OBJECTIVES
OF BU SIN ESS
FIRM S
Learning
Objectives
Profit as a business objective
Theories of profit
Profit maximization as a business
objective
Problems in profit measurement
Alternative objectives of business
Profit as Control Measure
Profit As Business
Objective
ACCOUNTING ECONOMIC
CONCEPT CONCEPT
• Profit is excess of revenue • ‘Pure’ Profit is return over
over and above all paid-out and above the opportunity
costs including cost. It is the residual left
manufacturing and after all contractual costs are
overhead expenses. met including transfer costs,
insurable risks, depriciation
and payments to shareholders.
• Profit=TR-(W+R+I+M)
• TR=Total Revenue, • Profit = Total Revenue -
• W=Wages and Salaries (Explicit + Implicit Costs)
• OR
• R=Rent
• Profit = Accounting Profit -
• I=Interest
(Opportunity Cost+
• M=Cost of Materials Unauthorized Payments)
Theories of
Profit
Walker’
s
Theory
of
Profit
Clark’s
Dynami
Monopol c
y Theory
of
Profit
Theorie
s
of
Schumpete Profit Hawley’s
r’s
Risk
Innovation
Theory of
Theory of
Profit
Profit
Knight’s
Theory
of
Profit
Profit Measurement
Problems
Depreciation as a Cost Element
Measuring Opportunity Cost Straight line method/Reducing
and method/Annuity
balance method/Sum-of-year’s
digit approach
Replacement Cost
Treatment of Capital Gains and
Losses(Windfalls) Capital gains recorded when
Windfalls unrecorded until realized but write off capital loss
they are transformed written off immediately.
into cash.
Current versus historical
costs
Current Variation though
Historical Costs are often
accurate is
outdated. difficult to validate.
5
Profit
Maximization
Profit Maximization Concept
Total Profit (II) = TR – TC where, TR = total
revenue and TC =Total cost.
• Profit is maximum where TR – TC is maximum.
• Two conditions required for profit
maximization:
• First order or necessary condition: MR=MC
and
• •Technically,
Second Order or
MR
TR Supplementary
/ Q and MC TC / QCondition:
MR=MC
under falling
• Theoritical MR andfor
Conditions rising MC.
profit
• (i)Necessary
maximization : TR / Q TC / Q and
Condition : TR / Q TC / Q
• (ii)Secondary
Condition : 6
Profit Maximization as Business
Objective
Against Defense
• Managers and owners are separate • Profit is indispensible for firm’s
entities with different objections survival.
• Assumptions of certainty about
market conditions as per equi- • Achieving other objectives depends
marginal principle is not realistic. upon firm’s ability to make profit.
• Modern firms work for short-term • Evidence against profit
profits and thus, they have adopted maximization is inconclusive.
the average cost principle, i.e. AC
= AVC + AFC + Normal margin of • Profit Maximizing objective has a
profit where, AC is the average
cost, AVC is the average variable greater predictive power.
cost and AFC is the average fixed
cost.
• Berle-Means-Galbraith (B-M-G)
hypothesis states that firms
controlled by owners have higher
rates of profit maximization as
compared to the firms controlled by
managers.
7
Alternative Objectives of
Business
Baumol’s hypothesis of sales
revenue maximization
Marris’s hypothesis of
maximization of firm’s
growth rate
Rothschild’s hypothesis of long-run survival
and market share goals
Williamson’s hypothesis of maximization of
managerial utility function
Cyert-March hypothesis of satisfying
behaviour
Alternative Business Objectives
Explained
Sales revenue maximization
Maximizing sales revenue boost personal income, performance,
reputation, etc.
Maximization of firm’s growth rate
Balanced growth by combined efforts of the manager’s & owner’s
utility functions.
Long-run survival and market share
goals
A firm should also aim at long-term
survival.
Maximization of managerial utility function
Maximize utility functions subject to a satisfactory profit satisfy the owners
Cyert-March Satisfying behaviour
Combine various goals to overcome the conflicts between manager’s &
owner’s objective.
Making Reasonable
Profits
To prevent entry of
competitors by combining
profit and pricing policy.
To project a favourable
public image.
To restrain demands of the
trade unions.
To maintain customer goodwill.
To restrain managerial utility
Standards of Reasonable
Profit
Forms • In terms of
• Fixed amount profit
of • percentage of sales
profit • return on
standar investments
d
• Capital-attracting standard:
Setting Enough profits to draw external
Capital
the • Plough-back standard: Maintain
profit Liquidity
• Normal earning standard: Enough
standard to satisfy stakeholders and reduce
competition.
1
1
Profit as a Control
Measure
Decentralizati Divisional
on and Profit and
control-by- Profit
profit. Standards
Maximization Total Net Profit
of personal vs
utility Proportionate
Profi
functions by Net Profit &
the Vertical
managers. t Integration.
Need for using Profit as Control
Measure
• Overspending by managers on
promotion of sales and
1 product line
• Subordinates spend too much
time
2 and money on perfections
• Managers are often more
concerned about their job
security and perks
Summar
y
Profit is excess of revenue over and above all paid-
out costs.
‘Pure’ Profit is return over and above the
opportunity
cost.
Profit Maximization: The most productive
business objective. The theoretical condition for
profit maximization is that MR=MC with
decreasing MR and rising MC.
Problems of profit measurement: Accounting vs
Economic Concept.
Sales revenue, firm’s growth rate, Long-run
survival and market share, of managerial utility