Profit Maximization an Actual or Theoretical Objective - Research Paper Example

Teacher Finance 25th October Profit Maximization – An Actual or Theoretical Objective? Introduction: The basic objective of all business operations is to make decent profits – from dropping newspapers at homes to import and export of goods. Numerous exchange transactions constitute business operations, whereby the value of a commodity is multiplied with each transaction till it reaches the consumer. The goods consumers buy are not in their raw form, instead these have been through numerous refining processes. For example, rice farmed and thrashed by the farmer is sold for a particular value to companies. These companies in turn process the rice, separating quality grains and packing them with their label, thereby increasing the value of rice. The transporters and stores extract their profit by integrating it in the cost of the rice. In the end, the consumer pays a multifold monetary worth for the rice along with comparable value for money. Some organizations tend to get carried away with their profit-making motives, ending up reaping unjustly high profits. Such organizations tend to lose their loyal customers for two major reasons: not being able to provide comparable value for money and with the entry of competition into their market. Profit Maximization is now a general trend, which had earlier been a typical phenomenon for monopolistic competition – where the absence of competition enables these organizations to charge unjustly high prices for their offerings. Hence it is said that free competition is the “invisible hand” for controlling market prices naturally (Smith). When companies are allowed to compete without regulatory interventions like government policies etc, the resultant market provides both buyers and sellers with best opportunities in terms of exchanges. Buyers and sellers benefit alike from the competition. Profit Maximization: Profit Maximization is a basic Economics concept, which implies extracting highest possible profits through production and sales processes. Profit is the difference between total revenue and the total cost. Total revenue implies the total amount an organization receives from business whereas the total cost means the total investment the organization makes to produce and sell the goods and services. At different activity levels, the cost incurred and the revenue earned tend to be different (as shown in the diagram). From: Sparknotes.com The above graph clearly shows varied profitability at different activity levels. However, the highest profitability is at the point marked “profit maximization”. At this point, the difference between costs and revenue is the greatest. At all activity levels below and above this point, the profit is lower in comparison with this point. Profit Maximization can be devised through numerous methods. The aforesaid theory is the Total Cost-Total Revenue methodology for determining the profits. Marginal Revenue-Marginal Cost method is also used to determine maximum profitability activity level. However, the base line for both methods is the same – revenue minus cost equals profit. Theoretically, Profit Maximization is often explained as an unethical practice on behalf of business owners, focusing extensively on monetary gains and overlooking other factors. On this note, it is important to remark that profit maximization does not necessary include unethical practices regarding pricing. However, “it fails to take adequate account of alternative desires of the businessmen, for power, leisure, social prestige, and similar non-monetary rewards” (Koplin). Some critics do not agree that Profit Maximization is the underlying objective for business operations since it does not take into account other factors important in the eyes of the investors. Most businesses do not operate for profit reasons only – some businesses like certain blood banks and hospitals work for societal welfare that cannot be weighed in monetary terms. But some critics maintain the importance of Profit Maximization in businesses. “The concept of profit maximization appears as the dominant feature of entrepreneurial motivation, insofar as this latter has appeared … in economic analysis” (Wilson). Profit Maximization is nevertheless an important part of businesses today; however, this is not the sole objective of these businesses. When talking about profits, it is vital to appreciate the difference between economic and accounting profits. Accounting profits only consider the cost of production and the revenues earned to equate the profits received. On the other hand, economic profits additionally take into account the implicit and explicit costs of production like the entrepreneur’s opportunity costs etc. Although accounting profits are mostly considered while registering the profitability of any organization, the economic profits determine the personal worth of the business for the entrepreneur. Therefore accounting profits are being generally referred to when talking about “profits”. There are alternative models of business objectives that have gained popular support: Sales Maximization Model (Baumol): The objective of business is to make maximum sales instead of increasing profits. Management Discretion Model (Williamson): The business operates on maximizing personal utility instead of meeting investor expectations. Consensus Model (Cyert and March): This model attempts to reach a middle-point of shareholders, managers, employees and customers’ objectives – thereby each settling for lower than their expectations. However, this model aims to maximize satisfaction rather than profits. Wealth Maximization Model: This model maximizes the value or wealth of the business instead of profits, thereby ensuring satisfactory returns for stockholders (Riley). This clearly shows that businesses in reality can have other underlying objectives than profit maximization. Therefore it is inappropriate to say profit maximization is the sole interest for organizations. The concept of profit maximization binds the financial decision maker to undertake all such actions as will increase income and decrease costs incurred, and avoid all such activities which will negatively impact the profitability of the organization. It naturally reflects the economic performance of the enterprise. Decisions based on profit maximization objective directs resources in activities promising maximum returns, thereby helping in optimal utilization of society’s economic resources. However, critics have monitored drawbacks of this model: It is vague: the term profit can be used in different senses. Simply from the word “profit”, it is not clear which profit is being referred to – whether it is before tax profit or after tax profit. Also, on the basis short-run and long-run organizational strategies, the profitability of operations can vary. Hence profit maximization, although a viable business objective, it is a vague terminology. It ignores time value factor: with time, the value of money diminishes. Profit maximization policies fail to take into account this change of value for money. A business activity providing immediate periodic earnings and another business activity providing same aggregate earnings after a period of time cannot be equated as equals. Profit maximization does not take this factor into account, thereby overlooking the actual worth of the profits earned. It ignores risk factor: profit maximization calls for repeating the tried and tested recipes. It focuses on reducing the risk factor of the business operations to almost zero. As a result, innovation is restricted. Also, different projects tend to possess different risks. A highly profitable project may be sacrificed for a low profitable project due to the risk involved, thereby contradicting its core policy (Bhavana). For these reasons, alternative models were devised, adequately considering these factors while determining the underlying objectives of business operations. As opposed to earlier belief of monopolistic competition, profit maximization is the level of output of any organization which brings maximum profits, regardless of the market structure in which it operates. Perfectly competitive organizations can also operate on profit maximization objectives. Monopolistic competition usually involves numerous small firms engaged in producing similar goods. Monopolistic competitive companies usually produce goods for a higher price than perfectly competitive industries. Higher prices increase these organizations’ revenues, thereby accentuating their profits. However, such a competition does not allow efficient utilization of resources as maximum satisfaction is not achieved. As opposed to monopolistic competition, absolute monopoly and oligopoly reap similar results of inefficiency. Perfect competition allows maximum satisfaction being extracted from minimum resources investment, thereby increasing the overall utility of the business operations (AmosWEB). Businesses operating on Profit Maximization phenomenon tend to possess different characteristics than those operating on other objectives. For example; “those who assert that they are in the cow-calf business primarily to maximize profits have on average larger herd sizes and acreage, they earn a greater percent of their total net income from farming and ranching, and they place more emphasis on supportive economic motivations and less on social reasons for owning cattle” (Young, Shumway and Goodwin). Hence those businesses operating on profit maximization objectives tend to ignore environmental consequences and instead focus on methods and means for multiplying profits. A firm’s activities are restricted by three things: The demand for its product: the popularity of the firm’s produce among the potential consumers and their willingness to pay a price for it. Those products that have high demand can be produced in vast quantities without the fear of failure; however, products with limited demand should be treated with care in order to avoid losses. The price of factors of production: this inevitably affects the production of organizations. If the price of factors of production like land, labor and capital are high, the final product tends to be expensive, often with low demand thereby incurring the firm with losses. In such a situation, it is vital to match the produce with the demand for maximizing profits. Technology: this helps reduce the costs of production, thereby aiding profit maximization. Technology helps organizations avail a competitive edge on rival companies for their benefit. It is important for all businesses to be able to generate profits in order to survive. Those firms able to cover their marginal costs and not generate profits can survive in the long-run. Any firm which is not able to cover its variable costs (marginal costs) comes closer to its doom. The method of calculating this marginal cost is vital in determining the profitability and survival of operations. If the total cost is simply divided into the units of production, the fixed cost also gets distributed on per unit basis, thereby increasing per unit costs. However, in determining the survivability, according to the shutdown rule of economics, being capable of covering variable costs only (even if fixed costs are not covered and profits not generated) allows businesses to continue their operations. For example: The case of Continental Airlines. Where several airlines cancelled their routes for incapability to fill at least 65% of its plane capacity on pretence of loss, Continental Airlines carried out their routes even with 50% capacity filled. Where several anticipated Continental Airlines’ doom, it proved to flourish with profits multiplying beyond competition. This case was also covered by Business Week newsletter. The reason was Continental Airlines’ appropriateness in calculating its marginal costs, exclusive of fixed costs (Hall and Leiberman). Conclusion: Undoubtedly, the aim of all businesses is to generate profits. If an organization is not able to generate profits and incurs loss instead, the organization can anticipate a rapid doom. However, maximizing profits is not the sole objective of organizations – alternative underlying objectives also exist like Sales Maximization, Management Discretion, Consensus and Wealth Maximization. Comparatively, Profit Maximization objective also possess drawbacks, rendering it as an inappropriate and inefficient motive for organizations. Profit Maximization is not only linked with monopolistic competitions, on the contrary, perfectly competitive organizations can also indulge in profit maximization by regulating their activity level. Profits are calculated by taking into account various factors. If the costs of production are extracted from revenues earned, it results in accounting profits. If the explicit and implicit costs are also integrated in the costs of production, it becomes the economic profit. If the profit is treated with tax deduction, it becomes after-tax profits. Hence the term “profit” in itself is extremely vague. Short-term profits can become a source of long-term loss and otherwise. Hence profit-oriented businesses tend to lack basis for financial decisions. Hence all entrepreneurs do not obligingly follow profit maximization – several non-monetary gains like leisure and power seem to have more worth in the eyes of business owners. The preference for profit maximization can therefore not be generalized and applied on all businesses. The need of the time is to utilize the scarce resources to their maximum capacity, and this efficiency is marred by market structure in which a firm operates. Profit Maximization is not an unethical practice; on the contrary, it ensures efficiency of business operations. Works Cited Smith, Adam. “Of Systems of Political Economy”. An Inquiry into the Nature and Causes of the Wealth of Nations. 1776. Print. Sparknotes. “Firm Behavior”. sparknotes.com. SparkNotes. 2011. Web. 25 Oct. 2011. Koplin, H. T. “The Profit Maximization Assumption”. Oxford Economic Papers 15(2): 130-139. 1963. Print. Wilson, J. R. “Maximization and Business Behavior”. Economic Record Volume 28: 29-39. May 1952. Print. Riley, Jim. “Objectives of Business – Alternatives to profit maximization”. Tutor2u.net. Tutor2u. n.d. Web. 25 Oct. 2011. Bhavana. “Chapter 1: Introduction. Core Concepts in financial management”. slideshare.net. Slide Share. 2010. Web. 25 Oct. 2011. AmosWEB. “Monopolistic Competition”. AmosWEB Encyclonomic WEB*pedia. 2000. Web. 25 Oct. 2011. Young, K. D. Shumway, C. R. Goodwin, H. L. “Profit Maximization – does it matter?”. Agribusiness, 6: 237-253. May 1990. Print. Hall, Robert E. Leiberman, Marc. “Getting it Right: Continental Airlines”. Microeconomics: Principles and Applications 246. 2009. Print. Read More