Economics

The duties and responsibilities of a company’s BOARD OF DIRECTORS in managing the company and their relationship with the SHAREHOLDERS of the company. With the DIVORCE OF OWNERSHIP FROM CONTROL, salaried professional managers have acquired substantial powers in respect of the affairs of the company they are paid to run on behalf of their shareholders. However, directors have not always had the best interests of shareholders in mind when performing their managerial functions (see PRINCIPAL-AGENT THEORY), and this has led to attempts to make directors more accountable for their policies and actions.

A number of reports were published in the UK in the 1990s, prompted by the public’s concern at cases of gross mismanagement (for example, the collapse of the BCCI bank and Polly Peck and the misappropriation of employee’s pension monies at the Mirror Group) and ‘fat cat’ pay increases secured by executive directors. The Cadbury Committee Report (1992) recommended a ‘Code of Best Practice’ relating to the appointment and responsibilities of executive directors, the independence of nonexecutive directors and tighter internal financial controls and reporting procedures. The Greenbury Committee Report (1995) specifically addressed the issue of directors’ pay, recommending that executive directors’ pay packages should be determined by companies’ remuneration committees, consisting solely of nonexecutive directors, and that share awards under EXECUTIVE SHARE OPTION SCHEMES and LONG-TERM INCENTIVE PLANS (LTIPS) should be linked to companies’ financial performance. The Hempel Committee Report (1998) covered many of the same issues raised by these two earlier reports, recommending (‘Principles of Good Governance’) checks on the power of any one individual executive director (by, for example, separating the roles of chairman and chief executive), a more independent and stronger voice for nonexecutives (including the appointment of a ‘senior’ nonexecutive to offer guidance to, and check ‘empire building’ tendencies on the part of, executive directors and in liaising with shareholder interests) and more accountability to shareholders at the AGM (including the approval of options and LTIP schemes).

In 1998 the ‘Code of Best Practice’ and ‘Principles of Good Governance’ were combined and formally incorporated into the listing rules of the London STOCK EXCHANGE.

In 1999 the Turnbull Committee Report on ‘Internal Control’ proposed guidelines for regular internal controls not only on financial procedures but also on business and operational matters with a greater emphasis on ‘risk’ management and evaluation to ensure that these are compatible with the company’s business objectives.

More recently, the Higgs Committee Report (2003) envisaged a more prominent role for nonexecutives, including the following recommendations: the chairman should be a nonexecutive; the senior independent nonexecutive director should be given additional responsibilities, particularly in regard to liaising between the board and the companies’ shareholders; nomination committees should consist entirely of nonexecutives; at least half the board’s directors should be nonexecutive; no full-time executive director should take on more than one additional non-executive position in another company.

For UK and other MULTINATIONAL COMPANIES operating in the USA the Sarbanes-Oxley Act (2002) requires them to follow strict financial accounting procedures, audits and reporting to increase financial transparency and to prevent fraud. The Act was introduced following a number of financial scandals, notably those at Enron and World Com., and the failure of nonexecutives and major accountancy firms such as Arthur Anderson (now broken up) to detect malpractices. In the UK itself, financial reporting has been tightenend up following the recommendations of the Smith Committee Report (2003) on internal auditing practices.

While traditionally the issue of corporate governance has tended to focus on director-shareholder relationships, the stakeholder approach emphasizes that directors have wider responsibilities to other groups with an interest or ‘stake’ in the business: their employees, consumers, suppliers and the community at large. See FIRM OBJECTIVES, MANAGERIAL THEORIES OF THE FIRM, SOCIAL RESPONSIBILITY.

corporate reengineering the process whereby the ORGANIZATION structure of a corporation is changed. This may involve a movement away from a functional organization to a multidivisional organization or the elimination or restructuring of certain product divisions within a multidivisional organization. Such reengineering often involves dramatic changes for managers and employees and can be linked with DOWNSIZING.

corporate sector that part of the ECONOMY concerned with the transactions of BUSINESSES. Businesses receive income from supplying goods and services and influence the workings of the economy through their use of, and payment for, factor inputs and INVESTMENT decisions. The corporate sector, together with the PERSONAL SECTOR and FINANCIAL SECTOR, constitute the PRIVATE SECTOR. The private sector, PUBLIC (GOVERNMENT) SECTOR and FOREIGN SECTOR make up the national economy. See CIRCULAR FLOW OF NATIONAL INCOME MODEL.

corporation 1 a private enterprise FIRM incorporated in the form of a JOINT-STOCK COMPANY.

2 a publicly owned business such as a nationalized industry.

corporation tax a DIRECT TAX levied by the government on the PROFITS accruing to businesses. The rate of corporation tax charged is important to a firm insofar as it determines the amount of after-tax profit it has available to pay DIVIDENDS to shareholders or to reinvest in the business.

In the UK currently (as at 2005/06) the general corporation tax rate is 30% of taxable profits per annum, but there is also a smaller companies’ corporation tax. No tax is payable on taxable profits up to £10,000 per annum and 19% on taxable profits over £10,000 up to a maximum of £300,000 per annum. See TAXATION, FISCAL POLICY, RETAINED PROFIT.

correlation a statistical term that describes the degree of association between two variables. When two variables tend to change together, then they are said to be correlated, and the extent to which they are correlated is measured by means of the CORRELATION COEFFICIENT.

correlation coefficient a statistical term (usually denoted by r) that measures the strength of the association between two variables.

Where two variables are completely unrelated, then their correlation coeffcient will be zero; where two variables are perfectly related, then their correlation would be one. A high correlation coefficient between two variables merely indicates that the two generally vary together – it does not imply causality in the sense of changes in one variable causing changes in the other.

Where high values of one variable are associated with high values of the other (and vice-versa), then they are said to be positively correlated. Where high values of one variable are associated with low values of the other (and vice-versa), then they are said to be negatively correlated. Thus correlation coefficients can range from +1 for perfect positive association to –1 for perfect negative association, with zero representing the case where there is no association between the two.

The correlation coefficient also serves to measure the goodness of fit of a regression line (see REGRESSION ANALYSIS) which has been fitted to a set of sample observations by the technique of ordinary least squares. A large positive correlation coefficient will be found when the regression line slopes upward from left to right and fits closely with the observations; a large negative correlation coefficient will be found when the regression line slopes downward from left to right and closely matches the observations. Where the regression equation contains two (or more) independent variables, a multiple correlation coefficient can be used to measure how closely the three-dimensional plane, representing the multiple regression equation, fits the set of data points.

corset see SPECIAL DEPOSITS.

cost the payments (both EXPLICIT COSTS and IMPLICIT COSTS) incurred by a firm in producing its output. See TOTAL COST, AVERAGE COST, MARGINAL COST, PRODUCTION COST, SELLING COST.

cost-based pricing pricing methods that determine the PRICE of a product on the basis of its production, distribution and marketing costs. See AVERAGE-COST PRICING, FULL-COST PRICING, MARGINAL-COST PRICING.

cost-benefit analysis a technique for enumerating and evaluating the total SOCIAL COSTS and total social benefits associated with an economic project. Cost-benefit analysis is generally used by public agencies when evaluating large-scale public INVESTMENT projects, such as major new motorways or rail lines, in order to assess the welfare or net social benefits that will accrue to the nation from these projects. This generally involves the sponsoring bodies taking a broader and longer-term view of a project than would a commercial organization concentrating on project profitability alone.

The main principles of cost-benefit are encompassed within four key questions:

(a) which costs and which benefits are to be included. All costs and benefits should be enumerated and ranked according to their remoteness from the main purpose of the project so that more remote costs and benefits might be excluded. This requires careful definition of the project and estimation of project life, and consideration of EXTERNALITIES and SECONDARY BENEFITS;

(b) how these costs and benefits are to be valued. The values placed on costs and benefits should pay attention to likely changes in relative prices but not the general price level, since the general price level prevailing in the initial year should be taken as the base level. Although market prices are normally used to value costs and benefits, difficulties arise when investment projects are so large that they significantly affect prices, when monopoly elements distort relative prices, when taxes artificially inflate the resource costs of inputs, and when significant unemployment of labour or other resources means that labour or other resource prices overstate the social costs of using those inputs that are in excess supply. In such cases, SHADOW PRICES may be needed for costs and benefits. In addition, there are particular problems of establishing prices for INTANGIBLE PRODUCTS and COLLECTIVE PRODUCTS;

(c) the interest rate at which costs and benefits are to be discounted. This requires consideration of the extent to which social time preference will dictate a lower DISCOUNT RATE than private time preference because social time preference discounts the future less heavily and OPPORTUNITY COST considerations, which mitigate against using a lower discount rate for public projects for fear that mediocre public projects may displace good private sector projects if the former have an easier criterion to meet;

(d) the relevant constraints. This group includes legal, administrative and budgetary constraints, and constraints on the redistribution of income. Essentially, cost-benefit analysis concentrates on the economic efficiency benefits from a project and, providing the benefits exceed the costs, recommends acceptance of the project, regardless of who benefits and who bears the costs. However, where the decision-maker feels that the redistribution of income associated with a project is unacceptable, he may reject that project despite its net benefits.

There is always uncertainty surrounding the estimates of future costs and benefits associated with a public investment project, and cost-benefit analysis needs to allow for this uncertainty by testing the sensitivity of the net benefits to changes in such factors as project life and interest rates. See WELFARE ECONOMICS, COST EFFECTIVENESS, TIME PREFERENCE, ENVIRONMENTAL AUDIT, VALUE FOR MONEY AUDIT, ENVIRONMENTAL IMPACT ASSESSMENT.

cost centre an organizational subunit of a firm that is given responsibility for minimizing COSTS but has no control over its product pricing and revenues. Cost centres facilitate management control by helping to ascertain a unit’s operating costs. See PROFIT CENTRE, INVESTMENT CENTRE.

cost drivers the factors that cause COSTS to vary within an organization and between organizations. Cost drivers can be related to the various value-creating activities within an organization. The main cost drivers are: firm size or scope (ECONOMIES OF SCALE or SCOPE); cumulative experience; (LEARNING CURVE); organization of transactions (VERTICAL INTEGRATION); and other factors such as location, raw material prices and process efficiency. The ability to ‘drive’ or ‘manage’ costs down (or to contain cost increases) is an important strategic consideration where cost leadership is the key basis of the firm’s COMPETITIVE ADVANTAGE over rival suppliers. See VALUE-CREATED MODEL.

cost effectiveness the achievement of maximum provision of a good or service from given quantities of resource inputs. Cost effectiveness is often established as an objective when organizations have a given level of expenditure available to them and are seeking to provide the maximum amount of service in a situation where service outputs cannot be valued in money terms (e.g. the UK National Health Service). Where it is possible to estimate the money value of outputs as well as inputs, then COST-BENEFIT techniques can be applied. See VALUE FOR MONEY AUDIT.

cost function a function that depicts the general relationship between the COST of FACTOR INPUTS and the cost of OUTPUT in a firm. In order to determine the cost of producing a particular output it is necessary to know not only the required quantities of the various inputs but also their prices. The cost function can be derived from the PRODUCTION FUNCTION by adding the information about factor prices. It would take the general form:

Qc = f(p1 I1, p2, I2, … , pn In)

where Qc is the cost of producing a particular output, Q, and p1 ,p2, etc., are the prices of the various factors used, while I1, I2, etc., are the quantities of factors 1, 2, etc., required. The factor prices p1, p2, etc., which a firm must pay in order to attract units of these factors will depend upon the interaction of the forces of demand and supply in factor markets. See EFFICIENCY, ISOCOST LINE, ISOQUANT CURVE.

cost leadership competitive strategy see COMPETITIVE STRATEGY.

cost minimization production of a given OUTPUT at minimum cost by combining FACTOR INPUTS with due regard to their relative prices. See COST FUNCTION, ISOQUANT CURVE.

cost of capital the payments made by a firm for the use of long-term capital employed in its business. The average cost of capital to a firm that uses several sources of long-term funds (e.g. LOANS, SHARE CAPITAL (equity)) to finance its investments will depend upon the individual cost of each separate source of capital (for example, INTEREST on loans) weighted in accordance with the proportions of each source used. See CAPITAL GEARING, DISCOUNT RATE.

cost of goods soldorcost of sales the relevant cost that is compared with sales revenue in order to determine GROSS PROFIT in the PROFIT-AND-LOSS ACCOUNT. Where a trading company has STOCKS of finished goods, the cost of goods sold is not the same as purchases of finished goods. Rather, purchases of goods must be added to stocks at the start of the trading period to determine the goods available for sale, then the stocks left at the end of the trading period must be deducted from this to determine the cost of the goods that have been sold during the period. See STOCK EVALUATION.

cost of living the general level of prices of goods and services measured in terms of a PRICE INDEX. To protect people’s living standards from being eroded by price increases (INFLATION), wage contracts and old-age pensions, etc., sometimes contain cost-of-living adjustment provisions that automatically operate to increase wages, pensions, etc., in proportion to price increases. See INDEXATION.

cost-plus pricing a pricing method that sets the PRICE of a product by adding a profit mark-up to AVERAGE COST or unit total cost. This method is similar to that of FULL-COST PRICING insofar as the price of a product is determined by adding a percentage profit mark-up to the product’s unit total cost. Indeed, the terms are often used interchangeably. Cost-plus pricing, however, is used more specifically to refer to an agreed price between a purchaser and the seller, where the price is based on actual costs incurred plus a fixed percentage of actual cost or a fixed amount of profit per unit. Such pricing methods are often used for large capital projects or high technology contracts where the length of time of construction or changing technical specifications leads to a high degree of uncertainty about the final price.

Cost-plus pricing is frequently criticized for failing to give the supplier an incentive to keep costs down.

cost price a PRICE for a product that just covers its production and distribution COSTS with no PROFIT MARGIN added.

cost-push inflation a general increase in PRICES caused by increases in FACTOR INPUT costs. Factor input costs may rise because raw materials and energy costs increase as a result of world-wide shortages or the operation of CARTELS (oil, for example) and where a country’s EXCHANGE RATE falls (see DEPRECIATION 1), or because WAGE RATES in the economy increase at a faster rate than output per man (PRODUCTIVITY). In the latter case, institutional factors, such as the use of COMPARABILITY and WAGE DIFFERENTIAL arguments in COLLECTIVE BARGAINING and persistence of RESTRICTIVE LABOUR PRACTICES, can serve to push up wages and limit the scope for productivity improvements. Faced with increased input costs, producers try to ‘pass on’ increased costs by charging higher prices. In order to maintain profit margins, producers would need to pass on the full increased costs in the form of higher prices, but whether they are able to depends upon PRICE ELASTICITY OF DEMAND for their products. Important elements in cost-push inflation in the UK and elsewhere have been periodic ‘explosions’ in commodity prices (the increases in the price of oil in 1973, 1979 and 1989 being cases in point), but more particularly ‘excessive’ increases in wages/earnings. Wages/earnings account for around 77% of total factor incomes (see FUNCTIONAL DISTRIBUTION OF INCOME) and are a critical ingredient of AGGREGATE DEMAND in the economy. Any tendency for money wages/earnings to outstrip underlying PRODUCTIVITY growth (i.e. the ability of the economy to ‘pay for/absorb’ higher wages by corresponding increases in output) is potentially inflationary. In the past PRICES AND INCOMES POLICIES have been used to limit pay awards. At the present time, policy is mainly directed towards creating a low inflation economy (see MONETARY POLICY, MONETARY POLICY COMMITTEE), thereby reducing the imperative for workers, through their TRADE UNIONS, to demand excessive wage/earnings increases to compensate themselves for falls in their real living standards.

The Monetary Policy Committee, in monitoring inflation, currently operates a ‘tolerance threshold’ for wage/earnings growth of no more than 4½% as being compatible with low inflation (this figure assumes productivity growth of around 2¾–3%). See INFLATION, INFLATIONARY SPIRAL, COLLECTIVE BARGAINING.

council tax see LOCAL TAX.

countercyclical policy see DEMAND MANAGEMENT.

countertrade the direct or indirect exchange of goods for other goods in INTERNATIONAL TRADE. Countertrade is generally resorted to when particular FOREIGN CURRENCIES are in short supply or when countries apply FOREIGN EXCHANGE CONTROLS. There are various forms of countertrade, including:

(a) BARTER: the direct exchange of product for product;

(b) compensation deal: where the seller from the exporting country receives part payment in his own currency and the remainder in goods supplied by the buyer;

(c) buyback: where the seller of plant and equipment from the exporting country agrees to accept some of the goods produced by that plant and equipment in the importing country as part payment;