Objectives of Business Firms

Presenters:
Jatinder Sharma
Kundan Kumar Thakur
Id Mohammad -114
Mukesh
Presented to: Raj kumar
khadka-104
Dr. Divya Verma
Santosh
 INTRODUCTION
The first and most important responsibility
of a business manager is to achieve the
business objective of the business firm he
manages. The primary objective of a
business firm is to make profit. Some
important objectives, other than profit
maximization are-
a) maximization of sales revenue.
b) Maximizations of firm’s growth rate.
c) Long run survival of the firm
d) Entry prevention and risk avoidance.
etc
 Profit as Business Objective
Profit
In a general sense ‘profit’ is regarded as income
accruing to the equity holders, in a same sense wages
accrue to the labour, interest accrues to the money
lenders.

Acc.. To layman-
“ profit means all income that
flows to the investors”.

Profit is defined in two different ways, one for

economics and one for accounting.
 Accounting vs. Economic profit
Accounting profit- profit is surplus of total revenue
over and above all paid-out costs, including both
manufacturing and overhead expenses. Accounting
profit equals revenue minus all explicit cost.

Economic Profit- economic profit is the difference

between a company's total revenue and its opportunity
costs. Economic profit equals revenue minus both
implicit and explicit cost.
 Problems in profit
measurement
In profit measurement, two questions
complicates
the task of measuring profit:-
a) which accounting concept should use for measuring profit?
b) What cost should be or should not be included in the
implicit and explicit cost?
The use of profit concept depends on
the purpose of measuring profit.
Accounting concept of profit is used when the purpose is to
produce a profit figure.
Economic concept is used to measure the ‘true profit’.
 1. Treatment of capital gain and
losses
Capital gain and losses are regarded as ‘windfalls’.
Fluctuations in the stock market price is the most
common source of ‘windfalls’.
In accounting concept, if sound accounting policy is
followed, there will be one profit and if other method is
followed then there will be another figure of profit. That is the
problem.
In economic concept, the economist would suggest
that the management should be aware of the approximate
magnitude of such ‘windfalls’ long before they become precise
enough to be acceptable by accountants.
 2. Current vs. Historical cost
The use of historical cost accounting excludes routine
adjustments for inflation. The main advantages of using
historical costs is Simplicity and certainty. The biggest
disadvantage is that book values may be based on badly
outof date costs. This becomes more of a Problem during
periods of high inflation. Historical cost recording does not
reflect such changes in values of assets and profits. This
Problem assumes a critical importance in case of
inventories and material stocks.
 Three popular methods of inventory
valuation
a) FIFO (first in first out)-this system exaggerates profits at
the time of rising price
b) LIFO (last in first out)-when inventory level fluctuate, this
method losses its advantages.
c) WAC (Weighted average cost )-this method takes the
weighted average material cost purchased at different prices
and different points of time to evaluate the inventory.

All these methods have their own weaknesses and

therefore, they do not reflect the ‘true profit’ of
business. So the problem of evaluating inventories so
as to yield a true profit figure remains.
 3.Problems in measuring
depreciation
Economist view depreciation as capital consumption from their
point of view, there are two distinct way of charging for
depreciation:-

a)Depreciation of an equipment must equal its opportunity cost

b)The replacement cost that will produce comparable earning.

To accountants depreciation is an allocation of capital

expenditure over time. To find out a depreciation a firm can
apply any one out of four methods
-straight-line method= cost of capital/years of capital life
-Reducing balanced method
-Annuity method
The above three methods gives three different
measures of annual depreciation and hence the different level
of profit.
 Theories of Profit

PROFIT AS RENT OF ABILITY

• F.A.WALKER
• Profit is the rent of "Exceptional abilities that an
entrepreneur may possess “ over others.
• profit is the difference between earning of the
least and the most efficient entrepreneurs.
• Assumed a state of perfect competition in
which all firms are presumed to possess equal
managerial ability
• under perfect competition there would earn
only managerial wages , which is popularly
known as 'normal profit'
 DYNAMIC THEORY OF
•
•
PROFIT
JB CLARK 1900
Distinction between a static and dynamic economy is fundamental to this theory of
profit.
• According to him profit are exclusively the result of dynamic change and no profit in
static economy.
• In this theory under static condition in a stationary state where no change in:
I. demand and supply
II. no increase either population or capital
III. method of production
IV. Firms of industrial organisation do not change and want of consumer do not
multiply.
• In static society since payments are made on the basis of managerial productivity
the total product will be distributed between wages and interest .the only income
of the entrepreneur is his wages of management or for co ordination or for his
routine work of supervision.
• In static economy every thing is known and knowable .there is no risk and
uncertainty is hence there are no profit.
• The long period competitive equilibrium is a good example of static economy.
• Clark says that our society is a dynamic one and changes
take place init every moment
I. change in the size of population
II. change in the supply of capital
III. change in production technique
IV. change in the forms of industrial organisation
V. change in human want

A. INTERNAL FACTOR
• new discovery
• new inventions
• innovation
• new production line
B. EXTERNAL FACTOR
• Regular change like trade cycle which may affect profit.
• Irregular change which may affect profit such as five,
earthquake change in national and international policies
etc.
CRITICISM OF THE DYNAMIC THEORY OF PROFIT

• The theory fails to make any difference in a

change that is foreseen and one that is unforeseen
in advance .As prof. knight point out, it is not all
types of dynamic change that lead to profit . it is
only those changes which cannot be foreseen that
give rise to profits.
• profits may also emerge in the absence of Clark's
five principal dynamic changes.
• Lastly , as prof. Taussig point out ,Clark's dynamic
theory creates an artificial distinction between
profits and wages of management.
 RISK THEORY OF PROFIT
• The risk theory of profit was propounded by an
American economist ,pofo. Hawley in his book
"Enterprise and the productive process"1907
• According to this theory risk taking is the main
function of the entrepreneur and profit is the
reward for risk taking.
• there is a time gap between the production and
selling of goods in the market.
• in modern era an entrepreneur has to forecast
about demand , cost , price etc . If these forecast
• prove true there will be profit, otherwise there can
be losses to entrepreneur.
• According to him “ There is proportional
relationship between risk and profit.
CRITICISM

• according to carver ,“ profits arise not because risk

are borne by the entrepreneurs, but because the
superior entrepreneurs are able to reduce them."
• according to prof. knight "profit is not the reward for
all types of risks . only uncertain risk provide basis for
profit . entrepreneur can cover certain risk by the
payment of insurance premium."
• There in no direct and proportion relationship
between profit and risk.
• other factor like monopoly gains , windfall gains etc.,
are not being considered by this theory.
UNCERTINTY BEARING THEORY OF
PROFIT
• prof.h.knight
• Uncertainty baring and not the risk
taking is the main function of the
entrepreneur for which he gets profit.
• prof. knight has divided risk into two
parts
• certain risk these are those risk which
are know foreseeable and insurable.
• uncertainty risk there are some risk
which cannot be foreseen.
• prof. knight pointed out that profit is the
reward for such unforeseen risk . which
cannot be insured or avoided.
CRITICISM
• Profit is not simply the reward of uncertainty bearing ,
rather is also the reward for management , organisation
and innovations etc .This theory does not give any place
to such function as coordination , supervision and decision
making.

• This theory considers uncertainty bearing as a separate

factor , which is not true . to bear uncertainty is just one of
the many important features of entrepreneurs working.

• sometimes there is no profit to entrepreneurs working.

• this theory does not explain the problem of profit

determination.
 INNOVATION THEORY OF
PROFIT
• Joseph schumpeteran eminent American economist.
• Profit to the introduction of innovation in the production
process or the sale of the product.
• He observed that the function of an entrepreneur is to
introduce innovation.
• Schumpeter pointed out that innovations can be of five
types:-
A) production of new or different kind of goods.
B) Adoption of new techniques of production.
C) Discovery of new source of raw material.
D) Discovery of new market for increasing sales.
E)change in the organisation of production.

Due to these innovations, there arises a difference

between cost of production and price, which gives rise to
profit.
COST
CRITICISM

• In this theory, no importance has been

given to uncertainties , whereas all
innovation are uncertain.
• Schumpeter did not give any
importance to risk taking function of the
entrepreneur.
• This theory ignores other factors which
are also responsible for the emergence
of profits.
MONOPOLY POWER AS SOURCE OF
PROFIT
• Monopoly is said to be another source of pure profit.
• An extrim contrast of perfect competition is the existence of
monopoly in the market . Monopoly characterizes a market situation
in which there is a single seller of a commodity without a close
substitute.
• Monopoly may arise due to such factors as
• economies of scale,
• sole ownership of certain crucial raw materials,
• legal sanction and protection and
• mergers and takeovers.
• A monopolist may earn 'pure profit' or what is generally called in
this case, 'monopoly profit', and maintain it in the long run by using
its monopoly powers.
• monopoly powers include
• power to control supply and price;
• powers to prevent the entry of competitors by price cutting and
• In some case, monopoly power to exercise control over certain input
markets.
 Profit Maximization
Profit maximization has been the most important assumption on which economics have built
price and production theories.

The conventional economic theory assumes profit maximization as the only objective of business
firms which forms the basis of conventional price theory. so It is regarded as the most reasonable
and analytically the most ‘productive ’ business objective.

Generally, profit maximization is a stage where a firm can earn the highest profit from a single
rupee investment.

Profit maximizing conditions:

Total profit (TP)is defined as:

TP = TR – TC

Where, TR= Total Revenue and TC = Total Cost

There are two conditions that must fulfilled for TR – TC to be maximum. These conditions are
called:
I.Necessary or the first- order condition
II.Secondary or supplementary condition

i)Necessary or the first order condition : A necessary condition is one that must be satisfied for
an event to take place. It is the condition which requires MR=MC to be satisfied for profit to be
maximum.
The first –order condition of profit maximization is that the first derivative of profit function
must be equal to zero. Differentiating the total profit function and setting it equal to zero, we
get
∂TP/ ∂Q = ∂TR/ ∂Q - ∂TC/ ∂Q = 0--------------------equn (i)

The condition holds only when

∂TR/ ∂Q= ∂TR/ ∂Q

In equation (i), the term ∂TR/ ∂Q gives the slope of the TR curve which in turn gives the
marginal revenue(MR). Similarly, the term ∂TC/ ∂Q gives the slope of the total cost curve which
is the same as marginal cost (MC). Thus, the first-order condition for profit maximization can
be stated as :
MR=MC
ii) Supplementary or second-order condition: The second-order quantity of profit
maximization requires that the first order condition is satisfied under rising MC and decreasing MR.
Technically, the second-order condition requires that the second derivative of the profit
function is negative .

The second derivative of the total profit function is given as:

∂2TP/ ∂Q2 = ∂2TR/ ∂Q2 - ∂2TC/ ∂Q2 …………………………..ii

The second-order condition requires that

∂2TR/ ∂Q2 < ∂2TC/ ∂Q2

Since ∂2TR/ ∂Q2 gives the slope of MR and ∂2TC/ ∂Q2 gives the slope of MC, the second order
condition may also be written as :

slope of MR = slope of MC

It implies that MC must have a steeper slope than MR or MC must intersect the MR from below.
Hence, profit is maximized where both the first and second order conditions are satisfied.

It is illustrated by the help of following figure:

 Profit maximization by the
P total cost-revenue and
TC Marginal Cost-revenue
1
Profit/revenue/cos

concept:
P
TR TC= Total Cost
TR= Total Revenue
P= break even point
t

P1= profit maximization point

MC= Marginal cost

MR= Marginal Revenue

O Q Q1 MC and MR curves are derived from TC

and TR functions respectively.
MC
MC and MR curves intersect at two
A points, P1 and P2.
B Thus, the first order Condition is satisfied
at both the points , but the second order
M condition of profit maximization is
R satisfied only at point B i.e. MC must
Intersect MR from below. Hence, it is a
profit maximization point.
O
Quantity
 Controversy over profit Maximization
Objective
Arguments against Profit maximization objective :

 Traditional theory assumes full and perfect knowledge about current market conditions and
the future developments in the business environment of the firm.
i) Modern economists question the validity of this assumption. They argue that the firms do
not posses the perfect knowledge of their costs, revenue and future business environment
because they operate in the world of uncertainty where most price and decisions are based
on probabilities.

 The equi-marginal principle of profit maximization, i.e. equalizing MC and MR, has been
claimed to be absent in the decision-making process of the firms. Empirical studies of the
pricing behaviour of the firms have shown that the marginal rule of pricing does not stand
the test of empirical verification .

The defence against arguments:

 The traditional theory seeks to explain market mechanism, resource allocation through
price mechanism and has a predictive value, rather than deal with specific pricing practices
of certain firms.
 In Maclup opinion , the practices of setting price equal to average
variable cost plus a profit margin is not incompatible with the
marginal rule of pricing and that the assumptions of traditional
theory are reasonable.

While the controversy on profit maximization objective remains

unresolved, the conventional theorists, the margianlists, continue
to defend the profit maximization objective and its marginal rules
time to time.
 Alternative Objectives of Business Firms

Baumol’s hypothesis of sales revenue

maximization

Baumol has postulated maximization of sales

revenue as an alternative to profit maximization
objective. He attributes this objective to the
dichotomy between ownership and management in
large business corporations. This dichotomy gives
managers an opportunity to set their goals other
than profit maximization goal which most owners
and businessmen pursue. Given the opportunity,
managers choose to maximize their own utility
function. According to baumol, the most plausible
factor in managers utility functions is maximization
of the sales revenue.
 According to Baumol, the factors which
explain the pursuance of sales
maximization by the managers are
following.
1. salary and other earnings of managers are more closely
related to sales revenue than to profits.
2. Banks and financial corporations look at and lay a great
emphasis on sales revenue while financing a corporation.
3. Trend in sales revenue is a readily available indicator of
the performance of the firm. It helps also in handling the
employee’s problem of awarding efficiency and penalizing
inefficiency.
4. Profit figures are available only annually, sales figures can
be obtained easily and more frequently to assess the
performance of a management. Maximization of sales is
more satisfying for the managers than the maximization
of profits which go to the pockets of the shareholders.
 Contd…
5. Managers find profit maximization a difficult
objective to fulfill consistently over time and
at the same level. Profits may fluctuate with
changing conditions.
6. Growing sales strengthen competitive spirit of the
firm in the market whereas decreasing sales put
the survival of the firm at risk.
Baumol’s model
MR
=0

k1
k2
k3
 Marris’s Hypothesis of Maximization of Firm’s
Growth Rate
Marris defines firms balanced growth rate(G) as
G = GD = GC
Where GD = Growth rate of demand for firm’s product,
GC = Growth rate of capital supply to the firm.

Marris translates the two growth rate into two utility functions:
Um = f(Salary, Power, Job Security, Prestige, Status)
U o = f(Output, Capital, Market-share, Profit, Public esteem)

The Um & U o are positively correlated with size of firm. Therefore managers seeks
to maximise the size of firm. Maximization of size of the firm depends on the
maximization of its growth rate. Hence, The managers seek to maximize a
steady growth rate.

Drawback:
 Fails to deal satisfactorily with oligopolistic interdependence.
 It ignores price determination.
 Williamson’s Hypothesis of Maximization of
Managerial Utility Function
Williamson say managers have discretion to pursue objectives
other than profit maximization. Instead of maximizing profit,
the managers of modern corporations seek to maximize their
own utility function subject to a minimum level of profit.

Managers’ utility function(U) is expressed as:

U = f(S, M, ID)
Where S = additional expenditure on staff,
M = managerial emoluments,
ID = discretionary investments.

Drawback:
 Fails to deal with the problem of oligopolistic interdependence.
 It only apply where rivalry between firms is not strong.
Cyert-March Hypothesis of satisfying Behavior

According to the Cyert-March hypothesis, firm’s behaviour is ‘satisfying behaviour’. It say

apart from dealing with uncertain business world, managers have to satisfy a variety of
groups like managerial staff, Workers, Shareholders, customers, financers, input
suppliers & authorities. All these groups have some kind of expectations, high or low,
from the firm & the firm or managers seeks to satisfy all of them in one way or another
way by sacrificing some of its interest.

Drawback:
 It does not explain the firm’s behaviour under dynamic conditions in long run.
 It cannot be used to predict exactly the future course of firm’s activities.
 This theory does not deal with the equilibrium of the firm or the industry.
 ROTHSCHILD’S HYPOTHESISLONG – RUN
SURVIVAL AND
MARKET SHARE GOALS

• Primary goal of the firm is long run survival.

•Some other economists have suggested that attainment and retention

of a constant market share is an additional objective of the firms. The
managers, therefore, seek to secure their market share and long-run
survival.

• The firms may seek to maximize their profit in the long-run though
it is not certain.
 Entry prevention and risk-avoidance
• Alternative objective of the firms suggested by some economists is to
prevent entry of new firms in to the industry
• Motive Behind entry-prevention
• Profit maximization in the long run
• Securing a constant market share.
• Avoidance of risk caused by unpredictable behavior of new firms.
Only profit maximizing firm can survive in the long run . They achieve all
others subsidiary goals easily if they can maximize their profits.

• Prevention of entry may be the major objective in the pricing policy of

the firm, particularly in case of limit pricing
 Making a reasonable profit- A Practical
Approach

Reasons for aiming at reasonable profits

• Preventing entry of competitors:- profit maximization under imperfect
market conditions generally leads to high “pure profit” which is bound to
attract competitors, particularly in case of a weak monopoly.
• Projecting a favorable public image:- it become often necessary for
large corporations to project and maintain a good public image, because if
public opinion turns against the firm, its begin to fall
• Maintain customer goodwill:- customer’s goodwill plays a significant
role in maintaining and promoting demands for the product of a firm.
• Customer’s goodwill depends largely on the quality of the product and
its ‘fair price”.
• Firms aiming at better prospects in the long run, sacrifice their short –
run profit maximization objective in favour of a reasonable profit”
 Standards of reasonable profit
• Forms of profit standards may be determined in terms
of
• Aggregate money terms
• % of sales
• %return 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 than other
standards. But when purpose is the appropriate profit
standards, provided competitors ‘ cost curve are
similar.
• Setting the profit standards
• The following are the important criteria that are taken
into account while setting the standards for a
“reasonable profits”.
• Capital – attracting standard. Important criterion used in setting
standards profits is that it must be high enough to attract
external(debt and equity) capital. For example if a firms stocks
are being sold in the market at five times their current earning , it
is necessary that the firm earns a profit of one – fifth or 20% of
the book investment.

• Normal earning standards : standards of reasonable profits is the

‘normal’ earning of firms of an industry over a normal period.
Company’s own normal earnings over a period of time often serve
as a valid criterion of reasonable profit, provided it succeeds in

• Attracting external capital.

• Discouraging growth of competition
• Keeping stockholders satisfied.
• When average of normal earning of a group of firms is used, then
only comparable firms and normal periods are chosen.
Continental Airlines was doing something that seemed like a horrible mistake.
All other airlines at the time where following a simple rule: They would only
offer a flight if, on average 65 % of the seats could be filled with paying
passengers, since only then could the flight break even. Continental, however,
was flying jets filled to just 50 % of capacity and was actually expanding flights
on many routes. When word of Continental’s policy leaked out, its stockholders
were angry and managers of competing airlines smiled knowingly, waiting for
Continental to fail. Yet Continental’s profit already higher then the industry
average continued to grow. What was going on?

There was, indeed, a serious mistake being made, but by the other airlines, not
Continental. This mistake is using average cost instead of marginal cost to make
decisions. The “65 percent of capacity” rule used throughout the industry was
derived more or less as follows:

 The total cost of the airline for the year (TC), was divided by the no. of
flights during the year(Q) to obtain the average cost of a flight (TC/Q= ATC).
For the typical flight, this came to about $4000, the industry regarded any flight
that repeatedly took off with less then 65 % as a money loser and cancelled it.

As usual, there are two problems with using ATC in this way.

i)first, an airlines average cost per flight includes many costs that are fixed and
are therefore irrelevant to the decision to add or subtract a flight. These include
the cost of running the reservation system, paying interest on the firm’s debt,
and fixed fees for landing rights at airports-non of which would change it the
firm added or subtracted a flight.
ii)Also, average cost ordinarily changes as output changes, so it is wrong to
assume it is constant in decisions about changing output.
Continental’s management, led by its Vice-President of operations, had decided
to try the marginal approach to profit. Whenever a new flight was being
considered, every department within the company ask to:

Determine the additional cost they would have to bear. Of course, the only
additional cost were for additional variables inputs, such as additional flight
attendants, ground crew personnel, in flight meals, and jet fuel.
These additional flight-$ 2000- was significantly less then the marginal revenue of
a flight filled to 65% of capacity-$ 4000. the marginal approach to profit tells us
that when MR>MC, output should be increased, which is just what Continental
was doing. Indeed, Continental correctly drew the conclusion that the Marginal
revenue of a flight filled at even 50% of capacity-$ 3000 – was still greater then
its marginal cost, and so offering the flight would increase profit. This is why
continental was expanding routes even when it could fill only 50% of its seat.

In the early 1960’s Continental was able to outperform its competitors by using a
secret- the marginal approach to profits. Today, of course, the secret is out, and
all the airlines use the marginal approach when flights to offer.

“Airline Tasks the marginal bone” Business week, April 20,1963

Than-Q?