Historically, profit maximization has been given quite a lot of importance as the prime objective of any business. But, the only way to achieve this is by maximizing revenues. A company cannot focus individually either on revenue maximization or profit maximization. Both of these factors have to work parallelly. Profit maximization solely as an objective has several limitations. Revenue maximization passes all those tests to become a rational objective for any business. Revenue vs. profit maximization is a very broader concept. To understand it, one should have clarity on revenue vs. profit.
Revenue vs. Profit
Profit and revenue are two important parameters in any business. Revenue is the sum of money that a business generates from selling its goods or services. At the same time, profit is the amount of money that a firm earns from the revenues after deducting all the expenses relating to the production of goods or services. Out of revenue vs. profit, profit stands out to be a better measure of a business’s efficiency, success, and sustainability. One should not confuse revenue and profit as a measure of efficiency/sustainability and maximization.
What is Revenue?
Revenue is the company’s sales in general terms, the earnings generated through the company’s primary operations. Expenses deduction does not take place for calculating the revenues.
Is Revenue a Measure of Efficiency/ Sustainability?
Revenues are a very vital part of any business. But they are not a good measure of efficiency because higher revenues do not always assure higher profits.
If a company sells its product/service below its cost of production, it can achieve unlimited revenues, but this revenue will accompany unlimited losses too. Are these revenues worth it? No, because the ultimate goal of a business is not to generate revenues but profits. But, as already mentioned, profit generation cannot be done in isolation. It has a direct link with revenue maximization.
Revenues could be a good indicator of a company’s growth. Increasing revenues are good till they can cover all the expenses and leave some profits.
What is Profit?
Profit is the surplus of total revenues after deducting all the expenses. It is the real measure of the efficiency or success of any business. No business can sustain for long without profits. Profit for a company includes all types of profits, whether they are from the business’s principal activity or other incomes such as a sale of machinery or scrap, interest or dividend from investments, etc.
Is Profit a Measure of Efficiency/Sustainability?
Profits are the lifeblood for any business to sustain and grow. If we compare revenue vs. profit as a measure of sustainability, profit will be the winner. At the same time, profit maximization is not the only way of looking at the welfare of a company. It is also equally important where this profit has come from.
Net Profit Figures can Mislead too
Suppose the income statement of the paper manufacturer shows a total profit of $500 million. On deep diving into the reports, we see that $600 million of profits is from other activities like interest, dividends, sale of machinery, etc. This suggests that the main activity, i.e., paper manufacturing, is generating a loss of $100 million. Here, the sustainability of this business is questionable because it is making losses in the activity/business for which its existence is in place. Since other incomes are not regular incomes and possibly won’t be there in the next year if they continue doing business in the same fashion, they will generate losses every year and slowly erode their capital.
In place of looking at the absolute net profit figures, it is important to check the source of net profit. Broadly, there are two sources – operational and non-operational.
Read Earnings vs Revenue to learn about the various difference between profit and revenue.
Goal of Business: Revenue vs. Profit Maximization?
There are probably three goals of a business with their pros and cons.
Increasing revenue as a goal should not be the only focus. Although the increase in revenue is a sign of the growth of the business, it should be accompanied by profits. The marginal revenue of the year should be the profit-making revenue. The product’s price should cover all the expenses and generate profits for the firm.
Maximizing profits is a superior goal in comparison to revenue maximization. Although, increasing profits have a direct link with growing revenues. General statements like “higher the revenues, higher will be the profits” proves wrong when the company generates additional revenue at a loss or a lesser profit margin.
What should be the Strategy?
It has been a difficult situation for managers in any “for-profit” business to decide on which goal to focus on. Managers need to keep all the stakeholders satisfied. Shareholders want appreciation in the value of their capital and regular dividends, which calls for profit maximization. On the other hand, sales are the driving factor for all, including the profits and performance of managers, which calls for revenue maximization or sales maximization.
It is a fact that profits are the lifeblood of any business, but at the same time, these profits are a by-product of revenues. There seems to be a strong and direct link between revenue and profits. But the limitation is that profits are not a physical activity. The company derives revenue from other activities like selling and producing. Practically, a manager can focus on revenue maximization rather than profit maximization.
The differences begin with the introduction of price and output. It is because the company cannot achieve all output levels at a fixed price. So, the correlation between profits and revenues may not show direct relation because higher sales or revenue with lower product prices will dip profits. Here, an increase in sales is not leading to a rise in profits.
Limitations of Profit Maximization
Why Revenue (Sales) Maximization and not Profit maximization?
- First of all, profit maximization is not a physical activity that one can perform. The other activities which 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.
- Secondly, we know that profits are a function of revenues and costs. Factually, the revenue generation and costs 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.
To further understand the situation, let us take an example. The sales of Air Conditioners (AC) in the market are dependent on the summer season. If it is too hot, the sales would be too high and vice-versa. The decision to produce the AC cannot be taken once the summer has arrived, but it has to be taken at the time of winter on the basis of some assumption and perception of a profitable venture. Profit maximizing objective cannot be pursued because one of the factors (i.e., cost) is not under control, and therefore the objective left is sales maximization.
Considering the limitations as discussed, the profit maximization as an objective, we can not safely conclude that revenue or sales maximization is a better or obvious choice for the managers.
Also read Profit vs. Wealth Maximization.