The following points highlight the two main policies on profit maximization. The policies are: 1. Setting Profit Standards 2. Profits for Control.
Profit Maximization: Policy # 1.
Setting Profit Standards:
If we consider the above six factors we observe that many companies, particularly big ones, do not operate on the principle of maximizing profit in terms of marginal cost and marginal revenue but rather set standards or targets of reasonable (satisfactory) profits.
This problem arises only in the real world of imperfect competition. In pure competition, prices have to be set close to the cost level and a firm can stay solvent only by trying to maximize profits. But multi-product companies may have a substantial monopoly position. They enjoy considerable pricing discretion both in the short run as well as in the long run. Such firms have to make crucial policy decisions on profit standards.
Forms of Standard:
Profit standards can be formulated in aggregate rupee terms (like Rs. 10,000 per annum), as a percentage of sales (like 12% of total sales revenue), or as a return on investment (like 10% on capital employed). They can be formulated for individual products or the whole product line for multi-product firm.
The form of profit standard that is appropriate depends on the use to which it is put. If the object is to discourage potential competitors, revenue on investment is the relevant standard, if, of course, entrants have similar costs. But if the object is to please the customers or to beat down suppliers, percentage, margins over unit cost in relation to the rupees they spend, is usually appropriate.
Dean has argued that “ratios of profits to sales are an eccentric standard of profitability. They vary widely among firms that have the same return on invested capital when there are differences in vertical integration of production processes, depth of mechanization, and capital structure and turnover. Since conventional net profits are principally an investor’s income, return on capital is the most important form of profit standard from the owners’ viewpoint.”
Four major criteria are used for setting profit standard:
(1) The Capital-attracting rate of return:
Here the question is: what it takes to attract outside capital. A profit standard can be formulated in terms of the cost of new capital in the capital market. The capital-attracting rate depends on the company’s capital structure.
(2) The ‘plough-back’ rate:
The second standard is in terms of the aggregate profits that must be retained in the business to finance a desired rate of growth without resorting to the capital market.
(3) Normal earnings:
The third criterion of reasonable profits is normal earnings of the company or of any industry group, conceived in terms of some average level over a normal period. In this context a strictly autonomous standard, such as the firm’s own past earnings, has enough validity.
(4) Reasonable earnings:
The final criterion is based on the results of surveys to find the public’s idea of a fair profit.
Profit Maximization: Policy # 2.
Profits for Control:
There are often deviations from the profit motive.
Three reasons account for this affair:
(1) Managers and executives spend most of their energy in expanding sales volume and product lines than in raising profitability.
(2) Subordinates spend lot of time, money and energy to do jobs perfectly regardless of cost and usefulness.
(3) Lower management feels insecure most of the time. There is always a fear of loss of jobs. They attempt to play safe because there is no reward for imaginative ventures.
There is need to counter tendencies which run contrary to profit-maximization. So there is need to exercise controls over executive performance. Two methods may be used for the purpose.
1. Firstly, there is need to re-align managerial organization “to shift the basic breakdown of operating responsibility from a functional basis (e.g., marketing, versus production, versus finance) to a commodity basis. The effect is to break the company up into several integral operating units (divisions) and give the executive, authority over all functions in his divisions, and make him responsible for profits.”
Of course, these divisional managers have to operate under a higher executive echelon.
2. Secondly, there is needed to reorient company reports “to conform to the areas of executive responsibility. Each executive is given a profit goal for his operation and his performance is appraised on the basis of periodic profit and loss statements, as well as subordinate budgetary controls.”