Profit Maximization - An Actual or Theoretical Objective - Essay Example

Profit Maximization - An Actual or Theoretical Objective? Profit maximization is the primary purpose of every business. For this reason, it is also one of the most integral objectives of financial management. Profit maximization represents the approach or process by which profits of the firm are increased. Primitively, all the decisions of the companies are aimed to maximize profits and minimize costs. In theory, it implies that every decision of company is taken on the light of maximizing profits. All the decision with respect to raising capital, investing in new projects, distributing dividends, acquisition of assets are studied to identifying their potential impact of profitability. If the results are observed to have positive impacts on profits, only then that decision is taken into consideration for further implementation. There are number of reasons due to which the model of profit maximization receives attention.it is encouraged because of undeniable and sustainable advantages which it offers to the business. Some of them include: Measurement Standard For identifying the performance of a firm, the first question is asked whether the firm is yielding profits or incurring losses. The higher the profits are earned, the better the performance of the firm. This phenomenon is not merely theoretical but its implications can be seen in the real world also. For instance, before investing into any specific firm, the first thing that investors examine is whether the firm is earning profits or not. Investors never invest in any loss making firm and always make a portfolio of firms that are generating higher profits (Kaneda and Matsui, 2003). Survival of Firm Profits are directly linked with firm’s survival. A company that is incurring losses is more likely to get bankrupt irrespective of its history or past performance (Dwivedi, 2012). The example of Kodak can be quoted here. Despite of its experience of 131 years, the company filed for bankruptcy in January 2012. The company could not hold its position and began to incur losses due to which it could not survive and ultimately, collapsed. Economic and Social Welfare Indirectly, the objective of profit maximization caters to economic and social welfare. In businesses, profits account for allocation of resources and efficient utilization. Making payments and allocating resources such as land, labor, capital, assist in taking care of economic and social welfare (Dwivedi, 2012). A lot of thought has been given to the question of profit maximization by economists. Some large and complex institutions where people of different background work together, the purpose is to maximize profits. In actual situation, profit maximization is so common that in some cases, it leads to severe ethical concerns. In the lust of earning higher profits, companies tend to shun ethical boundaries and violate ethics for earning greater returns. Some popular brand such as GAP, Nike, Levi’s, Converse, have proved to be guilty for ethical violation. Their customer base and headquarters are located in United States whereas their production processes are carried out in Asia; therefore they have been criticized for exploitation of workers. They fail to amend the malpractices at production sites of which they are aware but do not take action to correct them. Profit maximization is the fundamental assumption of economic theory. Although it is undeniably of greatest important however, by itself, it is not an ample criterion for effective business management. In practice, there are number of motivations and considerations that influence the desire for maximum economic efficiency and greatest profit as well as the accompanying assumptions that trigger the firm’s economic theory. Criticism to Profit Maximization Despite of such importance in theoretical and actual context, profit maximization is still criticized due to number of reasons. It is considered as undesirable on account of the reasons mentioned below. It overlooks the means involved to earn profits and overstresses the outcomes. The theory of profit maximization considers profits as the ultimate objective of the business. However, the ultimate objective of the business should be social welfare. When profit maximization becomes the ultimate objective of the business, businesses tend to achieve it by every means possible such black-marketing, profiteering, exploitation of consumers, workers, hoarding etc. (Singh, n.d) Profit maximization ignores other stakeholders and overstates the rewards for owners only. Profit is considered as a reward for capital and profit maximization gives the image that business entity is the domain for owners only. In actual world, a business cannot success without fullest cooperation and coordination of labor, government, consumers, and community. Assumption of profit maximization ignores the stake of these groups (Singh, n.d). Profit maximization also misleads managers to the point where they can jeopardize the survival of the company. For the sake of maximizing momentary profits, managers may take those decisions that can harm the future survival and reputation of the company. They may ignore executive development, research and development, long-term investments, pushing against easily profitable products etc. These activities can threaten the long-term success and survival of the business (Singh, n.d). Profit maximization is incoherent with the recent trends of businesses. Professionalization, diffusion of shareholders’ ownership, distinctive techno structure, growth and development of institutional shareholding are some of the latest trends in businesses (Singh, n.d). The overtones of profit maximization are capitalistic in nature. Profit maximization may end in mistreatment with poor by the rich. It also heightens inequalities in distribution of wealth and income. Such factors lead to numerous social problems (Singh, n.d). It has been observed that profit maximization has been subjected to a lot of criticism. The primary reason behind this is the fact that in real world, profit maximization has established negative perception among customers. Customers usually believe that firms that are longing for maximizing profits usually ignores the rights of stakeholders and keep on with their efforts of maximizing profits and earning higher returns. In this way, they break all the ethical boundaries and violate ethical practices, standards and norms. The subsequent sections of this paper include mathematical calculation of profit maximization as well as its implication in real world. Presentation, Computation and Technicalities Of Profit Maximization Before moving into real world implication of profit maximization, it is important to study the technical nature of profit maximization. As discussed above, the concept of profit maximization relates to various fields of business studies such as economics, accounting, finance and many others. Under this section, more emphasis will be given towards the implication of this concept under each category of business studies. 1. Accounting In accounting term, profit maximization is regarded as the core objective of the business which is generally highlighted in the annual reports of the entities. The annual reports consist of different sections of financial statements under which a specific section shows the computation of profit. Statement of comprehensive income is that statement which shows the computation of profit at various levels. At the first stage, the entity computes gross profit which is calculated by subtracting the Cost of Goods Sold from the Net Revenue figure. This gross profit shows the amount of profit earned by the company after incorporating all the directly attributable costs related to the production/trading/services. The next step is the computation of operating profit such that all other operating expenses necessary to generate the revenues are subtracted from gross profits. From operating profits, the entity deducts finance costs (interest expense) in order to reach at profit before tax figure. Tax amount is then deducted from the above one in order to reach at the full and final figure of Net Profit. The net profit figure highlights the actual amount profit earned after deducting all the costs, expenses and taxes. 2. Finance Profit maximization has the greater implications under finance studies such that the business owners i.e. shareholders of the corporations have the sole objective of the maximization of wealth. The biggest avenue of the generating greater wealth is generating higher revenues and thus higher profits. The investors are highly interested regarding two major areas of the business i.e. profitability and cash flow generation. Profitability is somehow different from cash flow generation because while computing the net profit, some non-cash expenses such as depreciation and amortization are subtracted from the other line items, therefore net profit does not reflect the true worth of the company. In this way, the investors are also interested in cash flows of the company which do not incorporate such expenses. For profitability, the investors compute various ratios for examining the existing profitability situation of the company such as gross profit margin, operating profit margin, net profit margin, return on assets, return on equity, return on capital employed etc. By computing such ratios, the investors compare these ratios with the previous period’s ratios as well as with other industry participants and competitors. In this way, the whole profitability performance of the company is highlighted in a convenient manner. On the other hand, the investors are also keen in understanding and analyzing the cash flow performance of the company which is quite evident from the cash flow statement prepared by the management of entity. The cash flow statement covers three main areas i.e. cash flows generated from operating, investing and financing activities. This statement is prepared with the help of net profit figure for the given period. 3. Economics As far as the economic theory is concerned for profit maximization, profit maximization has different approach under various markets states. These markets states are named as perfect market competition, monopoly, oligopoly, monopolistic competition etc. However, for the purpose of simplicity, the technicalities of profit maximization are discussed only under perfect market competition. In economics, profit is computed as the difference between the total revenues and total costs. If the difference is positive, it is regarded as profit, whereas a negative figure is regarded as loss. Regardless of the state of market, profit is maximized under the condition in which the additional or marginal revenue of producing one extra unit becomes equal to additional or marginal cost incurred to produce that unit. The equation for profit maximization can be written in the following manner: Profit Maximized: Marginal Revenue = Marginal Cost MR = MC The above equation provides the profit maximization quantity which needs to be produced. Marginal Revenue and Marginal Cost are further elaborated into detailed equations in order to compute the quantity at which the profit of the firm can be maximized. Under perfect market competition, the firm is the price seeker i.e. it has to take the market price and thus does not have any control on it. All it needs to do is to decrease its total cost, if it wants to achieve the objective of profit maximization. Conclusion Profit maximization is undoubtedly an actual and practical approach. The literature highly focuses upon the technical aspects of computation of profit maximization and its corresponding quantity. On the other hand, every business has a one-point agenda which is profit maximization. The businesses always aim at maximizing their profits. However, in pursing this objective they have to face strict challenges in the form of social, cultural, legal and ethical issues. In a free market economy, entrepreneurs are provided with the opportunity to exploit the maximum resources and generate as much as profit as they can. However, under planned economy, the businesses are reluctant to achieve profit maximization, as the excess profit is possessed with the government. The literature focuses upon the computation and disclosure or profitability and profit maximization quantity in various fields of business studies. Investors are highly interested in finding out the profitability of their investments as their wholesome objective is the maximization of wealth. Those investors compare and analyze the profitability performance of their investments with that of the competitors and others, so that they can find out the return or profit generated on their investments. Businesses also make their investments besides their normal business operations only because they want to show greater profitability to their owners. This also helps the businesses especially in those times when it becomes difficult to extract greater profits from the normal course of business operations. In a summarized way, it can be concluded the concept of profit maximization is not only theoretical objective for the individuals and the businesses but it has even greater implementation and implications in the real world. Works Cited Dwivedi, D. N. Microeconomics I: For University of Delhi. New Delhi: Pearson Education India, 2012. Print. Kaneda, Mitsuhiro, and Matsui, Akihiko. Do Profit Maximizers Maximize Profit?: Divergence of Objective and Result in Oligopoly. Top of FormBottom of Form N. Gregory Mankiw, Mark P. Taylor. Economics. Washington D.C.: Cengage Learning EMEA, 2006. Print.   Singh, Soumya. Why are Objections made against Profit-Maximisation? N.d. web. 4th November 2013. < http://www.preservearticles.com/2012022323598/why-are-objections-made-against-profit-maximisation.html> Walter J. Wessels. Economics. Chicago: Barron's Educational Series, 2006. Print.   Read More