Profit maximization is the process of increasing profits to the greatest possible amount, selling as many products or services as possible at the highest possible price while reducing the costs and overheads at the lowest level possible.
Meaning of Profit Maximization
Profit maximization means maximizing the firm’s profit. To achieve the goal, the financial manager would only take actions expected to contribute to the firm’s overall profits significantly.
For each alternative being considered, the financial manager would select the one expected to result in the highest monetary return.
Firms commonly measure profits in earnings per share (EPS), which represents the amount earned during the period on behalf of each outstanding share of common stock.
Definition of Profit Maximization
The ultimate goal of profit maximization is achieving the highest profitability possible to benefit shareholders and owners.
A company focuses on reducing costs by streamlining production processes or negotiating better deals with suppliers to maximize profits.
Profit maximization means maximizing the profit of the firms. In economic theory, the behavior of a firm is analyzed in terms of profit maximization.
Some people believe that the firm’s objective is always to maximize profit. While maximizing profit, a firm either produces maximum output for a given amount of input or uses minimum input for producing a given output.
Thus, the underlying logic of profit maximization is efficiency.
- “Profit maximization is the maximization of a firm’s net income.” – C. P. Jones.
- “Profit maximization means maximizing the rupee (currency) income of firms.” – I. M. Pandey.
- “The maximization of the firm’s net income is called profit maximization.” – Weston & Brigham.
- “The profit maximization criterion implies that the investment, financing, and dividend policy decisions of a firm should be oriented to the maximization of profit/EPS.” – Khan & Jain.
- “To achieve this (maximize profit) goal, the financial manager would take only those actions expected to make a major contribution to the firm’s overall profits.” – Lawrence J. Gitman.
Rationale and Objection to Profit Maximization
Profit maximization has some rationale and objections, which are given below:
- It is argued that profit maximization assumes perfect competition in the face of imperfect modem markets. It cannot be a legitimate objective of the firm.
- It is also argued that profit maximization is a business objective. However, it may be the only aim of the single-owner firm.
- Profit maximization behavior in a market economy may tend to produce goods and services. It is also feared that wasteful and unnecessary from society’s point of view.
- Profit is the only indicator of the growth of a firm. It might lead to inequality of income and wealth.
- Monopolies are quite a common phenomenon in modem economics. The main objective is to earn profit. It may not work due to imperfections in practice.
- Because of such conditions, it is difficult to have a truly competitive price system. It is doubtful if the profit-maximizing behavior will lend to the optimum social welfare.
4 Limitations of Profit Maximization
Profit maximization fails to serve as an operational criterion for maximizing economic welfare. It fails to provide an operationally feasible measure for ranking alternative courses of action in terms of their economic efficiency.
Definition of Profit
The precise meaning of the profit maximization objective is unclear. The definition of the term profit is ambiguous. Does it mean short or long-term, before or after tax, total or net profit? It is not clear.
Time Value of Money
The profit maximization objective does not distinguish between returns received at different times. It does not consider the time value of money; it values benefits received today and benefits received after a period as the same.
Cash Flows
Profits do not necessarily result in cash flows available to the stockholders. Owners receive cash flow in cash dividends or the proceeds from selling their shares for a higher price than initially paid.
Greater EPS does not necessarily mean that a firm’s board of directors will vote to increase dividend payments.
Risk and Return
The streams of benefits may possess different degrees of risk.
Two firms may have the same returns, but if one firm’s returns fluctuate considerably compared to the other, it will be riskier. Possibly, owners of the firm would prefer smaller but sure profits to a potentially larger but less certain stream of benefits.
Because profit maximization does not achieve the objectives of the firm’s owners, it should not be the goal of finance.
Profit Maximization Inconsistent With Wealth Maximization?
Profit and wealth maximization are two different objectives a business can have.
Profit maximization refers to the idea that a business should maximize its profits by increasing revenue or decreasing costs as much as possible. This can be done by selling more products or services or finding cheap ways to produce them.
On the other hand, wealth maximization refers to the idea that a business should maximize the wealth of its owners or shareholders.
This means that the business should aim to increase the company’s value, which may involve making investments or taking on risks that may not maximize profits in the short term but are expected to pay off in the long term.
One reason profit maximization may be inconsistent with wealth maximization is that a business focused on maximizing profits may not make the investments or take risks needed to increase the company’s value over the long term.
This can lead to missed opportunities for growth and may result in the company is worth less in the long run.
On the other hand, a business that focuses on wealth maximization may be more willing to take on such risks, which could lead to increased value for the company and its shareholders in the long term.
Profit maximization and wealth maximization are not necessarily inconsistent with each other, and a business can pursue both objectives at the same time.
Why is shareholders’ wealth maximization important? – Is shareholder wealth maximization immoral?
Shareholder value shows a company’s ability to make money for its shareholders in the future.
Shareholders’ wealth maximization measures a company’s value and performance in the market.
Suppose a company cannot generate low or no profit, and all its capital is tied up in assets that aren’t generating revenue. In that case, investors will withdraw their money from your business until you are forced into bankruptcy or restructuring.
To ensure long-term stability and profitability across different industries and market conditions, a company must maximize shareholder wealth.
The corporation board’s responsibility is to maximize the value of the company’s shares for the shareholders, which requires wealth maximization and profit maximization. So wealth maximizing for the shareholder wealth is not immoral.
Distinguish between profit maximization and wealth maximization
| Points of Distinction | Profit Maximization | Wealth maximization |
|---|---|---|
| Definition | The value of the firm could not be increased by profit maximization | Maximization of share price refers to the wealth maximization of a firm |
| Time Value of Money | It doesn’t .consider the time value of money | It considers the time value of money |
| Value of the firm | By increasing the share price the total value of the firm can be increased | By increasing the share price, the total value of the firm can be increased |
| Risk | It does not consider the uncertainty & risk. | It considers the uncertainty and risk |
| Cash flows | It doesn’t consider the cash flows | It considers the cash flows |
| Exactness | It is not a clear concept | It is a clear concept |
Conclusion
The main objective of a business is to maximize its worth, items of assets, liquidity, and market share.
