Profit maximization is the main aim of any business and therefore it is also an objective of financial management. Profit maximization, in financial management, represents the process or the approach by which profits Earning Per Share (EPS) is increased. In simple words, all the decisions whether investment or financing etc. are focused on maximizing the profits to optimum levels.
Profit maximization is the traditional approach and the primary objective of financial management. It implies that every decision relating to business is evaluated in the light of profits. All the decisions with respect to 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 have a positive effect on the profits, the decision is taken further for implementation.
Profit Maximization Theory / Model
The Rationale / Benefits:
Profit maximization theory of directing business decisions is encouraged because of following advantages associated with it.
Profit maximization theory is based on profits and profits are a must for 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 takes care of social and economic welfare.
Limitations of Profit Maximization as an objective of Financial Management
Profit maximization is criticized for some of its limitations which are discussed below:
The haziness of the concept “Profit”
The term “Profit” is a vague term. It is because different mindset will have a different perception of profit. For e.g. profits can be the net profit, gross profit, before tax profit, profit per share or the rate of profit etc. There is no clearly defined profit maximization rule about the profits.
Ignores Time Value of Money
The profit maximization formula simply suggests “higher the profit better is the proposal”. In essence, it is considering the naked profits without considering the timing of them. 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 timing pattern of cash flow.
Ignores the Risk
A decision solely based on profit maximization model would take a decision 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 questions the survival of a business. Between project A and B, project A may be more profitable however if it is substantially more riskier than 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 has gone through drastic changes. In the modern approach of business and financial management, much higher importance is assigned to wealth maximization in comparison of Profit Maximization vs. Wealth Maximization. The losing importance of profit maximization is not baseless and 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.