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= G D =G C where G D = f(d,k) & G C = f(r, π) G D = Demand for firm’s product where d is diversification and k is success rate) G C =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: U m= Utility function for managers U m = f(Salary, power, status, security) U o= Utility function for shareholders U o = f(profit, market share, brand image) Managers must try to maximise G D and G C

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 X O Y Total Revenue/ 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= Q and TR= 50Q BEP=TFC/ (P-AVC) From the above, we get TFC= 480 AVC= 10 per unit Since TR=P.Q, P=50 BEP= 480/ (50- 10) =480/40 = 12 units

Determining Break Even Point TC= Q and TR= 50Q At 12 units TC= 480+(10 *12)= 600 TR= 50* 12 = 600 Thus, TR=TC Net profit is zero.