PROFIT MAXIMISATION APPROACH

According to this approach, a firm should undertake all those activities which add to its profits and eliminate all others which reduce its profits. This objectives highlights the fact that all decisions:- financing, dividend and investment, should result in profit maximisation. Following arguments are given in favour of profit maximisation approach:-

1. Profit is a yardstick of efficiency on the basis of which economic efficiency of a business can be evaluated.
2. It helps in efficient allocation and utilisation of scarce means because only such resources are applied which maximise the profits.
3. The rate of return on capital employed is considered as the best measurement of the profits.
4. Profit acts as motivator which helps the business organisation to be more efficient through hard work.
5. By maximising profits, social & economics welfare is also maximised.

However this approach has been criticised on various counts:-

(1) Ambiguity:-

Profit can be expressed in various forms i.e it can be short term or long term or it can be profit before tax or after tax or it can be gross profit or net profit. Now the question arises, which profits can be maximised under profit maximisation approach.

(2) Time Value of Money

This approach is also criticised because it ignores time value of money i.e. under this approach income of different years get equal weight. But, in fact, the value of rupee today will be greater as compared to the value of rupee receivable after one year. In the same manner, the value of income received in the first year will be greater from that which will be received in later year e.g. the profits of 2 different projects are:-

Example:-

YEAR PROJECT1 PROJECT2

1 5,000 –

2 10,000 10,000

3 5,000 10,000

Both the projects have a total earnings of Rs 20,000 in 3 years and according to this approach both will be considered equally profitable. But Project 1 has greater profits in the initial years of the project & therefore, is more profitable in terms of value of income. The profits earned in initial years can be reinvested and more profits can be earned.

(3) Risk Factor:-

This approach ignores risk factor. The certainity or uncertainity of income receivable in future can be high or less. High uncertainity increases risk and less uncertainity reduces risk. Less income with more certainity is considered better as compared to high income with greater uncertainity.

Thus, this approach was more significant for sole trader & partnership firms because at that time when personal capital invested in business, they wanted to increase their assets by maximising profits. Companies are now managed by professional managers and capital is provided by shareholders, debenture holders, financial institutions etc. one of the major responsibilities of business management is to co-ordinate the conflicting interest of all these parties. In such a situation profit maximisation approach does not appear proper and practicable for financial decisions.