconomies of scale are increases in average costs of operations resulting from problems in managing large-scale enterprises. a firm must find that price-quantity combination that will produce the largest spread between its revenues and its costs. Following is a brief discussion of the overall market structures in which firms may operate. A. MARKET STRUCTURES AND PRICING Operating environments influence the strategic plan. 2. diseconomies of scale can also cause workers to feel disassociated from the firm with a resulting lack of motivation. Introduction Under perfect competition. Marginal Cost (MC) is the cost of producing one additional unit. B2-47 . Maximizing Short-Run Profits (MR = MC = P) It is assumed that the objective of any business is to maximize its profits. 2. A large number of suppliers and customers acting independently. Therefore. no individual firm can influence the market price of its product. the firm will continue adding units to production until it becomes unprofitable to do so (MR − MC = 0). 3. 2. Factors causing diseconomies of scale include: 1. goods and services are produced at the lowest cost to the consumer in the long run). 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. No barriers to entry because firms exert no influence over the market or price (thus. To do this. Marginal Revenue (MR) is the additional revenue brought in by producing one additional unit of output. b. the condition for maximizing profit is: MR=MC. PERFECT (PURE) COMPETITION 1. c. To maximize short-run profits. © 2009 DeVry/Becker Educational Development Corp. Attributes of perfect competition include: a. In a perfectly competitive market. 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. Very little product differentiation (homogeneous products). All rights reserved. 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. For example. strategic plans may include maintaining the market share and responsiveness of the sales price to market conditions. This is illustrated in Graphs N and O below.
the monopoly firm sets prices and is a "price setter. the firm incurs economic losses). which equals average revenue (P = MR = AR). P > AVC) because it will still cover all of its variable costs and some of its fixed costs. thus. cannot change the price itself). Because the price of an individual firm's output is the same regardless of how much it produces.e.e. 4. that firms earn a normal rate of return." discussed below. If abnormal profits exist. price equals marginal revenue. . (In a monopolistic market.. the firm is a "price taker" (i. In the long run. under conditions of perfect competition. new competitors enter and drive the price down. Operating at a Loss (P > AVC) In the short run.. The market maintains a lower price and larger quantity than in any other market structure. b. the firm should continue to operate in the short run as long as price is greater than average variable costs (i. If price is less than ATC at the profit maximizing level of output (i. Q1 is the profit-maximizing level of output of an individual firm. where MR = MC). 6.e.) 5. Firms are Price Takers Note that although the industry (market) demand curve slopes down. Each buyer that is willing to pay the market price will get as many units as the buyer desires. each firm has a horizontal demand curve at the equilibrium price for the industry. All rights reserved.. As illustrated in Graph O. B2-48 © 2009 DeVry/Becker Educational Development Corp. The entry and exit of new firms ensures that economic profits are zero in the long run and. thus.e. P = MC = Minimum ATC). Advantages Derived from Perfect Competition a. economic profits will be negative (i.. 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.e. firms may operate at a loss. thus. 3. utility is maximized. 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. the firm’s total profit in the short-run is given by the shaded area. However.
Assumptions and Market Characteristics of Monopoly a. the firm will maximize profits where marginal revenue equals marginal cost. the classic utility company. © 2009 DeVry/Becker Educational Development Corp. c. MONOPOLY Under a monopoly. it produces at a lower output and higher price than the competitive firms and earns above-normal profits. the monopolist's price will be higher than marginal revenue. 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. 2. B2-49 .. Since the firm produces where MR = MC. All rights reserved. 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. Monopoly (e. the firm's demand curve coincides with the industry demand curve for the product (because the firm and the industry are the same).g.. which was a "regulated" monopoly) represents concentration of supply in the hands of a single firm." as opposed to firms in perfect competition (which are "price takers"). strategic plans will likely ignore market share and focus on profitability from production levels that maximize profits. Higher prices are charged for supplying less of the product. b.Becker CPA Review Business Environment & Concepts 2 B. 1. d. however. In a monopoly.g. A single firm with a unique product Significant barriers to market entry The ability of the firm to set output and prices (e.
d.. Natural Monopoly A natural monopoly exists when economic and technical conditions permit only one efficient supplier. 3. etc. product research. MONOPOLISTIC COMPETITION Under monopolistic competition. the quantity produced by a monopolist is below the socially efficient level. 4.e. .. the firm incurs economic losses). the economic consequence of monopoly is that less output is produced than is socially optimal. aspirin. Inefficiency of Monopoly Monopolists produce at a point where price is greater than marginal cost..g.g. soft drinks.g. Assumptions and Market Conditions a. 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. c. All rights reserved.. 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. marketing. no one firm will be able to affect the prices charged by the other firms. 2. 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. b. B2-50 © 2009 DeVry/Becker Educational Development Corp. If the situation does not change in the long run. C. In that sense. Operating at a Loss In the short run.). brand name cosmetic products). Thus. etc. competition to increase brand awareness and loyalty) Brand Loyalty Instead of reducing prices.e. a monopolist that operates at an economic loss will shut down. If price is less than ATC at the profit maximizing level of output (i.Business Environment & Concepts 2 Becker CPA Review 3. where MR = MC). economic profits will be negative (i.. monopolies are inefficient because they produce a deadweight loss to society. 5. 1. Little Market Control by the Firm Because many firms compete in this scenario. and therefore. the firms spend money to create brand loyalty (e. As a result. there is little market control by each firm. firms may operate at an economic loss.
produce where MR = MC). 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. which include opportunity costs. Because there are few barriers to entry under monopolistic competition. If firm profits are negative in the short run. The firm maximizes profits by producing the level of output that equates marginal revenue and marginal cost (i. All rights reserved.. Maximize Profits Where MR = MC The following graph illustrates the profit maximizing output level and price of a monopolistically competitive firm. to produce where MR = MC and P = ATC. B2-51 . the "Big Three" automotive manufacturers) dominate the sales of a product and entry of new sellers is difficult or impossible. Relatively few firms with differentiated products Fairly significant barriers to entry (e. in the long run. An oligopoly is a market structure in which a few sellers (e.e. 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. firms will exit and drive profits up to zero. 1. Assumptions and Market Conditions a. c. more firms will enter and drive profits down to zero. b.g.. The long run equilibrium position for a monopolistically competitive firm is. OLIGOPOLY Under oligopoly. Zero Economic Profit in the Long Run Economic profit equals the difference between total revenue and total economic costs. In Graph Q. Graph Q Profit Maximization Price MC ATC P ATC AVC MR Q1 Demand Quantity of Output 5. it faces a downward sloping demand curve (similar to a monopolist). If profits are positive in the short run. monopolistically competitive firms will earn zero economic profits. therefore. D.Becker CPA Review Business Environment & Concepts 2 4. the firm earns an economic profit illustrated as the shaded area.. Because the firm sells a differentiated product.g.
Business Environment & Concepts 2 Becker CPA Review 2. All rights reserved. the airline industry). This causes the demand curves to have different slopes above and below the prevailing price. illustrating that there is not a direct relationship between price and quantity at all points on the demand curve. the firm will operate best when marginal revenue equals marginal cost (MR = MC). 3. D΄ $ P3 P1 P2 D If price is cut. Regardless of the model that represents the industry. . Oligopolists face a kinked demand curve because firms match price cuts of competitors but ignore price increases. Graph R illustrates the effects of price adjustment by an oligopolist. MARKET ASSUMPTIONS AND CONDITIONS 1. rival firms will match the reduction. B2-52 © 2009 DeVry/Becker Educational Development Corp. Firms would be foolish to engage in price cutting because rivals merely match the price reduction (e. monopolistic competition. 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. E. and the firm will lose a large portion of its sales. Graph R An Oligopolist's Kinked Demand Curve If price is raised above the prevailing level. 2. A kink in the demand-AR curve appears at the prevailing price. thereby limiting the potential gain in sales. Microeconomic theory holds that firms make decisions based upon marginal cost and marginal revenue (essentially ignoring fixed or sunk costs). The following table summarizes the market assumptions and conditions underlying perfect competition. monopoly. and oligopoly. This causes the demand curve to be kinked.g. Illustration of Kinked Demand Curve a.. rival firms will ignore the increase. b.
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. EFFECTS OF BOYCOTTS AND CARTELS ON PRICING AND OUTPUT 1. 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. 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. The likely effect of a cartel is to increase price and reduce output below the socially efficient level. © 2009 DeVry/Becker Educational Development Corp.. as it wants at the given market price) Firm has control over quantity produced only. All rights reserved. price is set by the market. or as little.e. B2-53 . firm must accept the market price Accepts market price. Cartels Cartels are groups of firms acting together to coordinate output decisions and control prices as if they were a single monopoly (i.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. OPEC and the Central Selling Organization of De Beers).
(1) (2) If the demand for a firm's output increases. labor (human capital). (Recall that marginal product (MP) is the change in total product resulting from a one-unit change in an input).Business Environment & Concepts 2 Becker CPA Review 2. B2-54 © 2009 DeVry/Becker Educational Development Corp. The price firms must pay for the factors of production is determined by the interaction of supply and demand in the input market. a. . The effectiveness of a boycott is measured as the achieved change in the target's disputed policies (normally price). 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. the demand for that input will also increase. the demand for inputs is directly related to the demand for the goods and services those inputs produce. the firms output) and the marginal product of the input itself. 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. Factors of Production (Resources) Businesses use resources to make final products. To maximize profits. Boycotts Boycotts are organized group refusals to conduct market transactions with a target group (using only social pressure.. Types of Inputs a. firms need to decide on the optimal levels of inputs to employ. b. Derived Demand Derived demand is the demand for factors of production. The primary resources from which final products are made consist of land (natural resources). X. PRODUCTION AND DEMAND FOR ECONOMIC RESOURCES 1. if the marginal product of an input increases. Factors of production are bought and sold in markets just like final goods and services are bought and sold in markets. Demand for Inputs Depends on Demand for Outputs The demand for any input depends on the demand for the product the input produces (i. Therefore. 2.e. b. These resources are known as factors of production. not legal obligation). 3. a. THE ECONOMY AS A SYSTEM OF MARKETS A. A firm's demand for inputs is derived from its decision to produce a good or service. 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. All rights reserved. the demand for the inputs used to produce that output will also increase. and capital (non-human physical capital accumulated through past investment). Similarly.
workers sell their services to employers in labor markets. nurses. The lower the wage. For example. the derived demand for doctors. Just like in any other market. that firm is known as a monopsonist. 1. the supply of labor and demand for labor determines the price. © 2009 DeVry/Becker Educational Development Corp. Much like a monopolist has market power in the product market. the greater the quantity of labor service demanded by employers. If the demand for medical services increases. All rights reserved. Thus. Illustration Graph S illustrates equilibrium in the labor market. The laws of demand and supply prevail in labor markets as they do in product markets. B2-55 . Labor Demand and Supply Under Monopsony A monopsony occurs when there is only one employer in a market. or wage.Becker CPA Review Business Environment & Concepts 2 b. wages are the price paid for labor. in the labor market. Graph S The Labor Market Wage Supply of Labor w1 Demand for Labor L1 Hours per Year 2. The equilibrium wage depends on the supply of and demand for labor. monopsony results in lower wages and lower levels of employment. where workers independently offer skills of a given quality to employers who compete for the workers' services. THE LABOR MARKET In modern economies. a monopsonist has market power in the input (labor) market. B. if a town contains a single firm. Relative to purely competitive labor market. The equilibrium wage is found where the demand curve for labor intersects the supply curve for labor. and medical equipment will also increase. of workers. Examples (1) (2) The demand for labor is directly related to the demand for the goods and services that labor produces.
the result is unemployment. 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. As a result. one unionized and the other not. or an excess supply of labor. if the minimum wage is above the equilibrium wage. wages in the nonunion sector may fall as the supply of labor in that sector increases. the minimum wage causes unemployment. Unions and Wages a. Suppose there are two sectors in an economy. If the minimum wage is set above the equilibrium wage. workers gain market power much in the same way that a monopoly or cartel has market power. 4. Effect on Non-Unionized Workers Unions may also affect the wages of non-unionized workers.Business Environment & Concepts 2 Becker CPA Review 3. As a result. the quantity of labor demanded decreases from L1 to LD and the quantity of labor supplied increases from L1 to LS. of (Ls – LD). In other words. the imposition of a minimum wage increases the income of those workers who have a job. The union may use its market power to bargain collectively for higher wages or restrict the supply of labor. As a result. an excess supply of labor will result. Effect on Unionized Workers By forming a union and acting collectively. B2-56 © 2009 DeVry/Becker Educational Development Corp. All rights reserved. Minimum Wage Laws The use of minimum wage laws to increase the wages of low skilled labor is controversial. . displaced workers may seek employment in the nonunion sector. they may fall in the sector that is not unionized. b. wages of unionized workers increase. The effect of a minimum wage is illustrated in Graph T. while wages rise in the unionized sector. Thus. but it decreases the income of workers who find themselves unemployed as a result of the imposition of the minimum wage. Because employment falls in the unionized sector.
TWO GENERAL TYPES OF FACTORS THAT INFLUENCE STRATEGY Firms use SWOT (Strengths. long look at what drives the consumers in the marketplace. A. Weaknesses. © 2009 DeVry/Becker Educational Development Corp. incremental analysis of relevant costs associated with changing the manner in which the identified activity in the value chain is accomplished can be performed. C. 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. and this does not only include doing all they can to match or beat what their competitors do. Firms desiring to achieve competitive advantage must focus on the needs and preferences of the buyers and then either meet or exceed their expectations. please read the expanded discussion of Value Chain Analysis at Appendix I. A. Relationship between strategic planning activities: Strategic Positioning Value Chain Analysis Balanced Scorecard* * Balanced Scorecard is discussed in Chapter B5. All rights reserved. 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.Becker CPA Review Business Environment & Concepts 2 XI. 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. Any strategy must consider these factors in its development. Once costs have been analyzed relative to each activity. B2-57 . Opportunities. value chain analysis is invaluable in assessing the ability of the firm to attain competitive advantage. VALUE CHAIN ANALYSIS Companies strive to attain competitive advantage in a variety of means. 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. It also means that they need to take a good. The firm will go through exercises to assess how its activities create value in the marketplace. Once the firm is aware of how its product is perceived. B. FACTORS THAT INFLUENCE STRATEGY When determining the effects of the market on business strategy. and Threats) analysis to assist in developing their appropriate strategic plans. XII. REQUIRED READING AT APPENDIX I As a supplement to the material above. Reduced cost or improved innovation can result.
f. h. b. i. 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. g. j. e. a. 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. . c. 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. Factors that Affect the Overall Industry and Competitive Environment of the Industry (1) (2) (3) (4) (5) (6) b. 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. (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. below.
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. a. 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. consumer desires for improved quality and service. other firms will desire to enter the market. firms will enter until profits fall to a competitive level. b. input costs. economies of scale. © 2009 DeVry/Becker Educational Development Corp. labor issues. technology changes. and other restrictions. 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. Barriers to entry are the various "hoops" and other obstacles that firms must combat.. trade barriers. 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. regulation. Market Competitiveness (Intensity of Competition) The existence of competition from rival firms is often the most significant of the five forces of competition. 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. b. including patents. 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. and other up-front competitive cost disadvantages. It is also possible that the simple threat of new entrants will scare firms into keeping their prices at competitive levels.g.Becker CPA Review Business Environment & Concepts 2 B. 1. Unless barriers to entry exist. along with facing the retaliation of those firms already competing in the market and the competitive cost advantages that existing firms enjoy. a.). When New Companies Will Attempt to Enter New companies will attempt to enter the competition when barriers to entry are low. high up-front capital requirements. learning curve issues. 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. potential high profits exist in the market. pre-existing customer preferences and loyalties. B2-59 . respond appropriately and timely. and the risk of retaliation by other firms is low. etc. If the industry as a whole is earning a profit. Barriers to Entry The firm faces the threat of new firms entering the market in which it operates. All rights reserved. FIVE FORCES THAT AFFECT THE COMPETITIVE ENVIRONMENT (AND PROFITABILITY) OF THE FIRM (MICHAEL PORTER. rival firms face barriers to entry in the form of government regulation. 2. the impact of this competitive factor is increased. and maintain its competitive advantage. supplier access. Types of Barriers to Entry Often. the firm faces a strong competitive force.
the costs of exiting the market exceed the cost of continuing to operate. and this could impact the firm's ability to obtain its inputs to the production process at advantageous prices and. d. 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). and the strategy of firms should focus on pleasing this group of customers. customers do not have strong brand preferences. and are priced at or below the price of the firm's product. thus. some firms profit from making certain moves to increase market share. buyers may have a limit on the maximum price that they are willing to pay. and this has a direct impact on the profits of the firm. and the various firms employ different types of strategic plans. a. The effect is further intensified when the costs of the buyer switching to the substitute product are low. and quality. the impact of this competitive factor is increased. have equal performance. Alliances of Rival Firms and Suppliers Often. it faces issues that need to be addressed in its strategic plan. Bargaining Power of the Customers If buyers are in the position to bargain with suppliers on the conditions of service. If the firm faces heavy competition from substitute products. rival firms focus on developing strong alliances with suppliers. competitors are usually able to sustain profitability without having to take market share from their rivals). If close substitutes exist. B2-60 © 2009 DeVry/Becker Educational Development Corp. 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 bargaining power (negotiating power) of the customer will significantly impact the competitive environment of the firm. Existence of Substitute Products If a firm operates in a market in which substitute products are available. price. 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. . in fast growing markets. 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. buyers have little choice of products and may be willing to pay a higher price for the products that are available. 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. 3. and large amounts of funds are expended by firms each year in this area. several equal-sized firms exist in the market. If few substitutes exist.Business Environment & Concepts 2 Becker CPA Review c. This is especially true if the substitutes are readily available to consumers. The strength of the relationship between the value chains of buyers and firms impacts the bargaining power that buyers have. Increase in Competition Competition becomes an even stronger force impacting the firm when the market is not growing fast (in contrast. the impact of this competitive factor is increased. e. All rights reserved. Marketing strategies are focused on the consumer of goods. reduce its competitive advantage. When alliances are created. 4.
and thus the price of the input. 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. a. c. especially when those input costs are a significant part of the overall product cost. will affect the profitability of firms. This result is intensified if the firm cannot easily change production without incurring high costs to begin producing another product.. the firm could be placed in a difficult situation. Reputation of Supplier and Demand for its Goods If the reputation of the supplier (e. d. the more the buyer will be able to compare and contrast features of a product and choose one over the other. the impact of the effect on the competitive environment from buyers is increased. 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. B2-61 . Firm is Unable to Change Suppliers If the firm is unable to use different suppliers or cannot change its inputs (i. Bargaining Power of the Suppliers When the bargaining power of the suppliers of inputs to the production process is high.. 5. Suppliers can take profits away from a firm simply by increasing the cost of the inputs to the firm's production process. All rights reserved. b. The strength of the relationship between the value chains of sellers and firms impacts the bargaining power that suppliers have.g. no substitutes are available). changes in the operations of the supplier. the firm must take a good look at its strategic plan with respect to the suppliers. the bargaining power of the buyer is increased. Buyer's Low Cost of Switching Products If the costs of switching from one product to another are low.Becker CPA Review Business Environment & Concepts 2 b. © 2009 DeVry/Becker Educational Development Corp. Availability of Information The more information that is available to the buyer. High Number of Alternate Suppliers When a large number of suppliers exist to serve the customers.e.
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. B2-62 © 2009 DeVry/Becker Educational Development Corp. timeliness of delivery. because it has overall lower total costs. When firms desire to achieve competitive advantage with respect to products. 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. . This advantage may be used by the firm in one of two ways: a. All rights reserved. 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.g. they are willing to pay a higher price for its uniqueness. performance measures. the firm has a competitive market advantage. After the product has been differentiated. Therefore.). it will be able to match the price of its rivals and. etc. b. wide range of goods. In any of the following strategic alternatives. 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. the firm must always be sure to remain profitable and recoup the cost of the "premium" they have included with their product. 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. beat the profitability of its rivals. This advantage may be used by the firm in one of two ways: a.Business Environment & Concepts 2 Becker CPA Review XIII. 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. 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. 1. the related value chain would be altered to take into account the chosen strategy. Build Market Share If the firm lowers the price of its product below the price of its competitors. 2. less risks. 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. All parts of the buying decision are affected by the perceived value of the product (e. A. superior service.. higher quality. there are two basic forms of advantage that they will choose from. b. If the total costs of the firm are less than those of rival firms. Match the Price of Rivals If a firm enjoys a low-cost competitive advantage.
2. Careful analysis of all the costs in the process must be made and costs must be eliminated. © 2009 DeVry/Becker Educational Development Corp. B2-63 . 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. 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. 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. the overall cost of a firm must be lower than other firms in the market. They are able to do this by setting their product "aside" from the others through a unique feature (e. When Cost Leadership Strategies Fail If firms focus too much on cutting costs of the current process. Lowest Overall Costs In order to be a low cost provider. 5. 4. value. Also.). they desire to create a competitive advantage by focusing customer preference on their products and away from the products of competitors. Further. reducing the firm's competitive advantage) if it sees that this strategy has worked in the marketplace.. If new features exist in other products. 3. and customers desire those features. etc. Create/Promote a Unique Feature in the Product When firms employ a differentiation strategy. special taste.Becker CPA Review Business Environment & Concepts 2 B." Any firm could easily use the same strategy (thus. superior customer service. image. 1. FIVE BASIC TYPES OF COMPETITIVE STRATEGIES 1. 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. 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. 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. quality. Cost leaders undermine the profitability of their competitors as a means of achieving overwhelming market share. the firm will gain competitive advantage by either having higher overall profit margins or being able to undercut the prices of the other firms. Firms that successfully differentiate their products are able to command higher prices. 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. 3. 1. evaluation of budgets and benchmarks are crucial. the firm has lost its cost leadership competitive advantage. and the firm has ignored this fact. prestige.g. if necessary. D. All rights reserved. 2. In this way.
"perception is often greater than reality. it will succeed in achieving competitive advantage because it will build customer brand loyalty and increase sales. Build Customer Brand Loyalty If the firm can achieve differentiation and still make a profit (i. B2-64 © 2009 DeVry/Becker Educational Development Corp. . etc. 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. the differentiation strategies can fail. 2.). 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.Business Environment & Concepts 2 Becker CPA Review 2." 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. 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. 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. Remember. If a firm is in a market where customers do not care about differentiation. 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 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. and are happy with paying a lower price for a more generic product. quality.g. 3. Further. when the product appeals to different people for different reasons. a quality product at a reasonable price). 1. superior customer service. 4.e.. 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. and when the firms who are competing in the market choose different features with which to differentiate their products. prestige. unique features that are part of the differentiation strategy.. 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. 5. Therefore. will not pay extra for unique features. All rights reserved. E. the firm cannot succeed if it loses profit because of the higher costs of the feature in the differentiation strategy). 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.e. Overall Lowest Cost in Industry is Not an Option Of course. When Differentiation Strategies Work Well Differentiation strategies work well when customers are able to see value in a product.. a differentiation strategy can fail. highlighting the areas the ultimate consumer cares about (e. it will succeed.
F. 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. 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. 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. or a niche." 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 Fail When other firms see that the niche has been successful for those serving it.e. If the firm is not easily responsive to change (flexible) for whatever reason. and provided the firm has the proper resources to adequately serve the needs of the niche group. 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. expand. to obtain technological knowledge of others that they do not currently have. © 2009 DeVry/Becker Educational Development Corp. the focus/niche strategies can fail. preferences change or the standard products have significantly improved). It often becomes difficult to attain the proper "middle" ground in the marketplace.. Rather than having to address the needs and preferences of a broad range of consumers. 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. G. these firms are able to focus on market niches where consumers have specialized needs and preferences. to combine research and development activities for efficiency and effectiveness. they will attempt to enter the market as competitors and take away some of the sales of the firm. likely reducing the firm's profits and its competitive advantage. 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. FOCUS/NICHE STRATEGIES Firms with cost leadership or differentiation strategies may choose to focus their chosen strategy on a select small group of consumers.Becker CPA Review Business Environment & Concepts 2 3. All rights reserved. While all of this can be beneficial for firms. this strategy may not work well. OTHER TYPES OF STRATEGIES 1. 2. B2-65 . thus causing consumers to buy the standard products on the market and stop buying the niche product that the firm offers. 1. unless the combined management is able to work together well and unless the combined operations can be run effectively together.
g. or to obtain information as a group that they could not obtain individually (or that may be too costly to obtain individually). profits must be made and consumers must have perceived value. they may choose to form strategic alliances in a cooperative strategy. Integrated supply chain management is a collaborative effort between buyers and sellers. etc. raw materials. XIV. SUPPLY CHAIN MANAGEMENT/INTEGRATED SUPPLY CHAIN MANAGEMENT (ISCM) A. All rights reserved. Vertical Integration A firm may desire to improve its competitive advantage through vertical integration. to share the cost of obtaining information on innovations in technology.). retailers. please read the expanded discussion of Supply Chain Management at Appendix II. customers. REQUIRED READING AT APPENDIX II As a supplement to the material above. a firm may be able to be successful in achieving the desired competitive advantage. . To increase value to the consumer. The goal of ISCM is to better understand the needs and preferences of customers and cultivate the relationship with them. Cooperative/Strategic Alliances When companies desire to achieve such things as economies of scale (in marketing or production). shipping. 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. However.). production. packaging. GOAL IS TO UNDERSTAND NEEDS AND PREFERENCES OF CUSTOMERS In order to attain and sustain competitive advantage. 3. and the relationship between them must be evaluated and managed as goods flows through the value chain. it would be employing the concept of integrated supply chain management (ISCM). When more of the competitive factors are controlled. 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. and service providers) are able to reasonably predict the expected demand of consumers for a product and then plan accordingly for supplying that demand. B2-66 © 2009 DeVry/Becker Educational Development Corp. COLLABORATIVE EFFORT OF BUYERS AND SELLERS If a firm and the entire supply chain (producers.. 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. If the actual demand of the customer is met and excess supply does not sit on the market. C.Business Environment & Concepts 2 Becker CPA Review 2. 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. While this strategy is not as formal as a merger or acquisition. etc. B. However. distributors. the firm will be able to minimize costs all along the supply chain (e. supply chain operations should generally be improved.
Auto manufacturers in Detroit may seek a vacation from time to time on a sandy beach with a balmy breeze. yet its roadways are teaming with vehicles of all types. The country predominantly specializes in tourism and uses the money it earns from its visitors to buy (import) vehicles and petroleum products. economic or translation risk. The ability to trade freely between markets is often limited by the physical immobility of the resource or regulatory barriers. EXAMPLE EXAMPLE © 2009 DeVry/Becker Educational Development Corp. Entities that conduct business outside the country in which they are organized are frequently referred to as multinational corporations (MNC). Comparative Advantage Specialization in the production and trade of specific products produces a comparative advantage in relation to trading partners. Lake Michigan is breezy but. The country maximizes the number of resources it can import by specializing in tourism and buying transportation resources elsewhere. 1. I. All rights reserved. in January. Companies and countries use their comparative advantage as a means of maximizing the value of their efforts and the value of their resources. B2-67 . Imperfect Markets Resource markets are often deemed to be imperfect. the auto manufacturer must go to Bermuda and spend dollars there. is not balmy and won't compare with Bermuda! In order to capitalize on resources available from that vacation destination. 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. In order to retrieve more resources. 2. 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. Several economic theories support international trade as a means of achieving improved shareholder value. companies must trade outside their borders. 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. The island nation of Bermuda produces no gasoline or vehicles. Clearly there is not opportunity to simply import the resource. A. MOTIVATIONS FOR INTERNATIONAL BUSINESS OPERATIONS Entities are encouraged to look beyond the political borders in which they were organized to maximize shareholder value.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.
corporation. Franchising Entities whose marketing service or delivery strategy provides training and related service delivery resources in exchange for a fee are franchisors. corporation. Inc. a French concern. EXAMPLE Flip-a-burger. 4. 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. a U. B. B2-68 © 2009 DeVry/Becker Educational Development Corp. obligates itself to establishing and maintaining cellular telephone systems in Mexico in exchange for a licensing fee to use its technology. METHODS OF CONDUCTING INTERNATIONAL BUSINESS OPERATIONS Multinational operations are structured in any number of ways. Acquisitions of Existing Operations The outright purchase of foreign companies as subsidiaries serves as a means of establishing international operations. The entity is then motivated to actually establish a business outside its boundaries to more effectively differentiate itself and compete with foreign competitors. obligates itself to providing training and the use of unique company logos to businesses that operate in Peru. 1. a U. 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. corporation. EXAMPLE Engulf & Devour Food products. Inc. All rights reserved.. International Trade Import/export operations characterize the use of purely international trade as a means of conducting international business. 5. b. to distribute US confections throughout France using Chez Brule's distribution network.Business Environment & Concepts 2 Becker CPA Review 3. EXAMPLE Wireless. Foreign success will promote foreign competition..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. 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.S. Licensing Entities that provide the right to use processes or technologies in exchange for a fee are engaged in licensing activities. The following terms help define different methods of organization. Direct Foreign Investment (DFI) a. 3. a U. 2. . teams with Chez Brule.S.
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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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then the net exposure in United States dollars is $1. a U. General Measurement of transaction exposure is generally done in two steps: a. The higher the degree of correlation.000 over the same period.000 × .000.80. a. Estimate the variability (risk) associated with the foreign currency. 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. 4. in part.500. the net exposure in Canadian dollars is a C$2.70 and $. . 3.000.000 (C$2.000. If the exchange rate is $. EXAMPLE Seattle Import/Export. Currency Correlation (Multiple Foreign Currencies) Currency correlation scenarios anticipate the settlement of future transactions in multiple foreign currencies. All rights reserved. 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.000 and $1. the most likely exchange rate. by transaction exposure. 1.600. the total fluctuation exposure would be expected to be between $1. judgmentally. 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. between $.000.000 to Canada over the next year while importing C$8.75 to each Canadian dollar. 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. b. b.000. The degree of transaction exposure is determined statistically by the degree to which the movement of exchange rates of multiple foreign currencies correlate. TRANSACTION EXPOSURE: DEFINITION AND MEASUREMENT Exchange rate risk is defined.S. Transaction exposure is generally measured in relation to currency variability or currency correlation. the greater the possibility that changes in exchange rates (either favorable or unfavorable) will compound and increase the risk of exchange rate fluctuation. 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. a. If Seattle Import/Export anticipated that it would export C$10.000 inflow. 2. 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. the expected variability in exchange rates is more difficult. Project foreign currency inflows and foreign currency outflows.75).Business Environment & Concepts 2 Becker CPA Review C.400. If the rate is anticipated to fluctuate five cents.
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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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Identifying Net Transaction Exposure Consolidated entities consider their net transaction exposure prior to considering hedge strategies. 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. less domestic currency than originally anticipated from the sale that created the receivable can be purchased with the foreign currency received. 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. Hedges can be effective or ineffective. An exchange loss will result. Accounts Receivable Application (1) B2-76 . While exchange rate issues might adversely affect one subsidiary. © 2009 DeVry/Becker Educational Development Corp. 2. Should the domestic currency weaken. TECHNIQUES FOR TRANSACTION EXPOSURE MITIGATION The following hedge transactions are used to mitigate exchange rate risk presented by foreign currency transaction exposure. An exchange loss will result. Hedges are likely to be effective just as often as they are likely to be ineffective if done consistently and. (2) b. 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. depending upon the actual exchange rate at the time of settlement in comparison to the hedge price and other factors. All rights reserved. c. Should the domestic currency strengthen. Net transaction exposure considers the impact of transaction exposure on the entity taken as a whole rather than individual subsidiaries. Accumulate the inflows and outflows of foreign currencies by subsidiary. Futures hedges are denominated in standard amounts and tend to be used for smaller transactions. Compute the net impact in total. they might favorably affect another. c. Consolidate the impact on the subsidiary by currency type. You will not be asked on the CPA exam to determine hedge effectiveness or ineffectiveness. Adjusting Invoice Policies International companies may hedge transactions without complex instruments by timing the payment for imports with the collection from exports. 3. a. The net transaction exposure is the aggregate exposure associated with a particular foreign currency for a particular time and is computed as follows: a. b. more domestic currency will be required to purchase the foreign currency and pay the payable. therefore. Management may elect to hedge inconsistently or selectively in order to ensure that hedge transactions are carried out with maximum effectiveness. theoretically have no impact on income.Business Environment & Concepts 2 Becker CPA Review a. 1. B. 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. b.
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. Purchase the amount of foreign currency equal to the net investment required and deposit the proceeds in the appropriate money market vehicle. While futures hedges tend to be used for smaller transactions. 2. 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. Money market hedges for payables satisfaction are easy to understand. forward hedges are contracts between businesses and commercial banks and normally are larger transactions. 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. 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. While a futures hedge might hedge a particular transaction. a forward hedge would anticipate a company's needs to either buy or sell a foreign currency at a particular point in time. © 2009 DeVry/Becker Educational Development Corp. a. a. All rights reserved. B2-77 . Money Market Hedge A money market hedge uses international money markets to plan to meet future currency requirements. 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. Accounts receivable denominated in a foreign currency represent a potential transaction exposure to exchange rate risk in the event that the domestic currency strengthens. Determine the amount of interest that can be earned prior to settling the payable. (2) b. Accounts Receivable Application (1) (2) 3. (1) (2) (3) (4) Determine the amount of the payable. Discount the amount of the payable to the net investment required. 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 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.
Invest pesos at Mexican interest rates and satisfy payables upon maturity of the investment. interest rates are 6%.08 per peso and Mexican interest rates are 16%. Duffy's Discount Piñatas has a receivable from a Mexican customer in the amount of 1. B2-78 EXAMPLE EXAMPLE © 2009 DeVry/Becker Educational Development Corp.923.538 pesos and convert them to $76.077 (76.Business Environment & Concepts 2 Becker CPA Review EXAMPLE Duffy's Discount Piñatas has a payable due to its Mexican suppliers in the amount of 1.000. Duffy has secured the satisfaction of its current $80.04 = 961. Duffy. and when the 90-day discounted note for 961. The current exchange rate is $.08 per peso and Mexican interest rates are 16%. Money Market Hedge: Receivables A money market hedge used for receivables denominated in foreign currencies effectively involves factoring receivables with foreign bank loans.S. Duffy performs the following steps: 1. Duffy will satisfy it with the collections from the foreign accounts receivable.000 pesos. 3.000/1.538 pesos matures for 1.000 pesos in 90 days.923 × 1. Purchase 961.538. Duffy needs the money now. b. 2. Mexican interest rates are 16%. c.08 per peso. The current exchange rate is $. Duffy has secured the satisfaction of its current $80.000. Duffy borrows the pesos from Mexican financial institutions. 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.000. Duffy computes that it can borrow 961. and U. Foreign currency amounts are borrowed in discounted amounts that are repaid in the ultimate maturity value of the receivable denominated in the foreign currency. Duffy computes that it must borrow $76.000 payable for $76.000 pesos in 90 days.000 pesos due in 90 days.015.000. All rights reserved. Duffy has $100.08).538 pesos with $76.923 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. so it elects to use a money market hedge technique to expedite collection and mitigate any transaction exposure to exchange rate risk. Duffy borrows the needed amount for 90 days in the United States. Duffy's Discount Piñatas has a payable due to its Mexican suppliers in the amount of 1.000 in excess cash and elects to use a money market hedge to mitigate transaction exposure to exchange rate risk. .000. Duffy will be able to meet whatever its current cash requirements are in the United States with the $76.923 consistent with the first money market hedge example.923 (961.923. is broke and cannot wait to receive $80. Determine the required investment in pesos at Mexican interest rates: 1. 6 percent for 90 days). Borrowed foreign currency amounts are converted into the domestic currency. The current exchange rate is $.000 in 90 days.538 pesos × . as usual.000 payable for $78.
2. 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 decisions serve the purpose of minimization of local taxation while remaining within the guidelines of foreign or other host governments.Becker CPA Review Business Environment & Concepts 2 IV. INTERCOMPANY TRANSACTIONS: RELATIVE TAX RATES Transfer prices (selling prices) in countries with higher tax rates will be reduced to optimum levels. reduce income in countries with higher taxes. A. even if those subsidiaries have lower rates. B2-79 . All rights reserved. Valuation of these transactions involve transfer pricing. 1. 2. Strong Cash Position Subsidiaries with strong cash positions tend to follow a "leading" transfer policy and pay other subsidiaries in advance. B. TRANSFER PRICING International businesses will likely transact businesses between the subsidiaries that cross political boundaries or between the domestic parent and foreign subsidiary. 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. © 2009 DeVry/Becker Educational Development Corp. 1. Transfer prices should be set up to maximize consolidated benefit. INTERCOMPANY CASH TRANSFERS Intercompany cash transfers are often managed through use of leading and lagging. and maximize the tax shield in countries with lower taxes.
handling the raw materials. etc. strategic planning.. INTERNAL DIFFERENTIATION ANALYSIS The firm may analyze its ability to create value through differentiation (e. When firms must assess every part of the value chain to allow them to provide their customers with maximum value. the manufacturing process. INTERNAL COSTS ANALYSIS In order to determine the internal value-creating ability of a firm. two major categories of business value activities exist: 1. MICHAEL PORTER'S WORK IN 1985 In 1985.Business Environment & Concepts 2 Becker CPA Review APPENDIX I Homework Reading Topic: Market Influences on Business Strategies Expanded Discussion of Value Chain Analysis I. Primary Activities Primary activities are those that are involved with the direct manufacture of products. According to Porter. All rights reserved. purchasing of the materials and supplies. VALUE ACTIVITIES A. the value starts with the suppliers who provide the raw materials for the production process. APPROACH OF VALUE CHAIN ANALYSIS Value chain analysis is part of an overall strategic plan. B. continues with the firm and its strategic plan. advertising the product. II. Three major forms of analysis are performed.g. accounting. taking orders for the product. In this view.. B. SHANK'S AND GOVINDARAJAN'S WORK IN 1993 John Shank and V.). development of the technology used. Support Activities Support activities are those activities that are performed by the support staff of an organization (e.g. 2. B2-80 © 2009 DeVry/Becker Educational Development Corp.g. Govindarajan took a look at the value chain in an even broader sense than Michael Porter. the sources of profit and costs of the internal activities within the firm must be analyzed. and servicing the product after it is sold). A. and then ends with the disposal and recycling of the materials. 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. They indicated that the firm itself is a part of the overall value chain of the industry. and it is an ongoing process used with strategic thinking. . finance. the delivery of the products through distribution channels.. 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. they must determine the parts of the value chain that will provide them with the largest amount of competitive advantage. and the support of the product that exists after the sale is made (e. management of employees. continues further with the value created by the customers.
preparing. the ultimate consumer actually ends up paying for the profit margins that exist all along the value chain..Becker CPA Review Business Environment & Concepts 2 C. that value not only benefits the specific activity in the chain but also benefits other activities. VERTICAL LINKAGE ANALYSIS Analyzing the vertical linkage of the firm means understanding the activities of the suppliers and buyers of the product (i. B. in-house customer service departments handle customer complaints in an efficient and courteous manner that establishes organizational responsiveness to the customer and creates loyalty. 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. Identification of cost drivers assists the organization in determining those areas in which it has a competitive advantage. 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 some cases. manufacturing. For example. Opportunities to add value depend on our overall strategy. Organizations might also identify those areas in which outsourcing is valuable. C. 1. 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. B2-81 . 4. Identify Opportunities for Reduced Cost Analysis of the cost drivers should show where the organization is not competitive. All rights reserved. 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. while firms with differentiation strategies will look at opportunities for innovation. three general "steps" emerge. Identify Opportunities for Added Value Identification of activities that add value to the customer follows from our review of competitive advantage. STEPS IN VALUE CHAIN ANALYSIS Considering all of the above introductory material regarding value chain analysis. IDENTIFY VALUE CHAIN ACTIVITIES Organizations must identify value activities performed as part of their business. 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. Inhouse customer service can also be alert for patterns of complaints and can influence product design. Elimination or outsourcing of those items for which the organization is not cost competitive is generally proposed from this step in value chain analysis.e. A. Each step of the value chain should produce some value. and delivering a good or service. Remember. Identify Competitive Advantage Firms with cost leadership strategies will look at cost saving opportunities. Value activities are generally those processes that are involved with designing. III. © 2009 DeVry/Becker Educational Development Corp. IDENTIFY COST DRIVERS ASSOCIATED WITH EACH ACTIVITY Cost drivers represent factors that increase total cost. 2. 3.
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. best practices). it does not focus on why one firm is able to create. They will each be discussed in detail later in this chapter. Identifying Core Competencies A competency is deemed a core competency if it has the ability to: a. b. A. segmentation analysis. They also play a significant role with respect to the market influence on business strategy.) 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. C. 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. 1. c. 3. These five forces assist the firm in determining what makes a firm more profitable compared to another firm. Increase perceived customer value. and superior technology and is also able to integrate them appropriately. is often helpful. learn new things (e. quality physical resources. STRATEGIC FRAMEWORKS IN VALUE CHAIN ANALYSIS Although value chain analysis is hardly a science. SEGMENTATION ANALYSIS Sometimes. work as a team.. (Vertical integration is also discussed later in this chapter as a possible strategy for firms to follow. 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.. B2-82 © 2009 DeVry/Becker Educational Development Corp. 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.e. thus. which means that it is involved in almost every aspect of the firm's value chain. 4. Can a large amount of markets be accessed?). Reduce the threat that competitors may copy the product. impact the competitive environment of a firm.g.Business Environment & Concepts 2 Becker CPA Review IV. from supplying the raw materials to distribution to the ultimate consumer. so they are listed here for introductory purposes only. which takes a look at the competitive advantages that exist in the various segments. a firm is vertically integrated. 1. 5. thus increasing the firm's competitive advantage. . 2. 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. three types of strategic frameworks have proven to be useful for value chain analysis. All rights reserved. and Provide leverage (i. and reduce inherent risks is increased. B. When a firm has a solid foundation in excellent employees. attain. 2. the ability of the firm to adapt to change.
a skilled labor force) that are required in a given industry. B. the nation will fare better with regard to global competitive advantage. tax regulations.Becker CPA Review Business Environment & Concepts 2 V. CONDITIONS OF THE FACTORS OF PRODUCTION If the nation has a strong set of factors of production (e. it will fare better with regard to global competitive advantage. If other rival firms who are competitive in the international environment exist. inflation rates. 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.. currency fluctuations. social values. STRUCTURE. FIRM STRATEGY. D. it may help the nation fare better with regard to global competitive advantage (unless the costs are prohibitively high).g. RELATED AND SUPPORTING INDUSTRIES If suppliers of material inputs exist within the nation. C. etc. All rights reserved. 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. CONDITIONS OF DOMESTIC DEMAND If the nation's domestic demand for the product is high. 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). the nation's competitive advantage is increased. When the various parts of the value chain (and thus the value-creating processes) exist in different parts of the world.): A. all influence the ability of the nation to attain and sustain competitive advantage. © 2009 DeVry/Becker Educational Development Corp. this often poses problems of costs of transportation and lack of control and communication. B2-83 . which can negatively impact the overall customer value. in his work in 1990. AND RIVALRY The practices of a nation with respect to how companies are managed and organized. Porter indicated four major factors that impact global competitive advantage (to be considered along with the risks of the political environment of the nation.
According to the Supply Chain Council. . it is necessary to procure the resources required to meet it and to manage the infrastructure that exists for the sources. All rights reserved. 6. which is essentially the entire supply chain. 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. inspecting. 7. 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). B. SUPPLY CHAIN OPERATIONS REFERENCE (SCOR) MODEL The SCOR Model was developed by the Supply Chain Council. 4. 2. 8.Business Environment & Concepts 2 Becker CPA Review APPENDIX II Homework Reading Topic: Market Influences on Business Strategies Expanded Discussion of Supply Chain Management I. 5. 3. and storing inputs to the production process Overseeing the quality assurance process Assessing vendor performance B2-84 © 2009 DeVry/Becker Educational Development Corp. examples of activities associated with "plan" are: 1. core activities of SCOR). According to the Supply Chain Council.. Selecting vendors Obtaining vendor feedback and certification Overseeing and obtaining proper vendor contracts Collecting and processing vendor payments Ordering. 5. this process deals with the following types of activities: 1. A. 2.e. 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. 6. 7. 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. 10. 3. 4. 9.
g. MAKE The "make" process encompasses all the activities that turn the raw materials into finished products that are produced to meet a planned demand. this process includes the following types of activities: 1. the process includes the following types of activities: 1. freight. 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. 11. 2.g. 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. enter orders. 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. provide quotes. 9. THE FUNDAMENTALS In this stage. etc. 10. 2. 4. Managing of orders (e. 3. truck coordination.Becker CPA Review Business Environment & Concepts 2 C. import/export issues. some firms have developed extended supply chains or elaborate supply chain communities. However. According to the Supply Chain Council.) Forecasting Pricing Managing transportation (e. grant credit. 8. © 2009 DeVry/Becker Educational Development Corp. Most are somewhere between implementing only the fundamentals of the process and having integration of the business enterprise. 9. 8. transportation issues. A. 5. STAGES OF SUPPLY CHAIN MANAGEMENT Not every firm implements supply chain management in the same way. 3. 6. 4. 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. B2-85 . and warehousing. etc. 5. According to the Supply Chain Council. 7. 7.. The following stages of supply chain management range from the least sophisticated to the most sophisticated. 6. All rights reserved..) Managing accounts receivable and collections Shipping of products Labeling of products Scheduling installation of products Delivering the inventory according to channel distribution rules II.
C. the firm could enjoy a significant positive impact on its profitability and competitive advantage. a synchronized supply chain community is formed. By themselves.e. this is significantly more difficult to implement than the previous four stages. The firm will focus on the total cost of delivery. INTEGRATED ENTERPRISE In this stage. E. C. B. management will move away from simple consolidation of its operations to an internally-integrated supply chain. firms may see potential for increased profits by unifying the supply chain and forming mutual objectives. and responding to customer needs. 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. D. and the extended supply chain may plan with point-of-sale tools and implement with customer management systems. III. 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. improvements in various aspects and activities along the supply chain can provide areas of cost savings for the firm. The main business issue the firm is concerned with at this stage is unreliable order fulfillment. 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. and create new types of vertical integration. management requires a quantified benefit before it will embark on any new type of plan. profitable growth.. BENEFITS OF IMPLEMENTING SUPPLY CHAIN MANAGEMENT Typically. The firm will seek to achieve communication at the cross-functional level for on-time and complete delivery of its product. Examples of benefits derived from implementing supply chain management include: A. goal congruence is essential). Networks play a large role in this stage. increase and leverage core competencies. B2-86 . as this process strives to integrate the supply chains of many operations. not just those internally. but when considered together. The community may be able to attain significant economies of scale. and the main business issue facing the firm is creating networks of preferred suppliers. EXTENDED SUPPLY CHAIN If integration of the supply chain moves external to the firm. 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. The need for those involved to be able to work as a unified team without bias is even more essential. the quantification of the benefits derived from such actions is not easily obtained. management will turn its attention to consolidation of the various departments that make up operations in order to solve the firm's problems. While it is generally accepted that the coordination and integration of goods being brought to market is a valid business endeavor. being profitable. The main business issue of this stage is slow. CROSS-FUNCTIONAL TEAMS In this stage. SUPPLY CHAIN COMMUNITIES When the extended supply chain actually forms a single competitive entity. However. D. For this stage to be successful. and integrated supply chain management is no exception. All rights reserved.Business Environment & Concepts 2 Becker CPA Review B. and it is very concerned about customer service. While the other stages focus on the operational side of the supply chain. 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.
3. J. B2-87 STEPS TO ALIGN THE SUPPLY CHAIN AND THE BUSINESS STRATEGY © 2009 DeVry/Becker Educational Development Corp. B. Assess the opportunities in the supply chain. Translate the ISCM strategy into actions. the general steps a firm would follow are: A. create value along the supply chain to achieve the planned goals. 3. Develop a vision for ISCM. E. L.Becker CPA Review Business Environment & Concepts 2 E. 2. Establish an information and communication network for ISCM. B. 2. G. Develop a strategy for ISCM. C. After the company has chosen how it will best serve its customers. FIVE SUPPLY CHAIN DRIVERS 1. Production Inventory Location Transportation Information Understand the markets the firm operates in and the customers it services. . This is essential to the ability of the firm to increase its market share and protect profits. IV. 4. H. K. 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. which is directed at serving the needs of the consumers of the firm's product. 1. Identify the core competencies of the firm and how the firm will use these to best serve its customers. 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. 5. A. F. V. C. F. Create an optimum organizational structure for ISCM. D. 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. All rights reserved. I.
Generally. the decisions made by management are influenced by the character of the transaction to be hedged and the instrument used. the business will allow the option to expire. However. a. All rights reserved. While the basic principles associated with hedge transactions are the same. 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. and assessment techniques for evaluating the effectiveness of hedge strategies. b. depending on which result is most favorable. non-transactional risks. they are a sunk cost and are irrelevant to the decision to exercise the options. I.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. While premiums are used to compute any net savings associated with option transactions. instead of requiring a commitment to a transaction. If the option price is more than the exchange rate at the time of settlement. B2-88 © 2009 DeVry/Becker Educational Development Corp. ADVANCED TECHNIQUES FOR MITIGATING TRANSACTION RISK AND EVALUATING STRATEGY A. 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 business evaluates the relationship between the option price and the exchange rate at the settlement date. The business has the option (not the obligation) to purchase the security at the option (strike) price. The following outline deals with the option contracts. . 1. if the option price is less than the exchange rate at the time of settlement. Similar to a futures contract or forward contract. 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. the business will exercise its option. CURRENCY OPTION HEDGES Currency option hedges use the same principles as forward hedge contracts and money market hedge transactions. longer term transactions.
085 Settlement Cost for 1. The business evaluates the relationship between the option price and the exchange rate at the settlement date. B2-89 .10 Net savings Option Price $.08. Although the peso is currently exchanged for the US dollar at $. if the option price is more than the exchange rate at the time of settlement. 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.000.085 Settlement Cost for 1. 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.Becker CPA Review Business Environment & Concepts 2 Gearty International owes its Mexican supplier 1.10 – . computed as follows: Spot Rate At Settlement $.10. the business will exercise its option.000 premium to reflect a $15.000.000 [(.005 premium to secure a call option to buy 1.000 pesos in 30 days for $.000 pesos due in 30 days.000 pesos] is reduced by the $5.08 Loss Option Price $. While premiums are used to compute any net preserved values associated with option transactions. the company is fearful that the Mexican peso will strengthen in comparison to the dollar before the settlement to as much as $.08) * 1. 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. is $5.000 (85.000 pesos $ 100.000. they are a sunk cost and are irrelevant to the decision to exercise the options. 2.000) $ 15. Gearty will exercise its option to achieve a $15. 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. The gross savings of $20. the $.000) Gearty will likely buy pesos at the spot rate regardless of the loss associated with the premium.08 Premium $.000 and is paid regardless of whether the option is exercised.000 pesos $ 80.005 Total Option $.000.000 net savings. All rights reserved. Generally. b.005 premium.000 Gearty's consideration for the option. that the premium is not included in the decision to exercise the option.08.08 Premium $. however. © 2009 DeVry/Becker Educational Development Corp.000 net savings. Gearty International pays a $. computed as follows: EXAMPLE Spot Rate At Settlement $. Remember. If Gearty is incorrect in its assessment of international exchange rates and the exchange rates stay constant at $.000 ($ 5. a. 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.08.000. If the option price is less than the exchange rate at the time of settlement. the business will allow the option to expire.005 Total Option $.000 85. Similar to a futures contract or forward contract.
the $.005 premium.000 $ 15. 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 Option Settlement Price $.075 Settlement Cost for 1.08. B2-90 © 2009 DeVry/Becker Educational Development Corp. If Gearty is incorrect in its assessment of international exchange rates and the exchange rates stay constant at $. 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. however.06 $.000.000 Gearty's consideration for the option.000 premium paid to reflect a net $15. Remember.000.000. computed as follows: Spot Rate At Settlement $.005 Total Option $. the company will exercise its option to achieve a net preservation of $15.000) Gearty will likely sell pesos at the spot rate regardless of the loss associated with the premium.000 pesos $ 60. the company is fearful that the Mexican peso will weaken in comparison to the dollar before the settlement to as little as $. The gross value "preserved" of $20. is $5.075 Settlement Cost for 1. Gearty International pays a $.08.000 pesos] is reduced by the $5.Business Environment & Concepts 2 Becker CPA Review Gearty International is owed 1.06.06) * 1.000 pesos in 30 days for $.000. that the premium is not included in the decision to exercise the option.000 in asset value.000 and paid regardless of whether the option is exercised.000.08.08 Net preserved value EXAMPLE Premium $.000 75.000 ($ 5.08 Premium $.000 preserved receivable value.000 pesos $ 80.08 Loss Option Price $.000 [(. . Although the peso is currently exchanged for the US dollar at $.000 75. All rights reserved.000 pesos due in 30 days from its Mexican customer.08 – .005 premium to secure a put option to sell 1.005 Total Option $.
1. B. If the exchange rate declines. Costs of Hedging or Not Hedging a.75. 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 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. EXAMPLE Assume the cost of the Canadian dollar is $. © 2009 DeVry/Becker Educational Development Corp. it is at risk for increases in the exchange rate or weakening of the domestic currency in relation to the foreign currency. the company would purchase a call option to buy the amounts needed at the spot rate.000. it is at risk for declines in the exchange rate or strengthening of the domestic currency in relation to the foreign currency. a monetary liability. All rights reserved. If the company owes accounts payable in a 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.000 is known to be $750. 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. 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. B2-91 . If the exchange rate increases. a monetary asset.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. The nominal cost of hedging C$1. the company would purchase a put option to sell the amounts collected at the spot rate.000. 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 company owns accounts receivable in a foreign currency. 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).
Real Cost of Hedging Receivables The real cost of hedging receivables is expressed in the following formula: a.000 less if it does not hedge.10 probability of falling to $. We would compute the nominal cost of not hedging a planned C$1.65. the real cost of hedging payables with the stated exchange rate is as follows: EXAMPLE RCHp = NCHp − NCp RCHp = $750.000 $320.000. a . while positive results indicate that the business should not hedge the transaction.80 Probability . The real cost of hedging payables indicates that the company will pay $15.10 . Assuming the results of the previous two concept examples.40 Domestic Value C$1.000 C$1. All rights reserved.40 probability of rising to .Business Environment & Concepts 2 Becker CPA Review b. and a . Negative results indicate that the business should enter into a hedge transaction.000 $735.65 . Real Cost of Hedging Payables The real cost of hedging payables is expressed in the following formula: a. 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.50 probability of falling to . .000 $350. b.70. Assume the cost of the Canadian dollar is $.000 Nominal Cost of Not Hedging $ 65. b.000 − $735.50 . 3.000.75.000.000 as follows: Possible Rates .70 . and we anticipate that the exchange rate has a .000 RCHp = $15.8.000 C$1. 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.000 The business should not hedge. 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.000.000 EXAMPLE Nominal Cost of Not Hedging 2.
To avoid the potential of overhedging. forward. Continual Short-Term Hedging Consistent short-term hedging can be ineffective over time because it mirrors the current trends of the market. 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. Uncertainty The amount of hedged transactions (e. b. Long-Term Forward Contracts Mechanically. or money market hedge. 2.. Currency Swaps Transaction exposure associated with exchange rate risk for longer-term transactions can be mitigated with currency swaps. Long-term purchase contracts may be hedged with longterm forward contracts. Logically. the company should only hedge the minimum amount known to be due or payable. the company is said to be overhedged. 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. while positive results indicate that the business should not hedge the transaction.000 The business should hedge. B2-93 . Financial Intermediaries Typically financial intermediaries are contacted to broker or match firms with currency needs.000 − $750. If the business hedges too much.Becker CPA Review Business Environment & Concepts 2 c.000 RCHr = −$15. payables or receivables) may not be known precisely prior to the execution of the futures. Long-term forward contracts are set up to stabilize transaction exposure over long periods. OTHER TECHNIQUES FOR TRANSACTION EXPOSURE MITIGATION: LONG-TERM TRANSACTIONS The following hedge transactions are used to mitigate exchange rate risk presented by transaction exposure. All rights reserved. C. The real cost of hedging receivables indicates that the business will likely receive $15. the same fact pattern applied to a liability and an asset produce equal and opposite results. The two entities essentially swap their currencies in an exchange negotiation completed years in advance of their receipt of the currencies. a. © 2009 DeVry/Becker Educational Development Corp. 1. Negative results indicate that the business should enter into a hedge transaction. the real cost of hedging receivables with the stated exchange rate is as follows: RCHr = NRr – NRHr EXAMPLE RCHr = $735. 2. D. long-term forward contracts deal with the same issues as any other forward contracts. LIMITATIONS ON HEDGING 1.000 less if it does not hedge.g. Assuming the results of the previous concept examples.
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.Business Environment & Concepts 2 Becker CPA Review 3. Generally. Pete's Primo Piñatas would suffer economic losses as a result of their economic exposure to exchange rate risk. B2-94 EXAMPLE © 2009 DeVry/Becker Educational Development Corp. 2. Cross-Hedging The technique known as cross-hedging involves those transactions that cannot be hedged. 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. . If the peso were to strengthen in relation to the dollar. II. The company's expenses paid to local suppliers are denominated in the peso. EXCHANGE RATE RISK: MANAGING ECONOMIC AND TRANSLATION EXPOSURE Businesses have various methods of managing the economic and translation exposure associated with exchange rate risks. The extent to which revenues and expenses are denominated in different currencies could seriously impact the profitability of an organization and represents economic exposure. 1. OTHER TECHNIQUES FOR TRANSACTION EXPOSURE MITIGATION: ALTERNATIVE HEDGING TECHNIQUES The following hedge transactions are used to mitigate exchange rate risk presented by transaction exposure. Currency Diversification The simplest hedge for long-term transactions is to diversify foreign currency holdings over time. A. Pete's Primo Piñatas manufactures piñatas in Mexico. E. 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. 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. the use of organization-wide solutions related to the entity itself and related reporting requirements are included in the approach. Leading and Lagging Leading and lagging represent transactions between subsidiaries or a subsidiary and a parent. All rights reserved. then imported revenues could be significantly less than domestic expenses. 3. 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. Hedging one instrument's risk with a different instrument by taking a position is a related derivatives contract. 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).
© 2009 DeVry/Becker Educational Development Corp. a. Weakening demand may cause the foreign government to implement tariffs or other regulatory measures that reduce foreign penetration. 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. Interest Rates a. 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. 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. Lower interest rates in the foreign country may be indicative of increased growth and demand. b. Foreign Demand A multinational corporation exporting to a foreign country is vitally concerned with demand within that country. A. 2. 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. COUNTRY RISK ANALYSIS: FOREIGN ECONOMY CONSIDERATIONS The state of the foreign economy in which the multinational company operates is highly significant to risk evaluation. 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. 1. Although very little can be done to fully mitigate this risk exposure. B2-95 . 1. Economic exposures to exchange rate fluctuations are viewed as more difficult to manage than transaction exposures. 2. Demand is directly affected by the health of the economy of the county in which it operates. Characteristics of Restructuring and Economic Exposure Restructuring tends to be more difficult than ordinary hedges.Becker CPA Review Business Environment & Concepts 2 B. Higher interest rates in the foreign country are indicators of slower economic growth and reduced demand. III. 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. a. international companies can perform a country risk analysis to fully assess the degree of their exposure. All rights reserved. b. Restructuring Economic exposure to currency fluctuations can be mitigated by restructuring the sources of income and expense to the consolidated entity.
b. 3. 4. B. Although expropriation of productive resources represents the most extreme political risk. Strong local currency increases demand for imported goods. 5. 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. 2. 4. All rights reserved. .Business Environment & Concepts 2 Becker CPA Review 3. other features of political risk must also be considered including: 1. 6. Exchange Rate a. COUNTRY RISK ANALYSIS: POLITICAL RISK CONSIDERATIONS Political risks represent non-economic events or environmental conditions that are potentially disruptive to financial operations. Inflation Higher local inflation and reduced purchasing power makes imported goods more expensive and reduces local demand for them. Weak local currency reduces demand for imported goods.
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. 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 . 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.
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. All rights reserved. .
16. 3. 5. © 2009 DeVry/Becker Educational Development Corp. 15. 7. Grade: Multiple-choice Questions Correct / 18 = __________% Correct Detailed explanations to the class questions are located in the back of this textbook. 8.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. 11. 17. B2-99 . 2. 4. 18. 6. 12. 9. 14. 13. 10. All rights reserved.
Business Environment & Concepts 2 Becker CPA Review NOTES B2-100 © 2009 DeVry/Becker Educational Development Corp. . All rights reserved.
The most plausible explanation for this is: a. Cyclical. An increase in wealth. $7. An increase in the level of real interest rates. Structural.215 billion. c. $ 5. which of the following was the U. GDP for the year in question? 4. CPA-03404 What type of unemployment is shown when individuals do not have the qualifications or skills necessary to fill available jobs? a. b. $6. d.015 billion $ 106 billion $ 1. © 2009 DeVry/Becker Educational Development Corp. 2.S.691 billion. An increase in the general level of confidence about the economic outlook. $6. CPA-03396 Assume the following data for the U. c. An increase in government spending. d. Frictional. CPA-03291 Which of the following is not likely to cause a rightward shift in the aggregate demand curve? a. c. CPA-03307 Suppose real GDP is rising while the overall price level is falling. A shift left in the aggregate demand curve. c. b. b. $6.958 billion. A shift right in the aggregate demand curve. A shift right in the aggregate supply curve.Becker CPA Review Business Environment & Concepts 2 CLASS QUESTIONS 1. Natural. B2-101 .953 billion. d. b. All rights reserved.040 billion $ 262 billion $ 183 billion $ 975 billion $ 5 billion Based on this information. 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. 3. A shift left in the aggregate supply curve. d.S.
All rights reserved. CPA-03471 Which of the following is not true regarding strategic plans? a. the real interest rate is: a. CPA-03667 Which one of the following changes will cause the demand curve for gasoline to shift to the left? a. c. b. d. 7. c. . The price of cars increases. CPA-03411 Deflation is best defined as: a. The money supply to increase and interest rates to rise. b. d. CPA-03395 An increase in the discount rate would cause: a. 10. d. 6. Minimum price below the equilibrium price. The price of cars decreases. A continuous decline in the overall price level. A continuous rise in the overall price level. Continual re-evaluation and revision of strategic plans is necessary. b. A continuous decline in real GDP. The money supply to decrease and interest rates to rise. Various levels of the organization will implement strategic plans differently. b. b. b. CPA-03412 If the nominal interest rate is 10% and the rate of inflation is 5%. Strategic plans will vary by segment based on the characteristics of the segments. 15% 2% 50% 5% 8.Business Environment & Concepts 2 Becker CPA Review 5. c. The price of gasoline increases. CPA-03670 The competitive model of supply and demand predicts that a surplus can only arise if there is a: a. The money supply to decrease and interest rates to fall. c. The money supply to increase and interest rates to fall. d. Maximum price above the equilibrium price. d. c. c. B2-102 © 2009 DeVry/Becker Educational Development Corp. d. The supply of gasoline decreases. 9. Minimum price above the equilibrium price. When the price of a particular good falls. The process of strategic planning begins with the creation of the plan. Maximum price below the equilibrium price.
All rights reserved. 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. strategic plans focus on: a. CPA-03479 Under pure competition.Becker CPA Review Business Environment & Concepts 2 11. b.20 10. A measure of how flexible the demand or supply of a product is when preferences change. ensuring product differentiation. 12. A measure of how well a firm's strategic plan is able to adapt to changes in demand or supply. d. d. A measure of how flexible the firm is with respect to responding to the needs of the consumers. Maintaining the market share and planning for enhanced product differentiation. B2-103 . Maintaining the market share and planning for enhanced product differentiation. Profitability from production levels that maximize profits. and adapting to price changes or required changes in production volume. © 2009 DeVry/Becker Educational Development Corp. c. A measure of how sensitive the demand for or supply of a product is to a change in its price. c.10 5.00 13. b. Maintaining the market share. Maintaining the market share and being responsive to market conditions related to sales price. CPA-03708 As the price for a particular product changes. c. CPA-03497 Elasticity of demand or supply is: a. b. ensuring product differentiation. c. b. 14. CPA-03493 Under oligopoly. d. Maintaining the market share and being responsive to market conditions related to sales price. and adapting to price changes or required changes in production volume.00 0. Maintaining the market share. d. strategic plans focus on: a. 0. Profitability from production levels that maximize profits.
. Customers are able to see (or perceive) a value in the firm's product compared to products of other firms. b. c. d. d. then the firm has a competitive market advantage. B2-104 © 2009 DeVry/Becker Educational Development Corp. b. An alliance with another firm that allows for economies of scale and sharing of costs in a less than formal manner. Market competitiveness. 16. A formal process in which two or more firms combine to provide for cost reductions they could not otherwise obtain on their own. b. The two major forms of competitive advantage are differentiation and cost leadership. A process in which the firm focuses on predicting the expected demand of consumers and then plans accordingly for it. CPA-03583 A firm is in heavy competition with a rival firm. CPA-03602 Which of the following statements regarding competitive advantage is not correct? a. The various rival firms have chosen different features on which to differentiate their products. b. The firm's product appeals to different people for different reasons. Barriers to entry. d. If the total costs of a firm are less than those of close rivals. 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. All rights reserved. Existence of substitute products. c. d. 18. c. Bargaining power of customers. c.Business Environment & Concepts 2 Becker CPA Review 15. CPA-03620 Vertical integration is: a. 17. 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. Differentiation advantage may best be obtained by a firm when a firm builds market share or decreases its price. CPA-03609 When do differentiation strategies fail? a. The value of the firm's premium does not exceed its cost. Cost leadership advantage may best be obtained by a firm when a firm builds market share or matches the price of its rivals. Which of the five forces that affect the competitive environment and profitability of a firm does this best demonstrate? a.