Profit maximization is the main aim of any business, and therefore it is also an objective of financial management. In financial management, it represents the process or the approach by which profits Earning Per Share (EPS) is increased. All the decisions, whether investment or financing, etc., focus on maximizing the profits to optimum levels.
It is the traditional approach and the primary objective of financial management. It implies that every decision relating to business evaluates in the light of profits. All the decisions concerning new projects, acquisition of assets, raising capital, etc., are studied for their impact on profits and profitability. If the result of a decision is perceived to affect the profits positively, the decision is taken further for implementation.
- Profit Maximization Theory / Model
- Limitations of Profit Maximization as an Objective of Financial Management
Profit Maximization Theory / Model
The Rationale / Benefits:
The following advantages associated with the profit maximization theory encourage directing the business decision:
Profit maximization theory is based on profits, and they are a must for the survival of any business.
Profits are the true measurement of the viability of a business model. Without profits, the business losses its primary objective and therefore has a direct risk to its survival.
Social and Economic Welfare
The profit maximization objective indirectly caters to social welfare. In a business, profits prove efficient utilization and allocation of resources. Resource allocation and payments for land, labor, capital, and organization ensure social and economic welfare.
Limitations of Profit Maximization as an Objective of Financial Management
This concept faces criticism because of some of its limitations that we will discuss below:
The Haziness of the Concept “Profit”
The term “Profit” is vague. It is because different mindsets will have a different perceptions of profit. E.g., profits can be the net profit, gross profit, before tax profit, profit per share, the rate of profit, etc. There is no clearly defined profit maximization rule about the profits. There is always a question on what is the best definition of profit.
Not a Physical Activity
Profit maximization is not a physical activity that one can perform. The other activities that one can practically perform are selling and production of the product. Production is under control, and management can influence easily. Managerial efforts are required in generating revenues, and therefore revenue maximization can be the Strategy to run the business.
Profit is a Function of Revenue and Cost
We know that profits are a function of revenues and costs. Factually, revenue generation and cost incurrence are not simultaneous activities. Costs are incurred first to do the production activity, and then the selling of the product is initiated. Prices also are not known when the product is being produced. After the cost incurrence, which may be considered sunk cost, the only objective left is to maximize the revenues as the cost are no more controllable by the managers.
Ignores Time Value of Money
The profit maximization formula suggests “higher the profit; better is the proposal.” In essence, it is considering the naked profits without considering their timing. Another important dictum of finance says, “a dollar today is not equal to a dollar a year later.” So, the time value of money is completely ignored. Alternatively, we can say that it ignores the timing pattern of cash flow.
Ignores the Risk
A decision solely based on the profit maximization model would decide in favor of profits. In the pursuit of profits, the risk involved is ignored, which may prove unaffordable at times simply because higher risks directly question the survival of a business. Between projects A and B, project A may be more profitable; however, if it is substantially more riskier, project B may be preferable.
The most problematic aspect of profit maximization as an objective is that it ignores the intangible benefits such as quality, image, technological advancements, etc. The contribution of intangible assets in generating value for a business is not worth ignoring. They indirectly create assets for the organization.
Profit maximization ruled the traditional business mindset, which drastically changed. In the modern approach of business and financial management, much higher importance is assigned to wealth maximization than profit maximization. The losing importance of maximizing profit is not baseless. It is not only because it ignores certain important areas such as risk, quality, and the time value of money but also because of the superiority of wealth maximization as an objective of the business or financial management.
Also read – Revenue Vs Profit Maximization.