Objectives of a Firm
Maximisation of Profits
Maximisation of profits ( Milton Friedman)
• Most common and theoretically easy
• Profits indispensable for a firm’s survival
• Whatever the stated objective, bottom line
is always important
• Achieving other objectives depends on the
firm’s ability to maximise profits
• Reliable measure of firm’s efficiency and
future performance
Maximisation of Profits
• Golden Rule of Profit Maximization
• Profit = TR – TC
• Profit maximizing output is at the point
where the gap between TR and TC is
maximum
Maximisation of Profits
• Which measure of profit- gross/ net/
before/ after tax-?
• Time period- current/ next year/ neat 5/10
years?
• If future profit, time value of money
• Impossible to max profits in competitive
markets
Maximisation of Sales Revenue
Baumol’s hypothesis: Managers aim at
Maximisation of firm’s total Revenue
rather than profits
In competitive markets, sales volume
determines market leadership
• Separation of management and
ownership- For managers, salary and
other earnings are more closely related to
sales revenue rather than to profits;
• Measure of performance
Maximisation of Sales Revenue
• Sales revenue important for financial
institutions and banks while financing;
• Data on trends in sales revenue is a
readily available indicator of performance;
• Consistently maintaining profits is difficult
for managers but increasing sales revenue
is feasible
• Growing sales strengthen competitive
spirit
Maximisation of Sales
Revenue
• Empirical evidence does not lead to
decisive conclusion on Baumol’s
hypothesis
Maximising Firm’s Growth
Rate
Marris’ Hypothesis of Maximising Firm’s
Growth Rate: When this happens,
managers maximise their own utility
function as well as that of the owners.
• Owners(shareholders) aim at maximising
profits and market share;
• Managers aim at better salary, job security
and growth
• The two sets of aims can be achieved by
maximising growth
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G= GD =GC where GD= f(d,k) & GC= f(r, π)
GD= Demand for firm’s product where d
is diversification and k is success rate)
GC=Growth rate of capital supply
R is weighted average of 3 financial ratios
π is rate of increase of profit
• The above proposition has the following
constraints:
• Um= Utility function for managers
Um= f(Salary, power, status, security)
Uo= Utility function for shareholders
• Uo= f(profit, market share, brand image)
Managers must try to maximise GD and GC
Maximising Managerial Utility
Function
• Williamson’s Hypothesis of Maximising
Managerial Utility Function• Combination of profit and growth
maximisation objectives
• Managers apply their discretionary power
to maximise their own utility function
• Includes variables like salary, prestige,
power, job security, professional
satisfaction
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•
•
•
Um= f(S, M, ID)
S= Salary
M= Managerial emoluments
ID= power of discretionary investment
Objectives of a Firm
• Entry Prevention and Risk Avoidance
• “Reasonable Profit”- to prevent entry of
competition, project a favourable public image,
restraining trade union demands, maintaining
customers’ goodwill, to prevent possibility of
government take-over
• For public sector, objective is to maximise
social gains- for private sector, maximising
profits is a strong aim.
• Modern corporations like to pursue multiple
objectives.
• Rothschild’s hypothesis of Long run
survival and Market share GoalsAttainment and retention of a constant
market share
Break Even Analysis
• In traditional theory of the firm, the basic
objective of the firm is to maximise profits.
• But profit is maximum at a certain level of output
and it is difficult to know what would be the
profit-maximising output at the outset;
• Even if it is known it can not be achieved at the
outset of production;
• In real life, firms begin their activity even at a
loss in anticipation of profits in future.
Break Even Analysis
• Firms can plan better if they know the level
of production where cost and revenue
break even- the profitable and nonprofitable range of production-
Break Even Point
• Break Even Analysis is a technique used
to study the relationship between total
costs, total revenue, and total profits and
losses over the whole range of stipulated
output
• Break Even Point- Point where TR=TC
and therefore no profit , no loss position.
Break Even Point
TR
Y
Total Revenue/ cost
TC
Break even Point
B
Variable Cost
TFC
Fixed Cost
X
O
Output/ Sales
Break Even Analysis
Uses of Break-Even Analysis
• The technique gives a preview of profit
prospects and is a tool of profit planning.
Profit can be forecast if estimates of
revenue and cost are available
• It integrates the cost and revenue
estimates to ascertain profits and losses
associated with different levels of output
• Effect of change in volume of sales, sale
price, and cost of production can be
appraised.
• Helps inter-firm comparisons on
profitability
• The concept emphasises the importance
of capacity utilisation
Break Even Analysis
Limitations:
• Static: Dynamic forces such as changes in prices,
technology, efficiency and capacity are not taken into
account
• Can not be applied if cost and price data can not be
ascertained beforehand
• Can not be applied where historical data are not
relevant for estimating future costs and price.
Despite limitations, useful tool in production planning.
Determining Break Even Point
Given the following total cost and total revenue
functions, find the BEP:TC= 480+10Q and TR= 50Q
BEP=TFC/ (P-AVC)
From the above, we get
TFC= 480
AVC= 10 per unit
Since TR=P.Q, P=50
BEP= 480/ (50- 10)
=480/40 = 12 units
Determining Break Even Point
TC= 480+10Q and
TR= 50Q
At 12 units TC= 480+(10 *12)= 600
TR= 50* 12 = 600
Thus, TR=TC
Net profit is zero.