As we know that objectives of business firms can be various. There is no unanimity among the economists and researchers on the objective of business firms.
One thing is, however, certain that the survival of a firm depends on the profit it can make.
So whatever the goal of the firm-sales maximization, maximisation of firms, growth, maximisation of managers’ utility function, long- run survival, market share, or entry-prevention-it has to be a profitable organisation.
Maximisation of profit in technical sense of the term may not be practicable, but profit has to be there in the objective function of the firms. The firms may differ on ‘how much profit’ but they set a profit target for themselves. Some firms set their objective at a ‘standard profit’, some at a ‘target profit’ and some at a ‘reasonable profit’. ‘A reasonable profit’ is the most common objective.
Let us now look into the policy questions related to setting standard or criteria for reasonable profits.
The important policy questions are:
1. Why do modem corporations aim at a “reasonable profit” rather than attempting to maximise profits?
2. What are the criteria for setting standard for a reasonable profit?
3. How should “reasonable profits” be determined?
Reasons for Aiming at “Reasonable Profits”:
For a variety of reasons, modern large corporation aims at making a reasonable profit rather than maximising the profit.
Joel Dean has listed the following reasons:
1. Preventing entry of competitors:
Profit maximisation under imperfect market conditions generally leads to a high ‘pure profit’ which is bound to attract competitors, particularly in case of a weak monopoly. The firms therefore adopt a pricing and a profit policy that assures them a reasonable profit and, at the same time, keeps potential competitors away.
2. Projecting a favourable public image:
It often becomes necessary for large corporations to project and maintain a good public image, for if public opinion turns against it and government officials start raising their eyebrows on profit figures, corporations may find it difficult to sail smoothly. So most firms set prices lower than that conforming to the maximum profit but high enough to ensure a “reasonable profit”.
3. Restraining trade union demands:
High profits make trade unions feel that they have a share in the high profit and therefore they raise demands for wage-hike. Wage-hike may lead to wage-price spiral and frustrate the firm’s objective of maximising profit. Therefore, profit restrain is sometimes used as a weapon against trade union activities.
4. Maintaining customer goodwill:
Customer’s goodwill plays a significant role in maintaining and promoting demand for the product of a firm. Customer’s goodwill depends largely on the quality of the product and its ‘fair price’. What consumers view as fair price may not commensurate with profit maximisation. Firms aiming at better profit prospects in the long run, sacrifice short-run profit maximisation in favour of a “reasonable profit”.
5. Other factors:
Some other factors that put restraint on profit maximisation include
(a) Managerial utility function being preferable to profit maximisation for executives,
(b) Congenial relation between executive levels within the firm,
(c) Maintaining internal control over management by restricting firm’s size and profit, and
(d) Forestalling the antitrust suits.
Standards of Reasonable Profits:
When firms voluntarily exercise restraint on profit maximisation and choose to make only a ‘reasonable profit’, the questions that arise are
(i) What form of profit standards should be used, and
ii) How should reasonable profit be determined?
(i) Forms of Profit Standards:
Profit standards may be determined in terms of:
(a) Aggregate money terms,
(b) Percentage of sales, or
(c) Percentage returns 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 to the other standards. But when purpose is to discourage the potential competitors, then a target rate of return on investment is the appropriate profit standard, provided competitors’ cost curves are similar.
The profit standard in terms of ‘ratio to sales is in eccentric standard’ because this ratio varies widely from firm to firm, even if they all have the ‘same return on capital invested’.
This is particularly so when there are differences in:
(a) Vertical integration of production process,
(b) Intensity of mechanization,
(c) Capital structure, and
(ii) Setting the Profit Standard:
The following are the important criteria that are taken into account while setting the standard for a “reasonable profit”.
(a) Capital-attracting standard:
An important criterion of profit standard is that it must be high enough to attract external (debt and equity) capital. For example, if the firm’s stocks are being sold in market at 5 times their current earnings, it is necessary that the firm earns a profit of 20 per cent of the book investment.
There is however certain problems associated with this criterion:
(i) Capital structure of the firms (i.e., the proportions of bonds, equity and preference shares) affects the cost of capital and thereby the rate of profit, and
(ii) Whether profit standard has to be based on current or long-run average cost of capital as it varies widely from company to company and may at times prove treacherous.
(b) ‘Plough-back’ standard:
In case a company intends to rely on its own sources for financing its growth, then the most relevant standard is the aggregate profit that provides for an adequate “plough-back” for financing a desired growth of the company without resorting to the capital market. This standard of profit is used when maintaining liquidity and avoiding debt are main considerations in profit policy.
Plough-back standard is however socially less acceptable than capital-attracting standard. From society’s point of view, it is more desirable that all earnings are distributed to stockholders and they should decide the further investment pattern. This is based on a belief that market forces allocate funds more efficiently and an individual is the best judge of his resource use.
On the other hand, retained earnings which are under the exclusive control of the management are likely to be wasted on low-earning projects within the company. But one cannot say for certain as to which of the two allocating agencies-market or management-is generally superior. It depends on “the relative abilities of management and outside investors to estimate earnings prospects.”
(c) Normal earnings standard:
Another important criterion for setting standard of reasonable profit is the ‘normal’ earnings of firms of an industry over a normal period. Companies own normal earnings over a period of time often serve as a valid criterion of reasonable profit;
(i) Attracting external capital,
(ii) Discouraging growth of competition, and
(iii) Keeping stockholders satisfied. When average of ‘normal’ earnings of a group of firms is used, then only comparable firms and normal periods are chosen.
In short, none of these standards of profits is perfect, A standard is therefore chosen after giving due consideration to the prevailing market conditions and public attitudes. In fact, different standards are used for different purposes because no single criterion satisfies all conditions and all the people concerned.