Objectives of a Firm

Objectives of a Firm

Maximisation of Profits

Maximisation of profits ( Milton Friedman)• Most common and theoretically easy• Profits indispensable for a firm’s survival • Whatever the stated objective, bottom line is

always important • Achieving other objectives depends on the

firm’s ability to maximise profits• Reliable measure of firm’s efficiency and

future performance

Maximisation of Profits

• Golden Rule of Profit Maximization

• Profit = TR – TC

• Profit maximizing output is at the point where the gap between TR and TC is maximum

Maximisation of Profits

• Which measure of profit- gross/ net/ before/ after tax-?

• Time period- current/ next year/ neat 5/10 years?

• If future profit, time value of money

• Impossible to max profits in competitive markets

Maximisation of Sales Revenue

Baumol’s hypothesis: Managers aim at Maximisation of firm’s total Revenue rather than profits

In competitive markets, sales volume determines market leadership

• Separation of management and ownership- For managers, salary and other earnings are more closely related to sales revenue rather than to profits;

• Measure of performance

Maximisation of Sales Revenue

• Sales revenue important for financial institutions and banks while financing;

• Data on trends in sales revenue is a readily available indicator of performance;

• Consistently maintaining profits is difficult for managers but increasing sales revenue is feasible

• Growing sales strengthen competitive spirit

Maximisation of Sales Revenue

• Empirical evidence does not lead to decisive conclusion on Baumol’s hypothesis

Maximising Firm’s Growth Rate

Marris’ Hypothesis of Maximising Firm’s Growth Rate: When this happens, managers maximise their own utility function as well as that of the owners.

• Owners(shareholders) aim at maximising profits and market share;

• Managers aim at better salary, job security and growth

• The two sets of aims can be achieved by maximising growth

• G= GD =GC where GD= f(d,k) & GC= f(r, π)

• GD= Demand for firm’s product where d

• is diversification and k is success rate)

• GC=Growth rate of capital supply

• R is weighted average of 3 financial ratios π is rate of increase of profit

• The above proposition has the following constraints:

• Um= Utility function for managers

Um= f(Salary, power, status, security)

Uo= Utility function for shareholders

• Uo= f(profit, market share, brand image)

Managers must try to maximise GD and GC

Maximising Managerial Utility Function

• Williamson’s Hypothesis of Maximising Managerial Utility Function-

• Combination of profit and growth maximisation objectives

• Managers apply their discretionary power to maximise their own utility function

• Includes variables like salary, prestige, power, job security, professional satisfaction

• Um= f(S, M, ID)

• S= Salary

• M= Managerial emoluments

• ID= power of discretionary investment

Objectives of a Firm

• Entry Prevention and Risk Avoidance• “Reasonable Profit”- to prevent entry of

competition, project a favourable public image, restraining trade union demands, maintaining customers’ goodwill, to prevent possibility of government take-over

• For public sector, objective is to maximise social gains- for private sector, maximising profits is a strong aim.

• Modern corporations like to pursue multiple objectives.

• Rothschild’s hypothesis of Long run survival and Market share Goals- Attainment and retention of a constant market share

Break Even Analysis

• In traditional theory of the firm, the basic objective of the firm is to maximise profits.

• But profit is maximum at a certain level of output and it is difficult to know what would be the profit-maximising output at the outset;

• Even if it is known it can not be achieved at the outset of production;

• In real life, firms begin their activity even at a loss in anticipation of profits in future.

Break Even Analysis

• Firms can plan better if they know the level of production where cost and revenue break even- the profitable and non-profitable range of production-

Break Even Point

• Break Even Analysis is a technique used to study the relationship between total costs, total revenue, and total profits and losses over the whole range of stipulated output

• Break Even Point- Point where TR=TC and therefore no profit , no loss position.

Break Even Point

TFC

TC

TR

Profit

Loss

Output/ Sales

XO

Y

Tot

al R

even

ue/

cost

Break even Point

Variable Cost

Fixed Cost

BB

Break Even Analysis

Uses of Break-Even Analysis

• The technique gives a preview of profit prospects and is a tool of profit planning. Profit can be forecast if estimates of revenue and cost are available

• It integrates the cost and revenue estimates to ascertain profits and losses associated with different levels of output

• Effect of change in volume of sales, sale price, and cost of production can be appraised.

• Helps inter-firm comparisons on profitability

• The concept emphasises the importance of capacity utilisation

Break Even Analysis

Limitations:• Static: Dynamic forces such as changes in prices,

technology, efficiency and capacity are not taken into account

• Can not be applied if cost and price data can not be ascertained beforehand

• Can not be applied where historical data are not relevant for estimating future costs and price.

Despite limitations, useful tool in production planning.

Determining Break Even Point

Given the following total cost and total revenue functions, find the BEP:TC= 480+10Q and TR= 50Q

BEP=TFC/ (P-AVC)

From the above, we getTFC= 480 AVC= 10 per unit

Since TR=P.Q, P=50

BEP= 480/ (50- 10) =480/40 = 12 units

Determining Break Even Point

TC= 480+10Q and TR= 50Q

At 12 units TC= 480+(10 *12)= 600

TR= 50* 12 = 600

Thus, TR=TC

Net profit is zero.