Profit Maximization - Essay Example

Profit Maximization College: Introduction The firm theory describes a business enterprise as a combination of financial and physical assets, people, and information. People are directly involved in running the enterprise as customers, employees, suppliers, stockholders, and management as well as the society surrounding the firm (Keown, 2003, p. 5). Firms exist to produce and distribute services and goods and they influence the surrounding community in various ways including taxes paid, use of scarce resources, provision of employment and production of the needed goods and services. In its simplest version, firm theory provides profit maximization as the primary goal of every firm. Business owners or the management are deemed to focus on maximizing profit in the short-run. Adopting simple profit optimization perspective can have positive results on a firm. This study will explore this assertion with a view to examine the positive impacts of profit optimization. Consideration will also be given to other views that suggest other perspectives that managerial decisions should consider. In today’s market, optimization of profits has gained a wider approach encompassing the consideration of uncertainty of time and value of money. This has added to the initial approach of firm theory arguing that the long-term goal of a firm is to maximize its value. Value of a firm is deemed as the present value, which is given by the expected cash flows. For simplicity, the expected cash flows are equated to profit and the present value is thus given as the value of all the profits or the cash flows, which is discounted at the selected interest rate (Keown, 2003, p. 5). Discounting is done to incorporate the uncertainty of time and value of money in the future. This study will explore the profit optimization perspective and its positive impacts, constraints faced by managerial decisions in their pursuit to optimize profits as well as the best perspective that managers should hold in the management of a firm. Profit maximization perspective Profit optimization is a short-run process that involves determining of price and output levels that gives the highest returns in form of profit. As mentioned by Hirschey (2008, p. 38), the level of activity that maximizes profit in a firm is given at the point where marginal revenue (MR) and the marginal cost (MC) are equal such that any further generation of revenue results offsets cost. A simple focus on profit maximization implies that a firm is simply focused on making profits and the resources are utilized with the sole aim of getting the highest level of profits possible. Pursuing a profit maximization perspective comes with the risk of being entrenched in a singular strategy that is meant to optimize profits that there is a possibility of losing everything in case of a sudden turn in the market environment or in the firms operations. Positive impacts of profit maximization Profit maximization has various positive impacts on a firm including expectation and goodwill, profit optimization perspective creates an expectation in a firm thus creating an environment where premium price is used and cost cutting is a primary goal. These are important goals in the modern competitive market where every firm struggling to meet the competition and reduce costs. The perspective also creates expectations among shareholders that they will have immediate gains and also improves the firm’s goodwill. Profit optimization also has a big advantage of generating cash flow (Donaldson & Preston, 1995, p.65). Under profit maximization perspective, primary considerations are given to investments, re-investments of funds and expansions of operations and markets, which results in generation of more cash flow. Such considerations allow the firm to operate in an environment that is more cost-efficient. Profit maximizing firms are known to be best in cost minimization since they are more concerned about reducing costs to improve profits. Profits keep building and this creates a health bottom line for the firm. Profit maximization can thus be used to allow the firm to generate more cash flow and that way reduces its debts or expands its operations. Profit maximization attracts investors and financiers of the firm. For lenders to give a firm credit, they want to be satisfied that the firm is creating profits and will thus stay in business in order to repay their funds. Investors also require that a firm is making certain levels of profits so that it can secure their funds and use them to expand. A firm has to be performing well for shareholders and potential investors to expect return on their investments. This makes profit optimization an important consideration to some degree. Profit maximization allows firms to meet their desired return on investment (Coughlin, 1998, p. 129). Profit maximization is deemed the utmost objective of managers in a firm and it is their corporate responsibility to ensure that shareholders financial interests are well taken care of and that the firm remains attractive to potential investors (Windsor, 2001, p. 502). Profit maximization perspective enables managers to carry out their ethical and moral duty of protecting interest of various components of a firm including the society (Whetten et al, 2001, p. 373). Profit maximization also enables a firm to acquire required cash flows which are reinvested in the firm’s operations and others are used to create new subsidiaries in new markets or to explore new product qualities, designs or tastes and all these are critically important in enhancing growth in a firm. Profitability lays a good foundation for enhance of growth (Godfrey, 2004, p. 779). In the global market, firms are competing in technology, in remuneration, in quality of goods in other various aspects of business, a firm that is not profitable may not be in position to pay its employees well and may result in high employee turnover while a high profitability firm allows management to come up with employee-friendly remunerations that play a critical role in attracting new and competent skills and talents into the firm. Profit maximization therefore helps a firm to pursue good and attractive staff and management compensation policies. Limitations that managerial decisions face in the pursuit of profit maximization Profit maximization is an overarching perspective, this is because cash flows and profits are essential but are derived from various positive outcomes from the enterprise, which makes the perspective face several constraints. Time compression, dynamics of innovation in technology and the rising trend of globalization have largely changed business driving forces in the market environment. Corporations require innovative technologies and products to meet customers demand in the challenging business environment (McEachern, 2011, p. 179). The need to outperform competitors and achieve desired outcomes may call for highly costly technological investments. Globalization has led to spread of technologies and information implying the knowledge and capability are shared fast in the integrated world. Technological innovations have particularly become a common place; technologies like wireless communications have led the market digital bringing dramatic changes in the market. Firms are challenged to keep in pace with the advancing technologies and failure to rapidly adopt these technologies may render firm’s product irrelevant or obsolete in the market. Competition has also heightened as a result of globalization. Such changes have greatly challenged managerial decisions shifting them from profit optimization to other relevant perspectives such as shareholders’ value optimization and maximization of market capitalization. The view that firms exist to solely make profits is often challenge by various other factors. For instance, managerial decisions are made in the light of other constraints that could be imposed by resource scarcity, technology, laws, contractual obligations, and regulations. To ensure that decisions made maximize value, firm management must consider the external constraints that affect the firm’s ability to attain the established objectives. Limitations of funds may also stand in the way of management decisions to pursue certain projects even though the projects are deemed profitable (Milberg & Eichner, 1992, p. 179). Managerial decisions are also be constrained by the contractual requirements of the projects pursued. For instance, most contracts require that certain quality level be met, the managers must therefore focus on meeting the required level of quality, which may not necessarily be the level that maximizes profit. Certain legal restrictions may also affect the marketing and production activities of a firm and thus influence managerial decisions. For instance, certain laws dictate on the minimum wages for workers, minimum safety and health standards, standards for pollution emission, fair marketing and pricing practices, fuel efficiency requirements. According to monopoly theory of organizations’ economic profits, some firms that have sheltered competition through high barriers such as high capital requirements, economies of scale, patents, and import protection among others can easily pursue profit maximization objective since they encounter low competition in the market and can thus set premium prices for their products. Monopoly profits provide a firm with above-normal profits that enables it to reinvest widely and expand its operations. Monopolistic operations provide a firm with the best opportunity to maximize profits and improve shareholders value thus attracting potential investors into the firm and enhancing growth. Professional service firms often adopt the microeconomic or single-goal perspective of profit maximization. They focus on determining output levels and price that will maximize profits (Schultz & Doerr, 2009, p. 12). Profit maximization perspective makes it easy for managers to determine the appropriate strategy to be used in the market. Negative impact s of profit maximization Profit optimization objective presents a single period or a short-term objective and is thus interpreted to mean optimization of profits for a specified period of time. In practice, firms’ reported earnings fluctuate widely, some of these variations rise from differential risk premiums. Most firms earn high economic profits and make meaningful losses at varying times. According to the frictional profit theory, markets attain disequilibrium at times due to unanticipated change in cost or demand conditions. Theses unanticipated shocks result in either negative or positive economic profits. While profit maximization is attainable and good in the short-run, it must be sustainable in the long-run, which often proves impossible making it irrelevant to the firm. In reality, opportunities exploited by a firm must focus on sustainable developments that result in ongoing success (Just et al, 2005, p. 49). Drawing from agency theory, profit maximization only focuses on meeting shareholders interest; however the perspective overlooks other important business relationships that exist between the various parties involved in business. For instance, profit maximization cannot push for lowering of prices and thus overlooks the interest of the surrounding community and the customers. From managerial stakeholder theory, management has the responsibility of balancing all the interest and rights of the firm’s stakeholders for future sustainability of the firm’s business. Stakeholders in this case refer to both external and internal stakeholders as well as the secondary and primary stakeholders (Philips, 2005, p. 163). Stakeholders comprise of staff, customers, surrounding community, government, shareholders, owners and suppliers. Profit optimization offers a single-stakeholder perspective; this makes profit maximization perspective less relevant given its complexity in the real business environment. Profit optimization could also be harmful to the firm since it might not always result in success. Other concepts are critical to firms’ success such as customer satisfaction. Product delivery system that comprise of customers, value networks, and supply networks is central to the achievement of customer satisfaction. Successful systems of product delivery may generate cash flow but its long-term success may not be guaranteed. Problems may arise with product liability and stakeholders that may drain the future funds and thus affect cash flows. Pursuing a narrow perspective even that of customer satisfaction or profit optimization may thus not include all business constituents and the solution therefore is to adopt a broader view of managerial decisions in the business environment, which include optimizing the value of an enterprise together with all its constituents (Barney & Hesterley, 2006, p. 119). The broader perspective of managerial decisions allows firms to generate cash flow efficiently and re-invest it back to the innovations and opportunities that provider great rewards. Linking profit optimization with its constituents ensures that the approaches taken by management are not narrowed but are rather balanced. It is therefore important to identify that objective of a business does not only revolve around increasing shareholders value or profit but rather transcends to various other constituents of the process of profit generation (Rainey, 2005, p. 92). Most pricing strategies do not support profit optimization objective and firms adopting this perspective should therefore be careful to select strategies that fit their firm objectives. It is important to consider overall financial goals in determining the appropriate pricing strategy. Sometimes the desired price may be high above the position of the company in the industry or may be high above what customers can accept and this may result in loss of customer loyalty. Alternatives to the profit optimization perspective Stockholder wealth maximization has the long-term approach to business and it takes stockholder’s interest in the present and the future time as well as the profits. The approach also incorporates risk of uncertainty of time and money value. Adopting a clear stockholder wealth maximization objective provides a clear relationship between the pursuits of today and the long-term achievements and recognizes the timing of firm’s returns and other stockholders returns as relevant (McGuigan et al, 2010, p. 14).maximizing the market value of shareholders common stock is important but it has its own practical limitations which include fluctuations in stock prices, changes in economy among others. It is thus important to uphold shareholders wealth maximization but this should be done in consideration of other stakeholders as well. Recommendations and conclusions According to Rainey (2005, p. 91), profit maximization concept is a good perspective but one that is impossible to articulate. Profit maximization helps firms to generate cash flow, improve shareholders expectations, improve a firm’s goodwill, and it also enables firms to meet their debt obligations. However, the concept is hard to articulate particularly in the competitive global market. Rapid growth of firms as well as decline of others like Cisco Systems and Lucent Technologies shows some of the difficulties that firms encounter in their effort to maximize profits, market capitalization, and shareholders’ value. According to Shim and Siegel (1998, p. 329), a firm that wishes to pursue a simple profit maximization objective should go for a new product financing to increase its earnings per share or it should seek diversifying the product mix in order to allow for more opportunities for profit generation in the firm. However, it is impossible to keep pursuing a new product at every turn and diversification or product mix does not also guarantee profits. According to Mukherjee (1990, p. 41), it is important to understand that a firm is not just a single-decision and single-goal unit but rather a multiple-decision and multiple-goal organizational coalition. A firm should thus be handled as a coalition of various groups, goals and objectives. These groups include customers, employees, managers, shareholders, suppliers and creditors among others. Each of these groups has its set of goals, needs and demand, for instance, workers may demand for increased wages, managers may demand for increased compensation and creditors may demand for payments of their funds. The consequence of appreciating the dichotomy should be to pursue perspectives that maximize the benefits of the firm like profitability, market capitalization and shareholders’ value together with their constituents such as customer satisfaction, suppliers needs, society’s needs (through CSR activities) and employee job satisfaction (Mukherjee, 1990, p. 42). Conclusion This study has explored the subject on profit maximization in effort to examine the assertion that profit maximization results in positive effects on a firm. The study has explored various views given by scholars on profit maximization and has found that the perspective has various positive impacts including cash flow generation, meeting expectations of shareholders, investors and financiers as well as enabling a firm to meet its debt obligations from the cash generated (Philips, 2005, p. 165). However, the study has also identified the perspective as one that is ineffective and hard to articulate particularly in the firm’s long-term sustainability. From the above discussion, the responsibility and the purpose of a firm is not to just attain the economic objective of profit generation but rather to attain profitability that is sustainable by taking care of social and economic rights and interest of all stakeholders in the firm (Freeman, 1984, p. 61). Simple profit maximization that does not take into consideration the various constituents is attainable in the short-run but irrelevant since it is not sustainable in the long term (Leroy & Jentz, 2010, p. 60). It is therefore important to consider the various stakeholders together with their interests and right so as to meet their needs and enhance the company’s future viability. According to Coughlin (1991, p. 130), profit maximization perspective assumes that a firm operates in an environment of comparative statics, which is not the case since the business environment is full of economic dynamics. References Barney, J. & Hesterley, W. (2006). Strategic Management and Competitive Advantage. New Jersey: Pearson Prentice Hall. Coughlin, R. (1991). Morality, rationality, and efficiency: new perspectives on socio-economics. New York: M.E. Sharpe. Donaldson, T. & Preston, L. (1995). The stakeholder theory of the corporation: Concepts, evidence, and implications. 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