What is Profit Maximization?
Meaning of Profit Maximization: – Profit maximization is the ability of a business or company to earn maximum profit with low cost which is considered as the main goal of any business and also considered as one of the objectives of financial management. Profit maximization is a short term objective of the firm and is necessary for the survival and growth of the enterprise.
According to financial management, profit maximization is the approach or process that increases the profit or earnings per share (EPS) of the business. More specifically, maximizing profit to the maximum level is the focus of investment or financial decisions.
What are the advantages of Profit Maximization?
The advantages of Profit Maximization are as follows: –
- Economic Existence: – The foundation of profit maximization theory is profit and profit is essential for the economic survival of any company or business.
- Performance Standard: – Profit determines the standard of performance of any business or company. When a business is unable to earn profit, it fails to fulfill its main goal and creates a risk to its existence.
- Economic and Social Welfare: – Profit maximization theory plays a role in economic and social welfare indirectly. When a business makes a profit, it makes proper use and allocation of resources that result in capital, fixed assets, labor and payments for the organization. Thus, economic and social welfare is done.
- Prediction of Real-World Behavior: – Using leverage maximization allows you to predict the behavior of companies in a real-world situation. Firms deal without too much difficulty and with reasonable accuracy. This makes profit maximization useful for explaining and predicting business behavior.
- Knowledge of Business Firms: – The profit motive is most influential in the dealings of business firms. For small firms with strong competition, they must act as profit maximization to increase their sales and reduce costs to avoid competition.
What are the disadvantages of Profit Maximization?
The disadvantages of Profit Maximization are as follows: –
- Ambiguity of Benefit Concept: – The concept of profit is uncertain as different people may have a different idea about profit, such as profit may be EPS, gross profit, net profit, profit before interest and tax, profit ratio etc. In particular, no fixed profit-maximizing rule or method actually exists.
- Does Not Consider Time Value of Money: – The profit maximization principle simply states that the higher the profit, the better the performance of the business. The theory considers only profit without considering the time value of money. The concept of time value of money states that a certain unit of money today will not be equal to the same unit of money a year later.
- Does Not Consider the Risk: – Any business decision considering only the profit maximization model ignores the risk factor involved which may be detrimental to the survival of the business in the long run. Because if the business is unable to handle the high risk, its existence will be in question.
- Ignoring The Quality: – Intangible benefits eg. Image, technological advancement, quality, etc. are not considered in profit maximization approach which is considered as one of the biggest drawbacks. These intangible assets have a remarkable role in creating value for the business which cannot be ignored. Profit maximization theory is based on a traditional approach, but modern business and financial concepts give more importance to profit than to maximizing wealth.
How to achieve Profit Maximization?
There are two ways to achieve Profit Maximization: –
- Increase in Sales-Revenue: –
- Increase sales volume by implementing better marketing strategies, improve quality, do a thorough market study to assess which segments are bringing in more money to the business and focus on driving more sales from those products or services. You can also borrow the best marketing strategy from your competitors, or similar businesses.
- Motivating existing customers to purchase additional services or products.
- Diversification by selling a wide variety of products or services.
- Modifying the pricing of products or services to achieve an increase in sales-revenue. If you are better at the quality of your product or service, you can charge a higher price for it. You may lose some customers temporarily but according to researchers, people prefer a quality product or services even by paying a little more.
- Motivating employees can also increase sales-revenue as satisfied employees will perform better and help in producing better products and services which will help the company to make profit. Better performance appraisal techniques like announcement of employee of the month, promotion, increment, etc. or picnics, going out for lunch, arranging cultural events etc. can motivate the employees.
- Educating both existing and potential customers for your product or service by TV or radio or newspaper advertisements, digital marketing or email-marketing or social-media marketing, publishing and distributing leaflets, posters, banners, etc.
- Cost-Cutting: –
- Analysis of the total expenditure of funds in different sectors.
- Negotiate with suppliers for cheaper prices, especially when buying in large quantities.
- The manufacturing process should be more efficient to reduce wastage. Techniques that save time and expand production should be implemented.
- Looking for a new cost-effective energy supplier as huge amount of money is spent on the energy sector.
- Outsourcing: – A business cannot do all the tasks by itself or a small business cannot hire talented people on a full-time basis at high outsourcing can save a lot of money here. Full-time employees will be engaged in revenue-generating projects and simple tasks can be done through outsourcing or freelancers.
What is Wealth Maximization?
Meaning of Wealth Maximization: – Wealth maximization is the ability of a company to increase the market value of its common stock over time. The market value of the firm is based on many factors like their goodwill, sales, services, quality of products, etc. It is the versatile goal of the company and highly recommended criterion for evaluating the performance of a business organisation. This will help the firm to increase their share in the market, attain leadership, maintain consumer satisfaction and many other benefits are also there.
Wealth maximization is the concept of increasing the value of a business in order to increase the value of the shares held by its stockholders. The concept requires a company’s management team to continually search for the highest possible returns on funds invested in the business, while mitigating any associated risk of loss. This calls for a detailed analysis of the cash flows associated with each prospective investment, as well as constant attention to the strategic direction of the organization.
The most direct evidence of wealth maximization is changes in the price of a company’s shares. For example, if a company spends funds to develop valuable new intellectual property, the investment community is likely to recognize the future positive cash flows associated with this new property by bidding up the price of the company’s shares. Similar reactions may occur if a business reports continuing increases in cash flow or profits.
Key Differences Between Profit Maximization and Wealth Maximization
The fundamental differences between profit maximization and wealth maximization is explained in points below: –
- The process through which the company is capable of increasing earning capacity known as Profit Maximization. On the other hand, the ability of the company in increasing the value of its stock in the market is known as wealth maximization.
- Profit maximization is a short term objective of the firm while the long-term objective is Wealth Maximization.
- Profit Maximization ignores risk and uncertainty. Unlike Wealth Maximization, which considers both.
- Profit Maximization avoids time value of money, but Wealth Maximization recognises it.
- Profit Maximization is necessary for the survival and growth of the enterprise. Conversely, Wealth Maximization accelerates the growth rate of the enterprise and aims at attaining the maximum market share of the economy.