Objectives of Business Firms

Presenters: Jatinder Sharma

Kundan Kumar ThakurId Mohammad -114

MukeshPresented to: Raj kumar khadka-104 Dr. Divya Verma Santosh

INTRODUCTION

The first and most important responsibility of a business manager is to achieve the business objective of the business firm he manages. The primary objective of a business firm is to make profit. Some important objectives, other than profit maximization are-

a) maximization of sales revenue.b) Maximizations of firm’s growth rate.c) Long run survival of the firmd) Entry prevention and risk avoidance. etc

Profit as Business Objective

Profit

In a general sense ‘profit’ is regarded as income accruing to the equity holders, in a same sense wages accrue to the labour, interest accrues to the money lenders.

Acc.. To layman- “ profit means all income that flows to the investors”.

Profit is defined in two different ways, one foreconomics and one for accounting.

Accounting vs. Economic profitAccounting profit- profit is surplus of total revenue over and

above all paid-out costs, including both manufacturing and overhead expenses. Accounting profit equals revenue minus all explicit cost.

Economic Profit- economic profit is the difference between a company's total revenue and its opportunity costs. Economic profit equals revenue minus both implicit and explicit cost.

Problems in profit measurement

In profit measurement, two questions complicatesthe task of measuring profit:- a) which accounting concept should use for measuring profit?b) What cost should be or should not be included in the implicit and

explicit cost? The use of profit concept depends on the purpose

of measuring profit. Accounting concept of profit is used when the purpose is to produce a

profit figure.Economic concept is used to measure the ‘true profit’.

1. Treatment of capital gain and losses

Capital gain and losses are regarded as ‘windfalls’.Fluctuations in the stock market price is the mostcommon source of ‘windfalls’. In accounting concept, if sound accounting policy is

followed, there will be one profit and if other method is followed then there will be another figure of profit. That is the problem.

In economic concept, the economist would suggest that the management should be aware of the approximate magnitude of such ‘windfalls’ long before they become precise enough to be acceptable by accountants.

2. Current vs. Historical cost

The use of historical cost accounting excludes routineadjustments for inflation. The main advantages of usinghistorical costs is Simplicity and certainty. The biggestdisadvantage is that book values may be based on badlyoutof date costs. This becomes more of a Problem duringperiods of high inflation. Historical cost recording does notreflect such changes in values of assets and profits. ThisProblem assumes a critical importance in case ofinventories and material stocks.

Three popular methods of inventory valuation

a) FIFO (first in first out)-this system exaggerates profits at the time of rising price

b) LIFO (last in first out)-when inventory level fluctuate, this method losses its advantages.

c) WAC (Weighted average cost )-this method takes the weighted average material cost purchased at different prices and different points of time to evaluate the inventory.

All these methods have their own weaknesses and therefore, they do not reflect the ‘true profit’ of business. So the problem of evaluating inventories so as to yield a true profit figure remains.

3.Problems in measuring depreciationEconomist view depreciation as capital consumption from their point of view, there are two distinct way of charging for depreciation:-

a)Depreciation of an equipment must equal its opportunity costb)The replacement cost that will produce comparable earning.

To accountants depreciation is an allocation of capital expenditure over time. To find out a depreciation a firm can apply any one out of four methods-straight-line method= cost of capital/years of capital life-Reducing balanced method-Annuity method The above three methods gives three different measures of annual depreciation and hence the different level of profit.

Theories of Profit

PROFIT AS RENT OF ABILITY

• F.A.WALKER• Profit is the rent of "Exceptional abilities that an

entrepreneur may possess “ over others.• profit is the difference between earning of the least

and the most efficient entrepreneurs.• Assumed a state of perfect competition in which all

firms are presumed to possess equal managerial ability

• under perfect competition there would earn only managerial wages , which is popularly known as 'normal profit'

DYNAMIC THEORY OF PROFIT• JB CLARK 1900• Distinction between a static and dynamic economy is fundamental to this theory of

profit.• According to him profit are exclusively the result of dynamic change and no profit in

static economy.• In this theory under static condition in a stationary state where no change in:I. demand and supplyII. no increase either population or capitalIII. method of productionIV. Firms of industrial organisation do not change and want of consumer do not

multiply.• In static society since payments are made on the basis of managerial productivity the

total product will be distributed between wages and interest .the only income of the entrepreneur is his wages of management or for co ordination or for his routine work of supervision.

• In static economy every thing is known and knowable .there is no risk and uncertainty is hence there are no profit.

• The long period competitive equilibrium is a good example of static economy.

• Clark says that our society is a dynamic one and changes take place init every moment

I. change in the size of populationII. change in the supply of capitalIII. change in production techniqueIV. change in the forms of industrial organisationV. change in human want

A. INTERNAL FACTOR• new discovery• new inventions• innovation• new production lineB. EXTERNAL FACTOR• Regular change like trade cycle which may affect profit.• Irregular change which may affect profit such as five, earthquake

change in national and international policies etc.

CRITICISM OF THE DYNAMIC THEORY OF PROFIT

• The theory fails to make any difference in a change that is foreseen and one that is unforeseen in advance .As prof. knight point out, it is not all types of dynamic change that lead to profit . it is only those changes which cannot be foreseen that give rise to profits.

• profits may also emerge in the absence of Clark's five principal dynamic changes.

• Lastly , as prof. Taussig point out ,Clark's dynamic theory creates an artificial distinction between profits and wages of management.

RISK THEORY OF PROFIT

• The risk theory of profit was propounded by an American economist ,pofo. Hawley in his book "Enterprise and the productive process"1907

• According to this theory risk taking is the main function of the entrepreneur and profit is the reward for risk taking.

• there is a time gap between the production and selling of goods in the market.

• in modern era an entrepreneur has to forecast about demand , cost , price etc . If these forecast

• prove true there will be profit, otherwise there can be losses to entrepreneur.

• According to him “ There is proportional relationship between risk and profit.

CRITICISM

• according to carver ,“ profits arise not because risk are borne by the entrepreneurs, but because the superior entrepreneurs are able to reduce them."

• according to prof. knight "profit is not the reward for all types of risks . only uncertain risk provide basis for profit . entrepreneur can cover certain risk by the payment of insurance premium."

• There in no direct and proportion relationship between profit and risk.

• other factor like monopoly gains , windfall gains etc., are not being considered by this theory.

UNCERTINTY BEARING THEORY OF PROFIT• prof.h.knight• Uncertainty baring and not the risk taking is the

main function of the entrepreneur for which he gets profit.

• prof. knight has divided risk into two parts• certain risk these are those risk which are know

foreseeable and insurable.• uncertainty risk there are some risk which

cannot be foreseen.• prof. knight pointed out that profit is the reward

for such unforeseen risk . which cannot be insured or avoided.

CRITICISM

• Profit is not simply the reward of uncertainty bearing , rather is also the reward for management , organisation and innovations etc .This theory does not give any place to such function as coordination , supervision and decision making.

• This theory considers uncertainty bearing as a separate factor , which is not true . to bear uncertainty is just one of the many important features of entrepreneurs working.

• sometimes there is no profit to entrepreneurs working.

• this theory does not explain the problem of profit determination.

INNOVATION THEORY OF PROFIT• Joseph schumpeteran eminent American economist.• Profit to the introduction of innovation in the production

process or the sale of the product.• He observed that the function of an entrepreneur is to

introduce innovation.• Schumpeter pointed out that innovations can be of five types:-A) production of new or different kind of goods.B) Adoption of new techniques of production.C) Discovery of new source of raw material.D) Discovery of new market for increasing sales.E) change in the organisation of production.

Due to these innovations, there arises a difference between cost of production and price, which gives rise to profit.

COST

CRITICISM

• In this theory, no importance has been given to uncertainties , whereas all innovation are uncertain.

• Schumpeter did not give any importance to risk taking function of the entrepreneur.

• This theory ignores other factors which are also responsible for the emergence of profits.

MONOPOLY POWER AS SOURCE OF PROFIT

• Monopoly is said to be another source of pure profit.• An extrim contrast of perfect competition is the existence of monopoly in the

market . Monopoly characterizes a market situation in which there is a single seller of a commodity without a close substitute.

• Monopoly may arise due to such factors as• economies of scale,• sole ownership of certain crucial raw materials,• legal sanction and protection and • mergers and takeovers.• A monopolist may earn 'pure profit' or what is generally called in this case,

'monopoly profit', and maintain it in the long run by using its monopoly powers.• monopoly powers include• power to control supply and price;• powers to prevent the entry of competitors by price cutting and • In some case, monopoly power to exercise control over certain input markets.

Profit MaximizationProfit maximization has been the most important assumption on which economics have built price and production theories.

The conventional economic theory assumes profit maximization as the only objective of business firms which forms the basis of conventional price theory. so It is regarded as the most reasonable and analytically the most ‘productive ’ business objective.

Generally, profit maximization is a stage where a firm can earn the highest profit from a single rupee investment.

Profit maximizing conditions:

Total profit (TP)is defined as:

TP = TR – TC

Where, TR= Total Revenue and TC = Total Cost

There are two conditions that must fulfilled for TR – TC to be maximum. These conditions are called:

I.Necessary or the first- order condition

II.Secondary or supplementary condition

i)Necessary or the first order condition : A necessary condition is one that must be satisfied for an event to take place. It is the condition which requires MR=MC to be satisfied for profit to be maximum.

The first –order condition of profit maximization is that the first derivative of profit function must be equal to zero. Differentiating the total profit function and setting it equal to zero, we get

∂TP/ ∂Q = ∂TR/ ∂Q - ∂TC/ ∂Q = 0--------------------equn (i)

The condition holds only when

∂TR/ ∂Q= ∂TR/ ∂Q

In equation (i), the term ∂TR/ ∂Q gives the slope of the TR curve which in turn gives the marginal revenue(MR). Similarly, the term ∂TC/ ∂Q gives the slope of the total cost curve which is the same as marginal cost (MC). Thus, the first-order condition for profit maximization can be stated as :

MR=MC

ii) Supplementary or second-order condition: The second-order quantity of profit maximization requires that the first order condition is satisfied under rising MC and decreasing MR.

Technically, the second-order condition requires that the second derivative of the profitfunction is negative .

The second derivative of the total profit function is given as:∂2TP/ ∂Q2 = ∂2TR/ ∂Q2 - ∂2TC/ ∂Q2 …………………………..ii

The second-order condition requires that∂2TR/ ∂Q2 < ∂2TC/ ∂Q2

Since ∂2TR/ ∂Q2 gives the slope of MR and ∂2TC/ ∂Q2 gives the slope of MC, the second order condition may also be written as :

slope of MR = slope of MC

It implies that MC must have a steeper slope than MR or MC must intersect the MR from below.Hence, profit is maximized where both the first and second order conditions are satisfied.

It is illustrated by the help of following figure:

Profit maximization by the total cost-revenue and Marginal Cost-revenue concept:TC= Total Cost TR= Total RevenueP= break even pointP1= profit maximization point

MC= Marginal costMR= Marginal Revenue

MC and MR curves are derived from TC and TR functions respectively.

MC and MR curves intersect at two points, P1 and P2.

Thus, the first order Condition is satisfied at both the points , but the second order condition of profit maximization is satisfied only at point B i.e. MC must Intersect MR from below. Hence, it is a profit maximization point.

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Controversy over profit Maximization ObjectiveArguments against Profit maximization objective :

Traditional theory assumes full and perfect knowledge about current market conditions and the future developments in the business environment of the firm.

i) Modern economists question the validity of this assumption. They argue that the firms do not posses the perfect knowledge of their costs, revenue and future business environment because they operate in the world of uncertainty where most price and decisions are based on probabilities.

The equi-marginal principle of profit maximization, i.e. equalizing MC and MR, has been claimed to be absent in the decision-making process of the firms. Empirical studies of the pricing behaviour of the firms have shown that the marginal rule of pricing does not stand the test of empirical verification .

The defence against arguments:

The traditional theory seeks to explain market mechanism, resource allocation through price mechanism and has a predictive value, rather than deal with specific pricing practices of certain firms.

In Maclup opinion , the practices of setting price equal to average variable cost plus a profit margin is not incompatible with the marginal rule of pricing and that the assumptions of traditional theory are reasonable.

While the controversy on profit maximization objective remains unresolved, the conventional theorists, the margianlists, continue to defend the profit maximization objective and its marginal rules time to time.

Alternative Objectives of Business Firms

Baumol’s hypothesis of sales revenue maximization

Baumol has postulated maximization of sales revenue as an alternative to profit maximization objective. He attributes this objective to the dichotomy between ownership and management in large business corporations. This dichotomy gives managers an opportunity to set their goals other than profit maximization goal which most owners and businessmen pursue. Given the opportunity, managers choose to maximize their own utility function. According to baumol, the most plausible factor in managers utility functions is maximization of the sales revenue.

According to Baumol, the factors which explain the pursuance of sales maximization by the managers are following.

1. salary and other earnings of managers are more closely related to sales revenue than to profits.

2. Banks and financial corporations look at and lay a great emphasis on sales revenue while financing a corporation.

3. Trend in sales revenue is a readily available indicator of the performance of the firm. It helps also in handling the employee’s problem of awarding efficiency and penalizing inefficiency.

4. Profit figures are available only annually, sales figures can be obtained easily and more frequently to assess the performance of a management. Maximization of sales is more satisfying for the managers than the maximization of profits which go to the pockets of the shareholders.

Contd…5. Managers find profit maximization a difficult objective to

fulfill consistently over time and at the same level. Profits may fluctuate with changing conditions.

6. Growing sales strengthen competitive spirit of the firm in the market whereas decreasing sales put the survival of the firm at risk.

Baumol’s model MR MR = 0= 0

k1k1k2k2

k3k3

Marris’s Hypothesis of Maximization of Firm’s Growth Rate

Marris defines firms balanced growth rate(G) as G = GD = GC Where GD = Growth rate of demand for firm’s product, GC = Growth rate of capital supply to the firm.

Marris translates the two growth rate into two utility functions: Um = f(Salary, Power, Job Security, Prestige, Status)

U o = f(Output, Capital, Market-share, Profit, Public esteem)

The Um & U o are positively correlated with size of firm. Therefore managers seeks to maximise the size of firm. Maximization of size of the firm depends on the maximization of its growth rate. Hence, The managers seek to maximize a steady growth rate.

Drawback: Fails to deal satisfactorily with oligopolistic interdependence. It ignores price determination.

Williamson’s Hypothesis of Maximization of Managerial Utility Function

Williamson say managers have discretion to pursue objectives other than profit maximization. Instead of maximizing profit, the managers of modern corporations seek to maximize their own utility function subject to a minimum level of profit.

Managers’ utility function(U) is expressed as:U = f(S, M, ID)

Where S = additional expenditure on staff, M = managerial emoluments, ID = discretionary investments.

Drawback: Fails to deal with the problem of oligopolistic interdependence. It only apply where rivalry between firms is not strong.

Cyert-March Hypothesis of satisfying Behavior

According to the Cyert-March hypothesis, firm’s behaviour is ‘satisfying behaviour’. It say apart from dealing with uncertain business world, managers have to satisfy a variety of groups like managerial staff, Workers, Shareholders, customers, financers, input suppliers & authorities. All these groups have some kind of expectations, high or low, from the firm & the firm or managers seeks to satisfy all of them in one way or another way by sacrificing some of its interest.

Drawback: It does not explain the firm’s behaviour under dynamic conditions in long

run. It cannot be used to predict exactly the future course of firm’s activities. This theory does not deal with the equilibrium of the firm or the industry.

ROTHSCHILD’S HYPOTHESISLONG – RUN SURVIVAL AND MARKET SHARE GOALS

• Primary goal of the firm is long run survival.

• Some other economists have suggested that attainment and retention of a constant market share is an additional objective of the firms. The managers, therefore, seek to secure their market share and long-run survival.

• The firms may seek to maximize their profit in the long-run though it is not certain.

Entry prevention and risk-avoidance

• Alternative objective of the firms suggested by some economists is to prevent entry of new firms in to the industry

• Motive Behind entry-prevention• Profit maximization in the long run • Securing a constant market share.• Avoidance of risk caused by unpredictable behavior of new firms.Only profit maximizing firm can survive in the long run . They achieve all

others subsidiary goals easily if they can maximize their profits.

• Prevention of entry may be the major objective in the pricing policy of the firm, particularly in case of limit pricing

Making a reasonable profit- A Practical Approach

Reasons for aiming at reasonable profits

• Preventing entry of competitors:- profit maximization under imperfect market conditions generally leads to high “pure profit” which is bound to attract competitors, particularly in case of a weak monopoly.

• Projecting a favorable public image:- it become often necessary for large corporations to project and maintain a good public image, because if public opinion turns against the firm, its begin to fall

• Maintain customer goodwill:- customer’s goodwill plays a significant role in maintaining and promoting demands for the product of a firm.

• Customer’s goodwill depends largely on the quality of the product and its ‘fair price”.

• Firms aiming at better prospects in the long run, sacrifice their short – run profit maximization objective in favour of a reasonable profit”

Standards of reasonable profit

• Forms of profit standards may be determined in terms of• Aggregate money terms • % of sales • %return on investment.• These standards may be determined with respect to the whole

product line or for each product separately. Of all the forms of profit standards the total net profit of the enterprise is more common than other standards. But when purpose is the appropriate profit standards, provided competitors ‘ cost curve are similar.

• Setting the profit standards • The following are the important criteria that are taken into

account while setting the standards for a “reasonable profits”.

• Capital – attracting standard. Important criterion used in setting standards profits is that it must be high enough to attract external(debt and equity) capital. For example if a firms stocks are being sold in the market at five times their current earning , it is necessary that the firm earns a profit of one – fifth or 20% of the book investment.

• Normal earning standards : standards of reasonable profits is the ‘normal’ earning of firms of an industry over a normal period. Company’s own normal earnings over a period of time often serve as a valid criterion of reasonable profit, provided it succeeds in

• Attracting external capital.• Discouraging growth of competition • Keeping stockholders satisfied.• When average of normal earning of a group of firms is used, then only

comparable firms and normal periods are chosen.

Continental Airlines was doing something that seemed like a horrible mistake. All other airlines at the time where following a simple rule: They would only offer a flight if, on average 65 % of the seats could be filled with paying passengers, since only then could the flight break even. Continental, however, was flying jets filled to just 50 % of capacity and was actually expanding flights on many routes. When word of Continental’s policy leaked out, its stockholders were angry and managers of competing airlines smiled knowingly, waiting for Continental to fail. Yet Continental’s profit already higher then the industry average continued to grow. What was going on?

There was, indeed, a serious mistake being made, but by the other airlines, not Continental. This mistake is using average cost instead of marginal cost to make decisions. The “65 percent of capacity” rule used throughout the industry was derived more or less as follows:

The total cost of the airline for the year (TC), was divided by the no. of flights during the year(Q) to obtain the average cost of a flight (TC/Q= ATC).

For the typical flight, this came to about $4000, the industry regarded any flight that repeatedly took off with less then 65 % as a money loser and cancelled it.

As usual, there are two problems with using ATC in this way.

i)first, an airlines average cost per flight includes many costs that are fixed and are therefore irrelevant to the decision to add or subtract a flight. These include the cost of running the reservation system, paying interest on the firm’s debt, and fixed fees for landing rights at airports-non of which would change it the firm added or subtracted a flight.ii)Also, average cost ordinarily changes as output changes, so it is wrong to assume it is constant in decisions about changing output. Continental’s management, led by its Vice-President of operations, had decided to try the marginal approach to profit. Whenever a new flight was being considered, every department within the company ask to:

Determine the additional cost they would have to bear. Of course, the only additional cost were for additional variables inputs, such as additional flight attendants, ground crew personnel, in flight meals, and jet fuel.

These additional flight-$ 2000- was significantly less then the marginal revenue of a flight filled to 65% of capacity-$ 4000. the marginal approach to profit tells us that when MR>MC, output should be increased, which is just what Continental was doing. Indeed, Continental correctly drew the conclusion that the Marginal revenue of a flight filled at even 50% of capacity-$ 3000 – was still greater then its marginal cost, and so offering the flight would increase profit. This is why continental was expanding routes even when it could fill only 50% of its seat.

In the early 1960’s Continental was able to outperform its competitors by using a secret- the marginal approach to profits. Today, of course, the secret is out, and all the airlines use the marginal approach when flights to offer.

“Airline Tasks the marginal bone” Business week, April 20,1963

Than-Q?