Executive Economics: Ten Tools for Business Decision Makers

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9780029197851: Executive Economics: Ten Tools for Business Decision Makers

As a science of decision-making, modern economics is unparalleled in its disciplined exploration of social dilemmas. This book explains how economic thinking can help clarify business decisions. Using ten basic principles for calculating accurate costs, benefits, and prices, the author shows how all decisions can be reduced to two questions: What is it really worth? What must I give up to get it? Using running examples from both large and small companies, the book shows executives how they can succeed using the creative discipline of the skilled economist.

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About the Author:

Shlomo Maital lives and teaches in Israel, and has a seasonal appointment as Visiting Professor at MIT's Sloan School of Management. He is author of Minds, Money and Markets: Psychological Foundations of Economic Behavior (1982) and Economic Games People Play (1984).

Excerpt. Reprinted by permission. All rights reserved.:

Chapter One

COST, VALUE, PRICE:
The Three Pillars of Profit

In 1984 I was asked to teach economics to a group of seasoned managers with scientific and engineering backgrounds in the MIT Sloan School of Management's Management of Technology M.Sc. program. In one class, a young woman -- a senior manager at IBM -- asked me politely but firmly, "why do I have to know this?" My response was pitifully lame -- something like, "well, because...because it's economics, and this is an economics course."

For me, that question was an epiphany. I encounter it often when facing her equally challenging successors. Generally, I try to ask it before they do.

Most master's programs in management require candidates to take at least one course in economics. It is considered self-evident that managers, whose job it is to hire labor, borrow capital, acquire technology, and buy materials to make goods and services, need to know microeconomics, the discipline that studies precisely that. But while obvious to their mentors, the relevance of economics in its current form is often not so obvious to the managers or would-be managers themselves. It is not obvious to working managers that the subject matter of conventional economics is either relevant or useful. This is true, despite the fact that among the CEOs of America's largest 1,000 companies, economics was their second most popular major in college (after engineering).

Most of my manager-students had over a decade of practical experience in business. They challenged me repeatedly to demonstrate the utility, relevance, viability, and applicability of the theories I taught them. For far longer than I would have wished, I drew a blank in proving to them the added value of economic concepts as tools in business decisions. It took me a decade of on-the-job training, teaching economics as a management tool to managers in the United States, Europe, and Israel, and recently serving as a consultant, for my manager-students and clients to educate me sufficiently so that I could write this book. To be honest -- another decade would not have hurt.

After about five years of teaching managers, I wondered whether anything that I taught them had proved useful, after they left the classroom and returned to their companies and jobs. I wrote to 150 former Management of Technology students and asked them to rate on a scale of one to six each of the 30 economic concepts I had taught them, in terms of how useful it had proved in their day-to-day decisions. I learned from their responses that the parts of micro-economics they used most were those that helped them understand costs -- including "hidden" or opportunity costs (see chapter 2), marginal costs, sunk costs, and learning curves -- and the links between the costs of production, the value of their products, and the prices they get for them. Later generations of managers have confirmed this finding. It is reflected in the fact that the first seven chapters of this book deal in one way or another with costs -- in contrast with most microeconomics texts, which usually race to discuss demand after a polite introduction, even though demand, I believe, is a subject where economics has relatively little to communicate to managers.

HOW MANAGERS USE ECONOMICS

My results echoed those from a broader survey of how managers use economics, undertaken in 1982 by Guisseppi A. Forgionne. He canvassed a random sample of 500 corporate executives drawn from the 1,500 largest American corporations. Forgionne found that fully 70 per cent of the executives said they make use of most of the basic economic concepts of cost (such as economies of scale, cost functions, and learning curves, all of which will be discussed in later chapters), price (supply and demand, marginal-cost pricing) and value. Some 86 percent of the respondents said the major benefit in implementing economic concepts in decision making is that "the analysis generates useful data, and...forces the decision maker to define the problem clearly and concisely." Yet, more than half cited "poor communication" between economic specialist and manager, and nearly 60 per cent complained that "inadequate data are a barrier to implementation [of economic tools]." This, despite the fact that most managers literally drown in data, spewed out endlessly by costly, sophisticated management information systems.

Clearly, the Exec need a travel guide to the curious land of the Econ, and a basic dictionary. And in a sense, this book is that travel diary, an account of what I learned in my decade-long journey among the Execs. My hike along the path of applying economics to business decisions began with the deep conviction that somehow, economics was a powerful tool for managers. It was the insightful comments and criticisms of hundreds of experienced managers delivered in classrooms through over a decade that strengthened that conviction and led me to write this book.

The thinker and essayist Ralph Waldo Emerson was known to despise small talk. He liked to greet friends and visitors with the question: What have you learned since we last met? This book is a response to Emerson's question: What have I learned since that day in class before a group of independent-minded managers who refused to swallow theory for the sake of theory alone? It is built on the belief that economics, a venerable discipline with well over two centuries' worth of serious intellectual capital, is a product or service of great potential value to managers -- provided that knowledge can be conveyed in a language and framework that is understandable and relevant to their experience and needs. It is stimulated by the incredible, rapid changes sweeping over the world, as nations once guided by blind adherence to central planning and Marxist doctrine switch to business-driven, free-enterprise market systems and bureaucrats yield power to entrepreneurs.

During the past three decades, management became "disciplinebased." Managers sought expertise in one particular area -- accounting, law, marketing, finance, production -- and rose to top jobs as their companies perceived that particular expertise crucial. Four of every 10 top executives rose to the top of their companies either through finance and accounting, or marketing -- roughly equally divided between the two disciplines.

To some degree, this trend continues. High-technology companies like IBM and Westinghouse have recently wooed and appointed to top posts managers with backgrounds and skill in marketing (from, for instance, RJR Nabisco, a food company, and Pepsi-Cola). They did this because they believe that this particular skill is of crucial importance for the health of their business.

Today, however, there is an increasing need for managers who have a broad range of skills and who understand their company's technology and R&D operations as well as its production, finance, marketing, and human resources. Only the general manager can seethe enterprise as a whole and imbue it with its own unique culture and set of values, appropriate for the times and for its competitive situation. As management expert Peter Drucker has phrased it, a manager's discipline or professional training has become far less important than their competencies, such as dealing with pressure, handling information, communicating with others. It is managers' performance, not credentials, that matter more now, in information-based organizations. (The same applies to organizations themselves. With increased global competition spurring rapid change in products and services, companies' "core competencies" -- what they know well and do well -- become far more important than what they currently make well, because those abilities enable companies to change their products quickly in response to market conditions.)

Take General Electric, one of America's most consistently profitable and well-managed companies, fifth-largest industrial company in the U.S., with a market value of $90 billion as of March 1994. GE has shown the ability to make money from such diverse businesses as jet engines, financial services, and a TV network (NBC) on a global basis. Part of that success is due to their cadre of good general managers, assiduously trained and cultivated, able to move between GE's widely differing businesses because of strong management competencies that cut across many different disciplines.

The new breed of general manager is far different from the ones that ran the old-style patchwork firms. The new-style manager is comfortable with diversity. He or she is able to assemble a well-defined company culture out of seemingly incompatible pieces. No longer is the CEO the only person expected to understand the company as a whole. No longer do functional vice-presidents meet and communicate only when the CEO calls them together. Increasingly, middle managers, too, need to have a broad view of their company, even if their responsibilities lie mainly in finance or marketing, or a single business or product area. Decisions are now often made by teams and team members, who need to know far more about each other's problems and expertise than in the past, because they cut across narrow functional partitions and product lines.

New corporate structures are forming with "fuzzy boundaries" that create many horizontal links among departments and divisions. Such links are facilitated by new technology like computer networks and information technology that enable managers to easily communicate with colleagues, subordinates, and suppliers across long distances. Once, top management found it costly and time-consuming to acquire information about a company's operations. Today, an unending stream of information is available at the touch of a modem button. General managers need to know how to tap that stream and how to sip from it judiciously.

The rise of the general manager poses new challenges for American companies. Companies with cadres of managers who read blueprints as easily as they decipher balance sheets, who can cooperate with competitors in R&D as fiercely as they compete with them in markets, and who know a lot of things about a lot of businesses, will win an enduring advantage over their rivals in the struggle to create new wealth and profits from new and existing assets.

In this new and different business world, competency counts, not credentials. As a result, it will no longer be sufficient for managers to employ economists. To some degree, they will have to become economists. That will require a fundamental understanding of the language and logic that underlies the economic approach to decisions.

To manage is to choose. Economic logic, employed properly, can be a tool of great parsimony and power for the new general manager, as he or she makes hard choices across a broad spectrum of business issues including technology, human resources, markets, production, finance, marketing, and social and ethical responsibilities.

The job of managers is to build and run businesses by selling goods and services that provide value at a reasonable price for their customers at an acceptable cost to the business. If managers create more value at lower cost than their competitors their businesses prosper and profit. This is the nub. Everything else is embroidery.

The health and wealth of a large number of individual businesses -- small, medium and large -- determine the economic health and wealth of a nation. When they succeed, managers create wealth, income, and jobs for large numbers of people. When they fail, working people and their families suffer. It is businesses that create wealth, not countries or governments. It is individual businesses that are either competitive in world markets or are unable to sell in them. It is businesses that decide how well or how poorly off we are. And in the end, it is the consistent quality of managers' decisions, along with how well they are implemented by the people who work for them, that decide how competitive businesses are and will become.

Business decisions are built on three pillars -- cost, value, and price (see figure 1.1). Cost is what businesses pay out to their workers and suppliers in order to make and market goods and services. Value is the degree to which buyers think those goods and services make them better off, than if they did without. And price is what buyers pay. Those are the three essential elements in the day-to-day choices managers make. Juggling those three elements is what managers are paid for.

Managers who know what their products cost and what they are worth to customers -- and who also know the costs, values, and prices of competing products -- will build good businesses, because their decisions will rest on sound foundations. Businesses run by managers who have only fuzzy knowledge of one of those three pillars will eventually stumble. It is deceptively difficult to build them, precisely because they have to be built -- the information required is often incomplete or not readily at hand.

Knowledge of the three pillars is necessary, but not sufficient, for smart decisions. Success also requires wisdom, experience, good humor, humility and courage, and luck. But other things equal, managers who truly understand costs, values, and prices and how they interact will do much better in the long run than those who do not.

This book provides a series of economic tools to help decision makers stay focused on building accurate perceptions of their companies' costs, prices, and values, and the links among them.

Regrettably, there is a large gap between what managers know about economic decision tools and what they need to know, one that needs to be closed. The eminent British scientist Lord Kelvin once said that "theory begins with measurement." His precise measurements formed the basis for what came to be known as Kelvin's Law. Many scientists would disagree with Kelvin. They would argue that theory begins with...theory. Few people would dispute, however, that management begins with measurement. What you cannot measure, you cannot effectively understand, control, or alter. Without an adequate understanding of the ten economic tools explained in this book, decision makers are more likely to miss, for example, important but hidden costs that should be taken into account, or regard as important sunk costs that deserve to be completely ignored. A major benefit of cost-price-value economics is that it forces decision makers to scrape together -- or have someone do it for them -- the basic data on performance without which good decisions cannot be made.

WHAT ARE MANAGERS WORTH?

Are managers really worth their pay? If cost-value logic is useful, then it should be be possible to use it to measure the value of managers, compared to their cost. This is an especially controversial topic these days, as the flagging performance of many American businesses contrasts sharply with the allegedly excessive salaries that their managers draw. According to a recent survey, American chief executives of companies with annual sales above $250 million earned five times more tha...

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