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Economics and the Premier League – Literature Review

| March 18, 2015

1. LITERATURE REVIEW

A. PROFITABILITY AND THE PREMIER LEAGUE
According to Morrow (2003), the business operations of British football clubs are unconventional. Even though they are limited liability companies, operating within similar legal and governance frameworks to other profit led businesses, they still exist within a different context emotionally and socially. Barros and Garcia (2008) discuss the unusually strong relationship between these companies and its stakeholders such as its community and supporters, and notes that this relationship is built on a sense of belonging and identity. Furthermore, this sense of belonging and identity is a core factor behind the unusual business behaviour and decision making that occurs generally within football clubs, in particular, the insatiable drive for success on the field and disregard of financial stability (Bose, 2010).

Carmichael et al (2001) state that the debate concerning the major objectives of footballs clubs is not new, they note that there has always been a major division between those that believe clubs are meant to win on the field, over those that believe they are meant to succeed financially, and most times, these are conflicting views. The impact of broadcasting income on the finances of football clubs has made the game much more popular, and even though this has substantially increased their collective and individual revenues, it has not had similar effects on the net financial performance on most football clubs (Deloitte and Touche, 2010).

Szymanski (2010) compares the Premier League to the banking businesses that failed during the financial crisis, describing it as an association of distraught businesses led by “extravagant salaries and lifestyles, decisions making driven by short term gain rather than long term success, weak regulation and managers who think they can risk everything because the business is too big to fail”. According to Carmichael et al (2001), the way clubs reached this juncture is quite similar to that which led to financial crisis. To buy the costly stars, the club owners borrowed money from the banks. By continuing to do this they created a kind of a bubble.

Greene (2003) also expresses that club owners have been bidding against each other to get the world’s leading players, sometimes going beyond what they can afford, creating an illusion of their financial clout. Even the leading English clubs are making financial losses. Manchester United is £716 million in the negative; Arsenal has a debt of £297 million; Liverpool has £237 million etc (Deloitte and Touche, 2010).

In contrast, Gerrard (2005) argues that the widely held consensus about loss making Premier League clubs is unfounded noting the general increase in revenue as a sure sign of financial prosperity. Deloitte and Touche’s (2010) annual report on football also notes that club revenue has been increasing consistently over the years through sponsorship agreements, stadium ticket sales, merchandise sales, domestic and international TV rights amongst others. The Premier League earns most of its revenues from the sale of TV rights. Thanks mainly to BskyB, the broadcasting revenues has grown at a rate of 29%, compounded annually, from the season of 1991-92 to the season of 2007-08 (Deloitte and Touche, 2010). During the period of 2008-2009, although the commercial revenues fell by £449m, the revenues of Premier League augmented by £49m during the same period, an increase of 3%. For the first time in the history of the Premier League, the total revenues of the top 92 English clubs crossed £2.5 billion in 2008-2009. Broadcasting continues to generate the maximum revenues for the Premier League accounting for 49% of the revenues in the last year.

However, analysis shows that though Premiership clubs have had dramatic increase in revenue over the past 10 years, most of the clubs have not had significant profits. Szymanski and Kuypers (2000) argue that the financial pressure has a negative effect on the on-field performance of these clubs; therefore, for them to remain competitive, their financial stability must become their primary importance. The following sub chapters would therefore look into various factors that have been theorised to affect performance within football clubs, with the aim of assessing their impact on profitability.

B. POTENTIAL FACTORS AFFECTING FOOTBALL FINANCES

I. TURNOVER/SCALE

Barros and Leach (2006) conducted a study on the impact of scale on efficiency within football clubs. Scale was measured in terms of size, popularity and revenue, while efficiency was measured in terms of Wage/Turnover. The study was conducted using data envelopment analysis (DEA) and results derived showed that scale is of the most importance to football clubs. They found that larger clubs with higher points were usually more efficient than clubs with fewer points. Clubs with higher points were seen to have higher scores in terms of efficiency than those with lower points. Those with a large population base, that were located in large population areas, also tended to have high efficiency scores. Thus hinting at the notion that larger clubs were far more efficient than smaller clubs. Therefore turnover and scale were seen as directly proportional to performance, and vice versa.

However, one major note to take into consideration is that this study was not conducted using profitability as a factor. Efficiency was calculated using wage/turnover, while scale was calculated in terms of size, popularity and revenue. Arguments by Guzman and Morrow (2007), and those expressed in the previous chapter, noted that clubs have achieved “revenue” prosperity in recent years, so that is a given. However this does not translate to financial profitability. Manchester United and Liverpool have been prosperous in terms of revenue and popularity, but have raked up debts, while Chelsea gains the most from its supporters but is still a loss leader in the Premier League. Therefore, the study by Barros and Leach (2006) cannot be utilised as an authoritative determinant of profitability within football clubs. However, high turnover and local fan base are important in achieving higher ranking within the league.

II. LEAGUE RANKING

Haugen and Hervik (2002) in their analysis of value creating factors within the Premier League clubs noted that their performance alone is enough to explain value. They also disregarded factors such as stadium quality, number of spectators, regional location etc as “unnecessary”. They repeated this research on a different data set and found similar data. Their calculations were based on a regression analysis of several factors such as stadium quality, league ranking, spectators, regional location etc and used that in determining value (revenue). They found a coefficient of determination of 0.96, illustrating that 96% of the value creation could be accounted for by these factors. When these factors were removed, leaving only league ranking, the coefficient of determination fell only by 2ppt to 0.94.

Guzman and Morrow (2007) conducted similar studies on the effect of league ranking, but instead of comparing against value created, they compared against efficiency scores (calculated based on Barros and Leach, 2006). Their analysis was conducted during the 2002 – 2003 season and their findings showed that clubs that achieved success such as Arsenal (2nd), Chelsea (4th), and Liverpool (5th) had relatively low efficiency scores, compared to less performing cubs such as Birmingham (13th) and West Bromwich Albion (19th), whose scores were much higher. If efficiency were related to profitability – as it calculates the manner in which the club efficiently utilises the resources as its disposal – then these findings cohere with that of Szymanski and Kuypers (2000), and contradict those of Haugen and Hervik (2002).

By basing their analysis on the efficiency of the football clubs, instead of value created, Guzman and Morrow (2007) have gone beyond conventional views of value being created through revenue, but have seen that value creation lies in efficiency and profitability (though profitability was not explicitly mentioned in the study). This finding also contradicts that of Barros and Leach (2006) who found that larger clubs were generally more efficient. I believe the major reason behind these contradictions is the fact that all theorists have different definitions of efficiency and non has explicitly measured factors affecting profitability. The most notable finding regarding ranking and profitability was by Syzmanski and Kuypers (2000), who argue that football clubs operate with the aim of succeeding on the pitch, regardless of their finances. However, “pitch success does not translate necessarily into financial success, and some clubs run deficits while others obtain positive financial results”. They also state that deficits that occur as a result of losing money, could strain the performance of the club, on the pitch, and sometimes result in relegation (e.g. Portsmouth).

III. ATTENDANCE

Dawson et al (2000) notes that ticket prices and the number of people attending a match day event, says a lot about the club’s popularity amongst the spectators. Leading clubs could command high prices and spectators for match at home and even in away matches, while clubs with lower ranking usually command lower prices and a lesser amount of spectators. Thus illustrating that ranking has a significant effect on revenue generated within football clubs. Haugen and Hervik (2002) note that match day attendance is connected with factors such as the clubs league ranking, the population of their community, the portfolio of players they have, and past performance. The most significant of which is league ranking and past performance. Match day attendance works to increase revenue considerable, however this only shows how money comes into the clubs, and now how they refrain from spending too much, which would then result in a loss.

IV. MANAGEMENT

Several views exist on the real function and responsibility of sport managers. Quirk and El Hodiri (1974) consider them as “profit maximizers”; Sloane (1971) assumes that they maximize utility in their pursuit of goals that are non-profit related, being led more by satisfaction instead of profit. Vrooman (2000) however assumes a position in between stating that sport managers conduct both functions: maximize profit and club performance. Though no definite theoretical analysis has been conducted to ascertain the major responsibility of sporting managers, it can be readily observed based on the unconventional business environment they operate in, that they are more performance than profit led. Barros and Santos (2004) however have a contradictory view, stating that contrary to media allegations, football clubs are well managed, and therefore the imbalance that currently occurs competitively and financially is based on other factors.

With respect to risk management factors, a survey conducted by Hadley et al (2000) revealed that less than 25% of all football clubs had an internal audit committee responsible for cross checking the firm’s activities, expenses and ensuring they were in line with appropriate risk management frameworks. In situations where audit committees were present within the club, there was no reported board overview of this audit committee or review of these audit reports. Hoeffler et al (1997) argues that regular risk assessment is an essential function in corporate governance, and if these football clubs fail to appropriately adopt corporate governance measures, then it is no surprise that they are lacking in profitability. Ramon et al (2010) further argues that the lack of corporate governance is an essential reason why a number of football clubs went into administration, after losing revenue, following the collapse of ITV Digital agreement. Scully (1994) recommends that these football clubs need to improve their corporate governance practises, financial planning and risk assessment procedures.

V. PLAYER WAGES

The “dyadic buyer-supplier relationships in the English football supply network” was an analytical study conducted by Londsdale (2004) that shed significant light on the buyer-supplier power occurring within English football clubs. According to Porter and Scully (1982), industries that have significant threat from suppliers, in which these suppliers have high bargaining power, would always need to play according to the rule of these suppliers. They would be forced to pay higher, or lose their suppliers to other companies, thus losing their competitive advantage. Scully (1994) notes that a large portion of the competitive advantage of several Premier League clubs lies in their players. Londsdale (2004) explained this relationship by stating “the dominant position of the buyer over the supplier has significant impact on the commercial outcome of the relationship. Similarly, when the supplier is dominant, this becomes a constraint for the ambitions of the buyer.”

The bargaining power of football clubs lies significantly with their suppliers – the players. According to Londsdale (2004), this is because these individuals with the talent are responsible for winning games and leagues, and thus responsible for revenue generation. Furthermore, signing up famous players could assist clubs in generating significant merchandise sales, and improving ticket sales significantly, as could be seen from Real Madrid (David Beckham) and Manchester City (Tevez etc). Football clubs therefore have to pay astronomical high prices just to sign on the right players, and that significantly increases their wage and debt burden. Manchester United, and Liverpool have serious debt burdens because of player signings they have been involved in. The owners of Manchester City and Chelsea have absorbed their debts, and even with that, these clubs are still loss making.

Londsdale (2004) notes that the increasing wage of players is the major reason behind the high debt and losses. These individuals have become aware of their bargaining power and are therefore able to command high prices when signing on. Clubs that are therefore focused on obtaining the most popular players are therefore likely to become loss leaders, unless they can win a number of tournaments (Barros and Garcia, 2008). However, that statement contradicts current events, because even when Chelsea won the Premier League, they were still operating at a loss with huge debts.

The benefits of acquiring leading players should not be understated though. Ramon et al (2010) found that the liberalisation of football player labour markets across Europe, has led to a steady influx of foreign players into European football leagues. In their study of 17 of these leagues (including the Premier League), they found that clubs that attracted the most foreign players were mostly likely to lead in their respective leagues than those who did not.
Szymanski and Kuper (2000) note that the link between football and financial activities is very important in order for football clubs to remain competitive. Based on the factors assessed in the aforementioned chapters, we can ascertain the following:
• Clubs with higher ranking, were seen as more efficient, and had more value.
• Ranking and revenue are directly related
• League ranking and profitability are not related
• Football clubs do not have effective risk management processes in place
• Most clubs make losses due to very high player wages
• Clubs with high player wages are likely to lead in their leagues
• Management within football clubs are focused on football performance, and little on financial performance.

The common theme amongst these findings is that they dictate what impacts revenue and league ranking, and not what determinates profitability. The only indirect factor relating to profitability is player wage, and that indicates that the higher number of famous players a club takes on, the higher its wages, and the more likely it is to report high debts and losses. The findings from this literature could also be used as an indication of the direction that most theorists have taken with respect to football clubs. They are more focused on revenue generation and league ranking, than on net profit, which according to Szymanski and Kuper (2000) is the real indicator of financial performance.

C. PROFITABILITY ENHANCERS

In order to accurately ascertain the factor that determines profitability within the football industry, a number of studies have been reviewed, in addition to those already highlighted in the previous chapter. These studies and arguments have taken into consideration the major factors that result in higher costs to the football clubs, even though they have been witnessing increased revenue over the years, and recommended alternatives to these loss-bearing actions.

Barros and Santos (2003) note that one of the major factors affecting profitability is net debt. Manchester United and Liverpool FC have been subject to substantial interest rate expenses as a result of debt incurred during their leveraged buyout. These clubs are seemingly profitable, however once interest payments have been deducted, the profitability declines substantially. According to Bose (2010), clubs that have not been exposed to leveraged buyout, usually find themselves in debt as a result of aggressive bidding for players. They buy players at prices they are unable to afford based on their current status, and therefore incur debt as a result. Gerrard (2005) therefore recommends that the debt a club incurs should be proportional to their ranking and finances, and should not be done blindly in the case of obtaining a magic bullet player that could rocket them to the top of their league.

The bargaining power of player has also been viewed as a factor significantly affecting football profitability (Londsdale, 2004). Players are paid extraordinarily high fees yearly, and this has been driven mostly by the pre-existing culture. Clubs need to pay high in order to attract and retain players and failure to do this would result in the inability to win games and leagues, and also the threat of relegation. Fizel and D’ltri (1997) therefore advises for clubs to thread carefully when negotiating player wages, and invest in developing raw talent rather than buying matured talent.

Greene (2005) also identifies maintenance and stadium construction cost as significant costs that could substantially impact profitability, and also increase the debt nature of a football club. Haas (2003) explains that some clubs want to build larger stadiums so they can attract more fans, however, their current ranking does not support such activities, and undertaking such would usually leave them in the red, but they still do it. He advocates for frugal spending within football clubs, and if necessary for these clubs to spread out their payments over periods of time so they do not incur substantially losses as a result of debt incurred.

Based on these theories, it can be ascertained that the main factors impeding profitability are high wages, and interest rates, which are incurred through leveraged buyouts, aggressive bidding for players, and unnecessary capital expenditure. If these are managed efficiently, then the revenues derived through television rights, ticket sales, merchandise sales, league ranking, and local popularity, would go a long way in ensuring financial stability within these clubs.

D. ANALYTICAL FRAMEWORKS

This subchapter highlights analytical frameworks that have been utilised in calculating profitability within sports clubs, and important findings that could be derived from them.

DEA (Data Envelopment analysis approach) is a “linear programming technique that enables management to benchmark the best-practice decision unit (DMU), i.e. the football clubs”. DEA is useful in providing estimates for further improvement for those DMUs, which are inefficient in their operations. Charnes et al. (1995), Coelli et al. (1998), Coelli (1996), Cooper et al. (2000) and Thanassoulis (2001) written in detail of the various aspects of DEA. These papers provide a rich insight into the advanced procedures followed in profit improvement.

Results from the heterogeneous frontier model research conducted Cooper et al (2000) showed that outputs have a positive impact on the costs, as enhancing sales or attendance is costly. The opposite occurs with the points, which are scored in the pitch based in the investment made in players. The authors conclude that their results corroborate previous studies in this area (Barros and Leach, 2006). They propose “heterogeneity must be considered a major issue in the English Premier League and thus “public policies towards clubs ought to take into account such heterogeneity.”

Two contemporary methods are used to measure profitability and efficiency: – “the econometric or parametric approach and the non-parametric approach.”

Below are some papers that have used the non-parametric approach. “Fizel and D’ Itri (1996, 1997), applied DEA analysis to measure the managerial efficiency of college basketball teams to assess the conflicting thesis concerning the impact of managerial succession on organizing performance; and Porter and Scully (1982), who analysed the managerial efficiency of baseball managers with a nonparametric approach. Recently Barros and Santos (2004) analysed the Portuguese football first division clubs with a DEA-CCR and BCC model. Haas (2003a) analysed the profitability of the English first league with a DEA-CCR model, and Haas (2003b) analysed the profitability of the USA soccer league.”

A Poisson regression model was used by Hadley et al. (2000) to analyse the performance of the NFL league. Dawson et al. (2000) analysed the managerial efficiency of English soccer managers with an econometric stochastic frontier and Carmichael et al. (2001) analysed the efficiency of the English Premiership clubs with residuals. Gerrard (2005) analyses the production function of coaches working in the English Premier League with win-ratios for the period 1992 to1998. Kahane (2005) analyses the efficiency of the USA Hockey League discriminatory hiring practices with a stochastic frontier model.

Following are the major implications and results from studies
1. The best-practice calculations signify that most clubs operate on a high level of efficiency.
2. Dominant source of profitability in clubs is their scale.
3. According to the scale efficiency, some clubs are efficient while others are not. Those clubs with DRS (decreasing returns to scale) are too large in size. Scale size should be decreased if decreasing returns to scale prevail.
4. English Premier League football clubs are “well managed by pure technical efficiency, but dimension makes a difference, and therefore some of them have decreasing returns to scale (DRS).”
E. CONCLUSION
Although the revenues of football clubs have increased the player wages have also increased simultaneously. This has been the main factor leading the clubs to go into huge debts. In this literature review, an attempt has been made to analyze the profitability of Premier League clubs by assessing a number of academic theories, and also using methods like the DEA. The different variables to be considered while evaluating the efficiency of football clubs are also discussed. This dissertation therefore would focus on the factors that determine profitability within the Premier League. Quantitative studies would be conducted, and the nature of this quantitative study would be discussed in the methodology chapter. The results chapter would highlight the findings from data collection and analysis, while the final discussion chapter would take into consideration the data analyzed, and theories from this literature review, and use them in reaching a viable conclusion on what actually facilitates profitability within football clubs.

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