Managing Business Activities

An income statement, also called a profit and loss statement (P&L), shows a business's financial performance over a specific period. It breaks down all revenues and expenses to show whether the business made a profit or loss.

Structure of an Income Statement

An income statement follows a step by step structure, moving from total revenue down to final net profit:

Step 1: Revenue is the total income from selling goods or services. This is the starting point of the statement.

Step 2: Cost of Sales (Cost of Goods Sold) includes the direct costs of producing the goods sold. This includes raw materials, wages for production workers, and manufacturing overhead directly related to production.

Step 3: Gross Profit is calculated by subtracting cost of sales from revenue. This shows the profit made purely from production and sales, before considering operating expenses.

Step 4: Operating Expenses are the costs of running the business that are not directly related to production. These include rent, salaries for office staff, insurance, marketing, utilities, and depreciation of equipment.

Step 5: Operating Profit is gross profit minus operating expenses. This shows how much profit the business makes from its everyday operations.

Step 6: Finance Costs include interest paid on loans or borrowings. Subtracting finance costs from operating profit gives profit before tax.

Step 7: Net Profit (Profit After Tax) is the final profit after all expenses and taxes have been deducted. This is the profit that belongs to the owners of the business.

A balance sheet shows a snapshot of a business's financial position at a specific point in time. It lists everything the business owns (assets), everything it owes (liabilities), and the owner's investment (equity). The balance sheet is based on the fundamental accounting equation: Assets = Liabilities + Equity.

Assets Section

Non Current Assets (Fixed Assets) are assets that a business intends to keep for more than one year. These include property, machinery, vehicles, and equipment. Non current assets lose value over time (depreciate) and are typically essential to running the business long term.

Current Assets are assets that can be converted into cash within one year. These include cash in the bank, inventory (stock of goods), and money owed to the business by customers (receivables).

Liabilities Section

Current Liabilities are debts and obligations that must be paid within one year. These include money owed to suppliers (payables), short term loans, and tax owed to the government.

Non Current Liabilities are long term debts that do not need to be paid within one year. These include long term bank loans and mortgages on property.

Equity Section

Net Assets (or Equity) represents the owner's stake in the business. It is calculated as total assets minus total liabilities. If a business closes down, this is the amount of money left for the owners after all debts are paid.

Balance Sheet Structure

A balance sheet is typically arranged in the following order:

ASSETS (Top Section)

Non Current Assets (e.g., property, machinery) at their book value after depreciation

Current Assets (e.g., cash, inventory, receivables)

Total Assets

LIABILITIES AND EQUITY (Bottom Section)

Current Liabilities (short term debts due within one year)

Non Current Liabilities (long term debts)

Total Liabilities

Equity (capital + retained profits)

Total Liabilities and Equity

The key point is that Total Assets must always equal Total Liabilities and Equity. This is why it is called a "balance" sheet.

Ratios are useful tools for analyzing financial statements. They allow us to compare businesses of different sizes and to see trends over time. Ratios are expressed as percentages or simple numbers, making them easier to interpret than raw figures.

Profitability Ratios

Profitability ratios measure how efficiently a business converts revenue into profit.

Liquidity Ratios

Liquidity ratios measure a business's ability to pay its short term debts. They show whether a business has enough liquid assets (cash and things easily converted to cash) to meet its obligations.

Efficiency Ratios

Return on Capital Employed (ROCE) measures how efficiently a business uses the money invested in it to generate profit.

Financial statements and ratios provide managers with valuable information for making business decisions. However, they must be interpreted carefully and used alongside other information.

How Managers Use Income Statements

Managers analyze income statements to understand business profitability and identify areas for improvement. If net profit is declining while revenue is stable, this suggests operating costs are rising and need to be controlled. If gross profit margin is falling, this could indicate rising production costs or pricing pressure from competitors.

How Managers Use Balance Sheets

Balance sheets help managers assess the financial health and solvency of the business. A healthy balance sheet shows a good mix of assets, low debt relative to equity, and sufficient current assets to cover current liabilities. Managers can use balance sheets to ensure the business has enough capital to fund growth and operations.

How Managers Use Ratios

Ratios allow managers to compare performance over time and against competitors. For example:

Improving profit margins indicate better cost control or successful price increases. Declining liquidity ratios warn of potential cash flow problems. Declining ROCE suggests the business is not generating adequate returns from its capital and may need strategic changes.

Limitations of Financial Data Analysis

While financial data is important, managers must understand its limitations:

Historical Information: Financial statements are based on past performance. They may not reflect current market conditions or future opportunities.

Non Financial Factors: Financial analysis does not capture important factors like brand reputation, employee morale, product innovation, or competitive position. A company could be financially strong but facing declining market demand.

Quality of Data: The accuracy of financial statements depends on honest accounting. Errors or intentional misstatement can mislead managers.

Seasonal Variations: Some businesses have seasonal patterns in revenue and expenses. A single snapshot balance sheet or income statement may not represent typical performance.

Comparison Issues: Comparing ratios between businesses requires careful consideration of differences in accounting methods, business models, and market conditions.

External Factors: Economic conditions, interest rates, exchange rates, and legislation can significantly impact financial performance in ways that ratios alone cannot capture.

A firm can choose from different production methods depending on the nature of its product and customer demand. Each method has distinct advantages and disadvantages.

Job Production

Job production involves making a single, one-off product to meet a specific customer order. Each item is unique and produced from start to finish before another begins.

Examples: Custom wedding cakes, bespoke furniture, architectural services, bridal gowns

Batch Production

Batch production creates groups of identical products in stages. Once one batch is completed, the machinery is adjusted to produce the next batch of a different product.

Examples: Batch baking of different bread types, holiday clothing collections, pharmaceutical batches, cosmetics production

Flow Production

Flow production involves the continuous mass production of identical products using an assembly line. Products move continuously through different stages of production.

Examples: Car manufacturing, fast food production, soft drink bottling, clothing manufacture

Cell Production

Cell production combines aspects of job and flow production. A team produces a complete product (or a significant component) within a dedicated cell or area.

Examples: Some car manufacturers use cells for specific components; furniture makers using team cells; electronics assembly teams

Capacity utilisation measures how much of a firm's productive capacity is being used. It is one of the most important measures of operational efficiency.

Why Capacity Utilisation Matters

High capacity utilisation shows efficient use of resources and typically leads to lower unit costs through spreading fixed costs. Low capacity utilisation means the firm is not using its assets fully and has higher per-unit costs.

High Capacity Utilisation

Low Capacity Utilisation

Methods to Improve Capacity Utilisation

• Subcontracting: Outsource excess demand to other firms when own capacity is exceeded; this allows meeting demand without investing in new capacity, improving utilisation without capital expenditure. However, risks include loss of quality control over subcontracted work and potential loss of competitive advantage or confidential information
• Rationalisation: Close down underused production facilities and consolidate remaining operations; reduces fixed costs by eliminating unnecessary overhead and improves remaining facility utilisation. However, this may cause workforce redundancies, employee morale damage, and reduced flexibility to respond to demand changes
• Increasing Demand: Pursue aggressive marketing and advertising, reduce product prices, develop new products, or expand into new geographic markets; these strategies increase sales volume and utilisation. However, these actions require substantial investment, carry market risk, and may fail to attract customers, wasting investment
• Shift Work: Operate production facilities for extended periods (such as 16 or 24 hours daily) to increase output without investing in new capacity; this improves utilisation and spreads fixed costs further. However, costs increase due to shift pay premiums and supervision requirements, and extended operations may reduce worker safety, increase fatigue-related errors, and damage long-term equipment due to continuous use

Inventory management is about controlling stock levels to balance the costs of holding stock against the risks of running out. Poor inventory management costs money and disrupts operations.

Costs Associated with Inventory

Holding Costs: Storage space, insurance, obsolescence, deterioration, opportunity cost of capital tied up in stock

Ordering Costs: Administration, delivery, quality checking, documentation

Stockout Costs: Lost sales, customer dissatisfaction, production delays, emergency restocking at higher prices

The Sawtooth Diagram

Stock control diagrams show the pattern of stock over time. Stock rises when goods are received and falls as they are used. The sawtooth shape illustrates the cycle of ordering and consumption.

Key Points on the Stock Diagram

Problems with Inventory Management

Too Much Stock: High holding costs, risk of obsolescence, storage space constraints, cash tied up, deterioration

Too Little Stock: Stockouts, lost sales, production delays, customer dissatisfaction, emergency ordering at high cost

Poor Data: If demand forecasts are inaccurate, reorder levels will be wrong. Requires good information systems.

Quality management is crucial for customer satisfaction, reputation, and profitability. There are different approaches to ensuring quality, each with distinct advantages.

Quality Control

Quality control involves inspecting finished products to identify and remove defects. It happens at the end of the production process.

Quality Assurance

Quality assurance focuses on preventing defects by building quality into the process itself. Systems and procedures are designed to prevent problems arising.

Total Quality Management (TQM)

TQM is a holistic approach where quality is the responsibility of every person and department. It aims for continuous improvement and excellence across all operations.

Key features of TQM:

• Quality circles: regular meetings where staff identify and solve problems
• Continuous improvement (kaizen): always looking for small improvements
• Zero defects philosophy: aim for perfect quality, not acceptable defect levels
• Employee empowerment: staff have authority to stop production if quality issues arise
• Supplier partnerships: working closely with suppliers to ensure quality materials

Key TQM Concepts

Zero Defects: The goal of TQM is to achieve zero defects (perfect quality) rather than accepting a certain percentage of faulty items. This sets a high standard for all employees.

Quality Circles: Small groups of employees meet regularly to identify problems and suggest improvements. Gives staff a voice and harnesses their knowledge of the work.

Continuous Improvement (Kaizen): Rather than making one big improvement, the focus is on many small, continuous improvements. Over time, these add up to significant gains. Kaizen is covered in more detail in the Lean Production subsection.

Lean production is a production philosophy focused on minimising waste while maximising value. It combines several techniques to achieve efficiency and quality.

Just In Time (JIT)

JIT is a key technique in lean production. Materials and components arrive exactly when needed, no earlier and no later. Stock levels are minimised.

Time Based Management

Lean production also focuses on reducing the time taken to complete tasks. Every minute of delay costs money and ties up resources.

Techniques include: Streamlining processes to eliminate delays, parallelising tasks where possible, reducing setup times between products, improving communication to avoid waiting time

Cell Production in Lean Systems

Cell production is often used in lean production systems. A team of workers completes a significant portion of the product, which allows flexibility and reduces waste from movement between stations.

Kaizen (Continuous Improvement)

Kaizen is a Japanese philosophy meaning "change for the better." It involves all employees, from shop floor workers to senior managers, constantly looking for small, incremental improvements to processes, quality, and efficiency. Rather than one large transformation, kaizen relies on many small improvements that accumulate into significant gains over time.

How Kaizen works in practice:

Workers meet regularly in quality circles to discuss problems and suggest improvements. Every employee is encouraged to identify inefficiencies, no matter how small. Management acts on suggestions quickly, reinforcing the culture. Changes are tested, measured, and refined continuously.

Benefits and Challenges of Lean Production

The business cycle is a repeating pattern of economic growth and decline. All economies experience cycles of expansion and contraction. Understanding where the economy is in the business cycle helps managers predict demand, plan investments, and manage risks. The cycle has four distinct phases.

Phase 1: Boom (Expansion)

During the boom phase, the economy is growing rapidly. Businesses are expanding, profits are rising, and unemployment is falling. Consumer confidence is high, so people spend more money. Businesses invest in new equipment, hire more workers, and production increases. Interest rates may start rising to prevent inflation from getting too high.

Phase 2: Recession

A recession occurs when the economy stops growing and begins to shrink. GDP (the total value of goods and services produced) falls for two consecutive quarters. Consumer and business confidence drops. Spending decreases, businesses reduce production, and some businesses fail. Unemployment rises as companies lay off workers. Asset prices like house and share prices may fall.

Phase 3: Slump (Depression)

If a recession deepens and lasts longer, it can become a slump or depression. This is a prolonged period of very low economic activity. Many businesses fail, unemployment is high, consumer spending is at very low levels, and there is little business investment. Banks may become reluctant to lend, making it hard for businesses to borrow money even if they want to invest.

Phase 4: Recovery

Recovery occurs when the economy begins to grow again after a slump. Consumer and business confidence starts to return. Spending increases, businesses begin to invest again, and unemployment falls as more jobs are created. This growth gradually accelerates until the economy enters a boom phase again.

Interest rates are the cost of borrowing money. When you borrow money from a bank, you pay interest, which is a percentage of the amount borrowed. Interest rates are crucial to business activity because they affect borrowing costs, consumer spending, saving behavior, and currency values.

The Bank of England and Interest Rates

In the UK, the Bank of England (the central bank) sets a base interest rate, often called Bank Rate. This is the interest rate at which the Bank of England lends to commercial banks. Commercial banks then set their own interest rates based on the Bank of England rate. The Bank of England changes interest rates to manage inflation and economic growth. When inflation is high, they raise rates to cool down the economy. When growth is weak, they lower rates to encourage borrowing and spending.

Impact on Borrowing Costs

Higher interest rates mean businesses must pay more to borrow money. This makes loans more expensive and can discourage business investment. A company might decide not to buy new machinery or expand if interest rates make the loan payments too costly. Lower interest rates encourage borrowing because loans are cheaper, so businesses are more likely to invest in growth.

Impact on Consumer Spending

Higher interest rates encourage people to save (because savings accounts pay more interest) and discourage borrowing for purchases like cars, homes, or holidays. This means consumers spend less, which reduces demand for business products and services. Lower interest rates reduce the return on savings, so people are more likely to spend rather than save, increasing demand for goods and services.

Impact on Different Businesses

Businesses that depend on consumer credit are highly sensitive to interest rates. Retailers, car manufacturers, and construction companies are especially affected because many customers finance purchases with loans. Banks and financial services firms actually benefit from higher interest rates because they earn more on their lending. However, they suffer when rates are too high because fewer people and businesses borrow.

Impact on Exchange Rates

Higher interest rates attract foreign investors looking for better returns on their savings. To invest in the UK, they need pounds, so they demand more sterling. This increases the value of the pound. A stronger pound makes UK exports more expensive and imports cheaper, which can hurt export oriented businesses.

An exchange rate is the value of one currency compared to another. It determines how much of one currency you need to buy another. Exchange rates constantly fluctuate based on supply and demand for different currencies. For international businesses, exchange rates are critical because they affect the price of imports and exports.

How Exchange Rates are Determined

Exchange rates are determined by supply and demand in foreign exchange markets. When there is high demand for sterling (for example, foreigners want to invest in UK businesses), the pound appreciates and becomes stronger. When demand for sterling is low, the pound depreciates and becomes weaker. Interest rate changes, inflation, economic growth, and political stability all affect demand for a currency.

Impact on Exporters

A stronger pound (appreciation) makes UK exports more expensive for foreign buyers because they need to pay more in their own currency to buy British goods. This reduces export competitiveness and can hurt exporting businesses. A weaker pound (depreciation) makes UK exports cheaper, which boosts export sales and helps exporters be more competitive.

Impact on Importers

A stronger pound makes imports cheaper because UK importers need less sterling to buy foreign goods. This helps importers and businesses that use imported raw materials or components. A weaker pound makes imports more expensive, which increases costs for importers and manufacturers that depend on imported inputs.

Currency Conversion

If a UK business exports goods worth 100,000 euros, it needs to convert euros to pounds at the exchange rate to know how much money it will actually receive.

Inflation is a sustained increase in the general price level of goods and services in an economy. When inflation is high, the purchasing power of money decreases because the same amount of money buys fewer goods. For businesses, inflation creates uncertainties about costs, pricing, and future planning.

Causes of Inflation

There are two main causes of inflation: demand pull and cost push.

Demand Pull Inflation: This occurs when aggregate demand (total spending) exceeds aggregate supply (total production). When there is too much money chasing too few goods, prices rise. This often happens during the boom phase of the business cycle when consumer confidence is high and unemployment is low. "Too much money chasing too few goods" is the classic description.

Cost Push Inflation: This occurs when production costs rise, forcing businesses to raise prices to maintain profit margins. Increases in wages, raw material costs, energy prices, or taxes can cause cost push inflation. For example, if oil prices surge, transport costs increase, which pushes up prices across the economy.

Measuring Inflation: The Consumer Price Index

Inflation is measured using the Consumer Price Index (CPI). The CPI tracks the prices of a representative basket of goods and services that typical households buy. It includes items like food, energy, housing, transport, and entertainment. The Office for National Statistics calculates CPI monthly, comparing prices to a base year (currently 2015, where the index = 100).

Impact on Business Costs

Inflation increases business costs. Materials, energy, and supplies become more expensive. Wages must often be increased to keep employees satisfied (otherwise they will seek jobs elsewhere). These rising costs reduce profit margins unless businesses can pass costs on to customers through higher prices.

Impact on Pricing Strategy

During inflation, businesses must decide whether to raise prices to maintain profits. However, raising prices can reduce demand if customers switch to cheaper alternatives or reduce consumption. Businesses must carefully balance cost increases against the risk of losing customers.

Impact on Wages and Workforce

Inflation erodes the purchasing power of wages. Employees expect pay rises to match inflation so their living standards do not fall. If wages do not keep up with inflation, workers become less motivated and may leave for better paying jobs. During high inflation, wage demands from workers intensify, further increasing business costs.

Impact on Uncertainty and Planning

High inflation creates uncertainty, making it difficult for businesses to plan ahead. Contracts become harder to negotiate because no one knows what future costs will be. Investments become riskier because the returns in real terms (after inflation) are uncertain. Businesses may become more cautious about spending on long term projects.

Governments impose laws and regulations that businesses must follow. These rules affect what businesses can do, how they treat employees, how they protect consumers, and how they interact with competitors. Compliance with regulations increases costs but protects workers, consumers, and the environment.

Employment Law

Employment law sets out the rights and responsibilities of employers and employees.

Minimum Wage: The government sets a legal minimum wage that employers must pay per hour. All workers must receive at least this amount. The minimum wage increases regularly with inflation and economic conditions. Increases in the minimum wage raise labor costs for businesses, particularly for low wage sectors like retail and hospitality. Small businesses and labor intensive industries are affected most because wage costs make up a large portion of total costs.

Working Time Regulations: The Working Time Directive sets maximum working hours (usually 48 hours per week averaged over 17 weeks) and minimum holiday entitlement. These rules protect employees from excessive working hours but require businesses to hire more staff to cover the same workload if they were previously working longer hours.

Discrimination and Equality: Businesses must not discriminate based on age, gender, race, religion, sexual orientation, or disability. This applies to hiring, pay, promotion, and dismissal. Businesses must ensure equal pay for work of equal value. Failure to comply can result in expensive discrimination cases.

Health and Safety: Businesses must provide a safe and healthy work environment. This includes proper equipment, training, hazard controls, and accident reporting. Different industries have different regulations; construction and manufacturing face stricter rules than office work. Health and safety compliance requires investment in equipment, training, and administration.

Consumer Protection Laws

Consumer protection laws require businesses to provide safe products, accurate information, and fair trading practices. The Consumer Rights Act protects customers from faulty goods, misleading advertising, and unfair contract terms. Businesses cannot sell dangerous products or make false claims about their goods. Meeting these requirements requires quality control, testing, and truthful marketing. Violations can result in fines, compensation claims, and reputational damage.

Competition Law

Competition law prevents businesses from engaging in anti competitive behavior. Businesses cannot form cartels (agreements with competitors to fix prices or limit supply), abuse dominant market positions, or engage in predatory pricing intended to eliminate competitors. The Competition and Markets Authority enforces these laws. Competition law ensures fair markets but may prevent mergers or joint ventures that businesses would otherwise find beneficial.

Environmental Regulations

Environmental laws control pollution, waste, and resource use. Businesses must minimize emissions, properly dispose of waste, and comply with environmental impact assessments for major projects. Environmental regulations are becoming stricter as governments address climate change. This requires investment in cleaner technology, waste management systems, and renewable energy. While compliance costs money, businesses increasingly find environmental efficiency also reduces costs (better fuel efficiency, less waste disposal costs).

Impact on Business Costs and Operations

Government regulation increases compliance costs. Businesses must spend on legal advice, administration, and systems to ensure compliance. Smaller businesses are often proportionally more affected by regulatory costs because they cannot spread compliance costs across as many employees or products. However, regulation also provides benefits by protecting businesses from unfair competition and ensuring a level playing field.

Beyond legal requirements, businesses face increasing pressure from consumers, investors, and society to behave ethically and sustainably. These environmental and ethical influences affect business decisions, brand reputation, and long term success.

Corporate Social Responsibility

Corporate Social Responsibility (CSR) refers to a business's responsibility to operate in a way that benefits society, not just shareholders. This includes environmental protection, ethical labor practices, community involvement, and charitable donations. CSR goes beyond minimum legal compliance.

Sustainability and Environmental Impact

Sustainability means operating in a way that meets current needs without harming the ability of future generations to meet their needs. Many consumers now prefer businesses that minimize environmental impact. This includes reducing carbon emissions, using renewable energy, minimizing waste, and using sustainable raw materials. Sustainable practices often require upfront investment but can reduce long term costs and attract conscious consumers willing to pay premium prices.

Pressure Groups and Activism

Environmental pressure groups like Greenpeace and Extinction Rebellion campaign against businesses they believe harm the environment. Negative publicity from pressure groups can damage brand reputation and consumer support. Businesses may respond by changing practices or investment plans. Social media has amplified the power of pressure groups; campaigns can quickly go viral and force businesses to respond.

Ethical Sourcing

Ethical sourcing means ensuring supply chains are fair and humane. Businesses ensure suppliers do not use child labor, force labor, or unsafe working conditions. Many consumers now check whether products are ethically sourced. Fashion and technology companies have faced major criticism for poor labor practices in supplier factories. Ensuring ethical sourcing requires supply chain audits and monitoring, adding costs. However, ethical brands attract loyal customers and avoid reputation damage.

Fair Trade and Labor Standards

Fair trade certification ensures producers in developing countries receive fair prices for their products and work in safe conditions. Fair trade products often cost more but appeal to ethical consumers. Some businesses have adopted fair trade principles for key products to demonstrate commitment to workers in developing countries.

Business Benefits of Ethics and Sustainability

While ethics and sustainability require investment, they provide business benefits. Ethical businesses attract talented employees who want to work for companies with values they share. Sustainable practices often reduce waste and resource costs. Conscious consumers may pay premium prices for ethical products. Investors increasingly consider environmental, social, and governance (ESG) factors when choosing where to invest, so strong ESG performance attracts investment capital.