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PROFIT MANAGEMENT

PROFIT MANAGEMENT

BY

JULLYANNE OKELLO REG. NO: HDE314-C004-3689 /2017

KEVIN MUTISYA KASOLI REG. NO: HDE314-C004-2409/2017

LINA NYABOKE OGWERA REG. NO: HDE314-C004-3691/2017

MICHAEL M. MUTISYA REG. NO: HDE314-C004-2406/2017

AN ASSIGNMENT SUBMITTED IN PARTIAL FULFILLMENT OF THE

REQUIREMENTS FOR THE AWARD OF THE DEGREE OF MASTER OF SCIENCE,

PROJECT MANAGEMENT JOMO KENYATTA UNIVERSITY OF SCIENCE AND

TECHNOLOGY

HEMH 3107: ECONOMICS

SUPERVISOR: Dr. JOSHUA MATANDA

DATE OF SUBMISSION: 2ND NOVEMBER, 2018

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DECLARATION

I JULLY OKELO, KEVIN KASOLI, LINA ISAMBOKE AND MICHAEL MUTISYA

hereby declare that the presented assignment, titled “ROFIT MANAGEMENT” is uniquely

prepared by us. We also confirm that, the report is only prepared for our academic requirement not

for any other purpose. This work was done under the guidance of Dr. Joseph Matanda of Jomo

Kenyatta University of science and Technology.

JULLYANNE OKELLO REG. NO: HDE314-C004-3689 /2017

Signed …………………………… Date …....... October, 2018

KEVIN MUTISYA KASOLI REG. NO: HDE314-C004-2409/2017

Signed …………………………… Date …....... October, 2018

LINA NYABOKE OGWERA REG. NO: HDE314-C004-3691/2017

Signed …………………………… Date …....... October, 2018

MICHAEL MUTUNGA MUTISYA REG. NO: HDE314-C004-2406/2017

Signed …………………………… Date …....... October, 2018

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TABLE OF CONTENTS

DECLARATION .................................................................................................................. 2

ABSTRACT ......................................................................................................................... 4

1.0 INTRODUCTION .......................................................................................................... 5

1.2 Factors determining profits ............................................................................................ 6

1.3 Nature and measurement of profits .............................................................................. 10

1.3.1 Profit versus return .....................................................................................................................10

1.3.2 Types of Profit: ...........................................................................................................................11
1.4 Profit policy, planning and forecasting ..................................................................... 13

1.4.1 Profit Policy ................................................................................................................................13

1.4.2 Profit Planning and Control: .......................................................................................................15
1.4.3 Profit Forecasting: ...............................................................................................................20
1.5 Profit hypothesis in firms ......................................................................................... 22

1.5.1 Hypothesis of Profit-Maximization: ...........................................................................................22

1.5.2 Assumptions: ..............................................................................................................................23
1.5.3 Advantages of Profit-Maximization Hypothesis: .......................................................................26
1.5.4 Disadvantages of Profit Maximization ................................................................................27
1.6 Break even techniques .................................................................................................. 33

1.6.1 Introduction to Break-Even Analysis: ........................................................................................33

1.6.2 Contents of Breakeven techniques..............................................................................................34
1.6.3 Limitations of Breakeven techniques .........................................................................................36
1.7 Profit volume analysis ................................................................................................... 37

REFERENCES................................................................................................................... 40
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Abstract

A business is considered to be sound if it includes consistency in earning profit while

considering the various risks as well. A firm is faced with a number of uncertainties. These

uncertainties are in terms of nature of consumer needs, the diverse nature of competition, the

uncontrollable nature of most elements of cost and the continuous technological developments.

The uncertainty about the pattern and extent of consumer demand for a particular product increases

the degree of risk faced by the firm. The nature of competition is related to either product, price or

to both simultaneously. Product competition is more important till the product reaches the stage of

maturity. Price competition begins from the product is established and reaches the maturity stage.

During the growth stage, the risk of obsolescence of a product and shortening of the product life

cycle is more. The degree of risk involved in product competition is greater than in price

competition. When the prices rise continuously, no firm can be certain of its internal cost structure.

This is because it does not have any control over the prices of raw materials or the wages to be

paid to the individuals. In course of time, continuous technological improvements may make

production completely obsolete. If an improved process is available, a firm can restrict its risk by

neglecting its fixed investment. If it does not have an access to the improved processes, it may

have to go out of business. Unless a firm is prepared to face the uncertainties, as a result of risk

element, its profits will be changed. To plan for profits, a thorough understanding of the

relationship of cost, price and volume is extremely helpful to business individuals.

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1.0 Introduction

Profitability has been given considerable importance in the finance and accounting

literatures. According to Hifza Malik, (2011), profitability is one of the most important objectives

of financial management since one goal of financial management is to maximize the owners’

wealth, and, profitability is very important determinant of performance. A business that is not

profitable cannot survive. Conversely, a business that is highly profitable has the ability to reward

its owners with a large return on their investment. Hence, the ultimate goal of a business entity is

to earn profit in order to make sure the sustainability of the business in prevailing market

conditions. Shahriar, A. Z. M., Schwarz, S., & Newman, A. (2016) defined the profitability as the

ability of a business, whereas it interprets the term profit in relation to other elements. It is

necessary to examine the determinants of profitability to understand how companies finance their

operations. A financial benefit is realized when the amount of revenue gained from a business

activity exceeds the expenses, costs and taxes needed to sustain the activity. Profitability analysis

classifies measures and assesses the performance of the company in terms of the profits it earns

either in relation to the shareholders’ investment or capital employed in the business or in relation

to sales, profit, (or loss). Given that most entrepreneurs invest in order to make a return, the profit

earned by a business can be used to measure the success of that investment. Kamau, S. M. (2014)

defines that profitability is the organizations’ ability to generate income and its inability to generate

income is a loss. He further asserts that if the income generated is greater than the input cost, that

is simply profitability but if the incomes are less than the input cost, it reflects poor performance.

A business firm is an organisation designed to make profits (Sivathaasan, N., Tharanika,

R., Sinthuja, M., & Hanitha, V. 2013), Profits are acid test of the individual firm’s performance.
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In appraising a company, we must first understand how profit arises. The concept of profit

maximization is very useful in selecting the alternatives in making a decision at the firm level.

Profit forecasting is an essential function of any management. It relates to projection of future

earnings and involves the analysis of actual and expected behavior of firms, the sales volume,

prices and competitor’s strategies, etc. The main aspects covered under this area are the nature and

measurement of profit, and profit policies of special significance to managerial decision making.

Managerial economics tries to find out the cause and effect relationship by factual study

and logical reasoning (Hirschey, M. 2016). For example, the statement that profits are at a

maximum when marginal revenue is equal to marginal cost, a substantial part of economic analysis

of this deductive proposition attempts to reach specific conclusions about what should be done.

The logic of linear programming is deduction of mathematical form. In fine, managerial economics

is a branch of normative economics that draws from descriptive economics and from well-

established deductive patterns of logic.

1.2 Factors determining profits

Making a profit is one of the most important objectives of a business. Calculating your

profit can not only help you determine your level of success, it also provides information about

where your business is making money and where you are spending it Obrinsky, M. (2015). The

essence of profitability is a firms (Revenue – Costs), with revenue depending upon price and

quantity of the good sold. Below are factors that determine the profit of a firm.

1. The degree of competition a firm face’s.

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If a firm has monopoly power, then it has little competition. Therefore, demand will be

more inelastic. This enables the firm to increase profits by increasing the price. For example, very

profitable firms, such as Google and Microsoft have developed a degree of monopoly power, with

limited competition. If the market is very competitive, then profit will be lower. This is because

consumers would only buy from the cheapest firms. Also important is the idea of contestability.

Market contestability is how easy it is for new firms to enter the market. If entry is easy then firms

will always face the threat of competition; even if it is just “hit and run competition” – this will

reduce profits.

2. The strength of demand.

Demand will be high if the product is fashionable, e.g. mobile phone companies were

profitable during the period of rising demand and growth in the market. Products which have

falling demand like Spam (tinned meat) will lead to low profit for the company. Some companies,

like Apple, have successfully carved out strong brand loyalty making customers demand many of

the new Apple products. However, in recent years, profits for mobile phone companies have fallen

because the high profit encouraged oversupply, negating the increase in demand.

3. The state of the economy.

If there is economic growth, then there will be increased demand for most products

especially luxury products with a high-income elasticity of demand. For example, manufacturers

of luxury sports cars will benefit from economic growth but will suffer in times of recession.

4. Advertising and promotional campaigns.

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A successful advertising campaign can increase demand and make the product more

inelastic demand. However, the increased revenue will need to cover the costs of the advertising.

Sometimes the best methods are word of mouth. For example, it was not necessary for YouTube

to do much advertising.

5. Substitutes,

if there are many substitutes or substitutes are expensive then demand for the product will be

higher. Similarly, complementary goods will be important for the profits of a company.

6. Relative costs.

An increase in costs will decrease profits; this could include labour costs, raw material

costs and cost of rent. For example, a devaluation of the exchange rate would increase the cost of

imports, and therefore companies who imported raw materials would face an increase in costs.

Alternatively, if the firm is able to increase productivity by improving technology then profits

should increase. If a firm imports raw materials the exchange rate will be important. A depreciation

making imports more expensive. However, a depreciation of the exchange rate is good for

exporters who will become more competitive.

7. Economies of scale.

A firm with high fixed costs will need to produce a lot to benefit from economies of scale

and produce on the minimum efficient scale, otherwise average costs will be too high. For example,

in the steel industry, we have seen a lot of rationalisation where medium-sized firms have lost their

competitiveness and had to merge with others.

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8. Dynamically efficient.

If a firm is not dynamically efficient then overtime costs will increase. For example, state

monopolies often had little incentive to cut costs, e.g. get rid of surplus labour. Therefore, before

privatization, they made little profit, however with the workings and incentives of the market they

became more efficient.

9. Price discrimination.

If the firm can price discriminate it will be more efficient. This involves charging different

prices for the same good so that the firm can charge higher prices to those with inelastic demand.

This is important for airline firms.

10. Management.

Successful management is important for the long-term growth and profitability of firms.

For example, poor management can lead to a decline in worker morale, which harms customer

service and worker turnover. Also, firms may suffer from taking wrong expansion plans. For

example, many banks took out risky subprime mortgages, but this led to large losses. Tesco

suffered from expanding into unrelated business, like garden centre. This led to over-stretching the

company and losing sight of their core business.

11. Objectives of firms.

Not all firms are profit maximising. Some firms may seek to increase market share, in

which case profits will be sacrificed to gain market share. For example, this is the strategy of

Walmart and to an extent Amazon.

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12. Exchange rate.

If a firm relies on exports, a depreciation in the exchange rate will increase profitability. A

fall in the exchange rate makes exports cheaper to foreign buyers. Therefore, the firm can sell more

or choose to have a bigger profit margin. If the firm imports raw materials, a depreciation will

increase costs of production.

1.3 Nature and measurement of profits

The term profit has distinct meaning for different people, such as businessmen,

accountants, policymakers, workers and economists. Businesses exist to make a profit by selling

products and/or services to the public at a price higher than what the business owner paid for them

in order to make profit. How much higher is up to the individual businessperson from what the

market will bear to a "fair profit" in his mind. An important factor in running a business is to try

and keep your business expenses i.e. everything from cost of goods to rent to bills to insurance to

paying employees as low as possible so that you can charge a lower price for your

products/services and still make a profit. Businesses calculate profitability in several ways, but the

bottom line is net profits.1

1.3.1 Profit versus return

According to Davila, T., Epstein, M., & Shelton, R. (2012). profits are the rewards of purely

entrepreneurial functions. According to Thomas S.E., “pure profit is a payment made exclusively

for bearing risk. The essential function of the entrepreneur is considered to be something which

only he can perform. This something cannot be the task of management, for managers can be hired,

1 Net profit is profit realised after deducting all the operation expenses and taxes from the gross revenue.
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nor can it be any other function which the entrepreneur can delegate. Hence, it is contended that

the entrepreneur receives a profit as a reward for assuming final responsibility, a responsibility

that cannot be shifted on the shoulders of anyone else.”

1.3.2 Types of Profit:

Different people have described profit differently. Individuals have associated profit with

additional income revenue, and reward. However, none of the description of profit is said to be

right or wrong; it only depends on the field which the word profit is described. On the basis of

fields, profit can be classified into two types, which are explained as follows:

1. Accounting Profit:

Weygandt, J. J., Kimmel, P. D., & Kieso, D. E. (2015) defines accounting profit as the total

earnings of an organization. It is a return that is calculated as a difference between revenue and

costs, including both manufacturing and overhead expenses. The costs are generally explicit costs,

which refer to cash payments made by the organization to outsiders for its goods and services. In

other words, explicit costs can be defined as payments incurred by an organization in return for

labor, material, plant, advertisements, and machinery.

The accounting profit is calculated as:

Accounting Profit= TR - (W + R + I + M) = TR- Explicit Costs

TR = Total Revenue; W = Wages and Salaries; R = Rent; I = Interest and M = Cost of Materials

The accounting profit is used for determining the taxable income of an organization and

assessing its financial stability.

Example of accounting profit

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Let us take an example of accounting profit. Suppose that the total revenue earned by an

organization is Kes. 2, 50,000. Its explicit costs are equal to Kes. 10, 000. The accounting profit

equals = Kes. 2, 50,000 – Kes. 10,000 = Kes. 2, 40,000.

It is to be noted that the accounting profit is also called gross profit. When depreciation and

government taxes are deducted from the gross profit, we get the net profit.

2. Economic Profit:

Takes into account both explicit costs and implicit costs or imputed costs. Implicit that is

foregone which an entrepreneur can gain from the next best alternative use of resources. Thus,

implicit costs are also known as opportunity cost. The examples of implicit costs are rents on own

land, salary of proprietor, and interest on entrepreneur’s own investment. Suppose an individual A

is undertaking his own business manager in an organization. In such a case, he sacrifices his salary

as a manager because of his business. This loss of salary will opportunity cost for him from his

own business.

The economic profit is calculated as:

Economic profit = Total revenue - (Explicit costs + implicit costs)

Example of Economic Profit:

Suppose a person uses, his own resources, land, capital, his own time in the production of goods.

The opportunity costs of these resources is included below in finding out economic profit of the

firm.

Accounting Profit = Kes. 55,000

Entrepreneur's own forgone salary = Kes. 40,000

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Foregone interest on capital = Kes. 1,000

Foregone rent = Kes. 2,000

Economic Profit = Total revenue (Kes 55,000) - (Explicit costs (Kes 2,000) + implicit costs

(40,000 + 1,000) = Kes. 12000

Alternatively, economic profit can be defined as follows:

Pure profit = Accounting profit- (opportunity cost + unauthorized payments, such as bribes)

Economic profit is not always positive; it can also be negative, which is called economic loss.

Economic profit indicates that resources of a business are efficiently utilized, whereas economic

loss indicates that business resources can be better employed elsewhere.

Table 1: Comparison between Accounting and Economic Profits

# Accounting Profits Economic Profits

1 Refers to profit that can be determined as per Refers to the profit that is determined by

Generally Accepted Accounting Principles economic principles

(GAAP)

2 Includes explicit cost only Includes explicit and implicit costs

3 Helps in assessing taxes and financial Helps in determining the entry, stay or exit of

performance of a business the organization

1.4 Profit policy, planning and forecasting

1.4.1 Profit Policy

A project plays two primary roles in the functioning of the economic system. First, the

project acts as a signal to producers to change the rate of output or to enter or leave an industry.
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Second, profit is a reward that encourages entrepreneurs to organise factors of production and take

risk. High profits in an industry usually are a signal that buyers want more output from that industry

(Dosi, G., Fagiolo, G., Napoletano, M., Roventini, A., & Treibich, T. 2015).

Those profits provide the incentive for firms to increase output and for new firms to enter

the market. Conversely, low profits are a signal that less output is being demanded by consumers

or that production methods are not efficient (Ferrando, A., & Mulier, K. 2015). Firms may not

maximise profit, but they do have a profit policy. Profit policy and profit planning must go

together. The profit policy is more strategy-oriented and the profit planning is more technique-

oriented. The firm has to consider a lot of short run and long run factors in designing its profit

policy. The main motive of the businessman is to make profits. The profit that a firm makes should

not be at the point of exploitation of consumers. The firm while making profits should also satisfy

the requirements of the consumers. There are two issues involved in profit policy decisions and

they are:

a) Setting Profit Standards:

Profit standards involve a choice of a particular measure and concept of profit with

reference to which achievements and aspirations may be compared. In profit policy decision, the

task is to decide an acceptable rate of profit. The firm has to consider rate of profit earned by other

firms in the same industry, historical profit rate earned by the firm itself in the past, rate of profit

sufficient to attract equity capital and rate of profit necessary to generate internal finance for

replacement and expansion.

b) Limiting the Target Profit:

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From setting profit standards, the firm should also consider a set of environmental factors

to limit its rate of target profit. The profit target should be limited which means the shareholders

do not ask for higher dividends, the wage earners do not ask for higher wages, the government

does not impose high taxes, the consumers do not ask for lower prices, the suppliers do not ask for

higher rates, and the goodwill of the business is not affected.

1.4.2 Profit Planning and Control:

Profit planning is a disciplined method whereby the environments encroaching on an

organisation are analysed, the available resources and internal competence identified, agreed

objectives established and plans made to achieve them. Profit planning is largely routine and

covers a definite time span. Strategy is a word often used in conjunction with profit planning.

Profit planning and strategy formulation are complementary. Profit planning is often a reasonable

substitute for the fair and imagination need of the entrepreneurs.

a) Essential Elements in Profit Planning:

The following are the essential elements in profit planning:

1. Objectives and results are established and measured at all management levels.

2. The role of the chief executive is often vital in ensuring success.

3. The system should become the major framework in guiding and controlling management

performance.

4. The system should be totally pervasive, especially in framing objectives.

5. The system is recognised as the key method of management in the organisation.

6. Planners have been trained in economics or associated disciplines.

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7. Budgeting, cost control, and contribution analyses are the key elements in controlling a

profit plan.

b) Steps in Profit Planning:

Some rudimentary form of planning may already be in existence in most organisations.

Many of the techniques used in profit planning may be in use. The following activities will need

to be introduced or improved or enhanced if they are undertaken at present.

1. Establish Suitable Objectives:

Objectives can cover many factors of the business survival, profits or increase in net worth.

The way in which objectives are determined is nearly as important as the types that are pursued. It

will be essential to take account of past performance, resource availability, management

competence, environment changes, competitors’ activities and so on. Objectives should not be

imposed.

2. Establish Suitable Control System:

Profit planning and control may have grown out of budgetary control systems. It is

necessary to have some form of budgetary cost control, plan monitoring and management

information systems which will serve to enable profit planning to be effective.

3. Establishing Job Responsibilities:

Often job responsibilities are too imprecise to provide the information on which

performance standards can be established and then judged. It is necessary to have job breakdowns

in such detail that the need for resources can be identified.

4. Carry Out a Situation Audit:

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It entails an audit of all the factors both internal and external that will have an influence on

company affairs. It should include establishing the skills of competition, the economic situation

which will impinge on company performance and the potential and actual social, technological

and cultural changes to be accommodated.

5. Gap Analysis:

This is an activity where the desired company objectives are compared with the probable

results of continuing current trends. A gap will almost certainly be obvious between the two. Profit

planning is largely concerned with how the gap can be closed.

6. Establishing Base Data:

Often the base data essential for profit planning is either nonexistent or set out in a way

that is inappropriate for planning purposes. The data include product and operational costs,

production speeds, material utilisation, labour efficiency, etc.

7. Establish Appropriate Plans and Strategies:

The management should ensure that there is plan integration. Strategies are the results of

choosing between alternatives in the use of the company resources through which it is hoped that

the corporate objectives will be achieved. They can be highly complex and appropriate alternatives

need to be set out.

c) Need for Profit Planning:

The need for profit planning arises:

1. To improve management performance.

2. To ensure that the organisation as a whole pull in the right direction.

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3. To ensure that objectives should be set which will stretch but not overwhelm managers.

4. To encourage strict evaluation of manager’s performance in monetary terms.

5. To run a company in a more demanding way.

d) Aids to Profit Planning:

The following are the aids to profit planning in an organisation:

1. Organisation:

Profit planning organisation must ensure that it is sensitive to environmental changes and

that such changes are speedily reflected in profit plans. To carry profit planning, the organisation

must be designed accordingly. A high state of expertise is required and this should be reflected in

the profit planning organisation. Involvement and participation are more important. Wherever

possible, decentralisation should be established. It is essential that the organisation should be

dynamic. The organisation must help goal identification and problem resolution.

2. Information System:

Management information systems are an essential factor in profit planning and control.

This system must help to provide the means for allocation of resources and the measurement of

results. It should help to identify the various strategy alternatives and help for the integration of

various main plans and sub-plans.

3. The Computer:

A computer can be applied in profit planning modelling. Information of all kinds can be

obtained much faster than when normal files are used. The computer should be able to help

management to make profit planning decisions. The interactive nature of many planning decisions
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can be generated more cheaply. Application programme changes are simplified and amendments

to output requirements take less time and cost.

4. Use of Modelling:

A model is a representation of a real life situation. A model is fabricating and integrating

the relationships. Models have been used to aid decision making and forecasting. A model provides

an opportunity to manipulate a situation. It is the only way in which a solution to the problem can

reasonably be obtained.

5. Planning Techniques:

Profit planning should be a management activity that guides the use of company resources

at all management levels. Profit planning can itself be regarded as a technique. Most techniques

used by management services like forecasting, investment appraisal, risk analysis, decision theory,

and organisational development might be applied in profit planning.

6. Control of Profit:

The main goal of the business firm is to produce and market the goods and services which

satisfy the buyers and thereby earn a profit sufficient for the survival and growth of business. Profit

making is no doubt an essential function of a business firm. Profit as such is not at all a defective

objective. The future growth of the economy depends upon generation and reinvestment of profit.

Profit should serve as a motivation for expansion, diversification and innovation. Therefore, we

need some control over it.

Profit control may be achieved by controlling the internal and external factors which have

an influence on profits. Some planning at a particular level has to be done to achieve this control.
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For this, we have to find out the chief factors which influence the volume of profit. In reality, sales

revenue and the total cost of production are the chief factors which influence the volume of profit.

1.4.3 Profit Forecasting:

It is usual to calculate a profit forecast for each major product group or service which an

organisation offers. It presupposes that it is possible to assume what rates of inflation will occur,

the market share the company will obtain and the degree of overall economic activity which the

company will enjoy. Profit forecasting means projection of future earnings taking into

consideration all the factors affecting the size of business profits. It is an essential part of operation

planning. The major factors are the turnover and costs.

a) Turnover:

Turnover is the major factor and its element is the product. It must, however, be emphasized

at the outset that the product is the starting point for all planning activities. To a manufacturer, the

special aspect of a product is most relevant which earns good profit. A higher turnover indicates a

healthier performance.

b) Costs:

It is the costs that form the basis for many managerial decisions. It is the level of costs

relative to revenue that determines the firm’s overall profitability. In order to maximise profits, a

firm tries to increase its revenue and lower its costs. The costs can be brought down either by

producing the optimum level of output, using the least cost combinations of inputs or increasing

factor productivities, or by improving the organisational efficiency. The elements of costs are sales
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cost, product development, distribution, inventories, production, general administration,

depreciation and reserves.

Approaches to Profit Forecasting:

According to Figlewski, S. (1997), profit forecasting is indispensable for profit planning.

Profit forecasting means projecting the future profits assuming the factors like growth of the size

of the business, the pricing policies of the firm, the cost control policies, depreciation and so on. It

is also necessary from the point of view of economic health and stability of the firm to project for

certain years the growth of sales increase in costs and consequently the profits also. According to

Joel Dean, there are three approaches to profit forecasting:

1. Spot Projection:

It relates to projecting the entire profit and loss for a specified period, say five years or

seven years or ten years. The projection of profit and loss statements for this period depends on

the projection of sales, costs and prices of the same period. Since profits are surpluses resulting

from the forces that shape demand for the company’s products and govern the behaviour of costs,

their predictions are subject to wide margins of error, from culmination of errors in forecasting

revenues and costs, and from the interrelation of the income statement.

2. Environmental Analysis:

It relates the company’s profit to key variables in the economic development during the

relevant period. The key variables are general business activity and general price level. These are

external to the company. These factors are beyond the control of the firm and force the firm to

abandon the profit maximising goal. In reality, factors that control profit have a tendency to move
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in regular and related patterns. The controlling factors of profit are the rate of output, prices, wages,

material costs and efficiency. These are all inter-connected in aggregate business activity. The

environmental analysis might show areas where the company has superior competence or

advantage of some kind.

3. Break-Even Analysis:

The break-even analysis is a powerful tool for profit planning and management control. Of

the three techniques, the break-even analysis is the most important tool of profit forecasting. The

break-even analysis involves the study of revenues and costs of a firm in relation to its volume of

sales and particularly the determination of that volume at which the firm’s costs and revenues will

be equal. The break-even point may be defined as the level of sales at which total revenues equal

total costs and the net income is equal to zero. This is also known as no-profit no-loss point. The

main objective of the break-even analysis is not simply to spot the ВЕР, but to develop an

understanding of the relationship of costs, price and volume within a company’s practical range.

1.5 Profit hypothesis in firms

1.5.1 Hypothesis of Profit-Maximization:

In the neoclassical theory of the firm, the main objective of a business firm is profit

maximization. The firm maximizes its profits when it satisfies the two rules:
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(i) MC = MR: (Where MC = Marginal Cost which is the increase in cost by producing one

more unit of the good and MR = Marginal Revenue which is the change in total revenue as a

result of changing the rate of sales by one unit). ……. and,

(ii) MC curve cuts the MR curve from below.

Maximum profits refer to pure profits which are a surplus above the average cost of

production. It is the amount left with the entrepreneur after he has made payments to all factors of

production, including his wages of management. In other words, it is a residual income over and

above his normal profits.

The profit maximisation condition of the firm can be expressed as:

Maximise π (Q)

Where π (Q)=R (Q)-C (Q)

Where π (Q) is profit, R (Q) is revenue, C (Q) are costs, and Q are the units of output sold.

The two marginal rules and the profit maximisation condition stated above are applicable both to

a perfectly competitive firm and to a monopoly firm.

1.5.2 Assumptions:

The profit maximisation theory is based on the following assumptions:

1. The objective of the firm is to maximise its profits where profits are the difference between

the firm’s revenue and costs.

2. The entrepreneur is the sole owner of the firm.

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3. Tastes and habits of consumers are given and constant.

4. Techniques of production are given.

5. The firm produces a single, perfectly divisible and standardised commodity.

6. The firm has complete knowledge about the amount of output which can be sold at each

price.

7. The firm’s own demand and costs are known with certainty.

8. New firms can enter the industry only in the long run. Entry of firms in the short run is not

possible.

9. The firm maximises its profits over some time-horizon.

10. Profits are maximised both in the short run and the long run.

Given these assumptions, the profit maximising model of firm can be shown under perfect com-

petition and monopoly.

1. Profit Maximisation under Perfect Competition Firm:

Under perfect competition, the firm is one among a large number of producers. It cannot

influence the market price of the product. It is the price-taker and quantity-adjuster. It can only

decide about the output to be sold at the market price. Therefore, under conditions of perfect

competition, the MR curve of a firm coincides with its AR curve.

The MR curve is horizontal to the X-axis because the price is set by the market and the

firm sells its output at that price. The firm is thus in equilibrium when MC= MR= AR (Price). The

equilibrium of the profit maximisation firm under perfect competition is shown in Figure 1 where

the MC curve cuts the MR curve first at point A.

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It satisfies the condition of MC = MR, but it is not a point of maximum profits because after point

A, the MC curve is below the MR curve. It does not pay the firm to produce the minimum output

when it can earn larger profits by producing beyond OM.

It will, however, stop further production when it reaches the OM level of output where the firm

satisfies both conditions of equilibrium. If it has any plans to produce more than OM 1 it will be

including losses, for the marginal cost exceeds the marginal revenue after the equilibrium point B.

Thus the firm maximises its profits at M1 B price at the output level OM1.

2. Profit Maximisation under Monopoly Firm:

There being one seller of the product under monopoly, the monopoly firm is the industry

itself. Therefore, the demand curve for its product is downward sloping to the right, given the tastes

and incomes of its customers. It is a price-maker which can set the price to its maximum advantage.

But it does not mean that the firm can set both price and output. It can do either of the two things.

If the firm selects its output level, its price is determined by the market demand for its

product. Or, if it sets the price for its product, its output is determined by what the consumers will

take at that price. In any situation, the ultimate aim of the monopoly firm is to maximise its profits.
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The conditions for equilibrium of the monopoly firm are:

(1) MC = MR<AR (Price), and

(2) The MC curve cuts the MR curve from below.

In Figure 2, the profit maximising level of output is OQ and the profit-maximisation price

is OP. If more than OQ output is produced, MC will be higher than MR, and the level of profit

will fall. If cost and demand conditions remain the same, the firm has no incentive to change its

price and output. The firm is said to be in equilibrium.

1.5.3 Advantages of Profit-Maximization Hypothesis:

a) Prediction:
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The profit-maximization hypothesis allows us to predict quite well the behaviour of

business firms in the real world. It does not matter that few firms are maximizers in reality. What

matters is that they behave without too much difficulty and with reasonable accuracy. Further

Arguments for the Profit-Maximization Hypothesis.

b) Proper Explanation of Business Behavior:

The economist relies on the profit- maximization hypothesis because it is useful in

explaining and predicting business behavior.

c) Knowledge of Business Firms:

Profit motive is the most pervasive force that governs the behavior of business firms. In

the case of small firms facing strong competition from others, they are forced to act as profit

maximizers. They must do everything possible to increase sales and reduce costs in order to survive

in their competitive environment.

d) Simple Working:

The profit-maximization hypothesis is simple, and there are well- developed mathematical

tools of analyzing maximization or minimization problems.

e) More Realistic:

Profit maximization is the single best assumption available and introduction of more “realistic”

assumptions complicates the analysis considerably without adding much to the predictive power

of the model.

1.5.4 Disadvantages of Profit Maximization

a) Ambiguity in the Concept of Profit:

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It has been pointed out that in the assumption of profit maximization; the concept of profit

has never been unambiguously stated. Is it rate of profit, total or net profits that a firm tends to

maximize? The three concepts have entirely different implications for price theory.

b) Multiplicity of Interests in a Joint Stock Company:

It is argued that with the ushering in of corporate form of enterprise, profit maximization

goal has a considerably reduced edge; other goals have come to the fore.

c) No Compulsion of Competition for a Monopolist:

As far as a monopolist goes he has no compulsions to maximize his profit. Since the

monopolist ordinarily earns above-normal returns, why should he maximize? In imperfectly

competitive industries where barriers to entry are effective, the firm ordinarily does not have to

walk the tightrope of zero economic profits. Instead, the existence of monopoly power provides

wider range of various alternatives than order conditions of perfect competition.

d) Separation of Ownership from Control:

Under the impact of managerial revolution, there has been a considerable divorce of

ownership and control. In modern, gigantic corporations little attempt is made either by individuals

or by the groups to maximize profits. Generally, the salaried managers cease to look for profits

beyond the level which suffices to pay their salaries and keep the shareholders quiet and the owners

are powerless to remedy the situation. In a public corporation set up by statute with no share but

only loan capital, the divorce of ownership from control is as complete as imaginable. In such

cases, it may be asked, what replaces profits in the mangers’ mind. In really very large firms, the

managers may only try to minimize costs and avoid losses but have no interest in increasing profits.
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e) The Principle of Decreasing Power:

Keeping maximum business power is another common craze among organizers. It is seen

in many cases that growth of the firm through increased number of owners is profitable. But the

existing owners are unwilling to introduce any more partners. This is because the greater the

number of owners, the lesser is the power in each hand. The diminution of power on account of

the introduction of new partners is called the Principle of decreasing Power. In this way, most

entrepreneurs owning small firms have strong feeling to stick to a small firm and independent and

exercise unrestrained power rather than to invite new owners and enlarge their profits.

f) Stress on Efficiency, not Profit:

In particular cases some other motives become more important than profit maximizing. In

many industries, the manager’s aim is the attainment of some non-economic ideal of efficiency

such as beauty, size, durability, sharpness of product. Managers pursue it not only for its own sake

but for the good professional reputation it gives them in the trade. In large multi-branch firms, the

practice is common to encourage the branches to compete both in buying and selling. Therefore,

in place of profit, efficiency is given top priority.

g) Tendency of Following One Trade Only:

It is often seen that businessmen refrain from “integration or other forms of expansion not

because they have been calculated to be unprofitable but because “jack of all trades, master of

none or some such proverbial wisdom is always there.”

h) Conspicuous Consumption:

It should be noted that the firm is not only a producer but a consumer also. Often firms, to

impress their clients and various civil servants visiting it, indulge in what may be called
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Conspicuous consumption. In this regard it may be noted that this kind of consumption does not

go against profit-maximization; profits are first maximized and then spent on non-essential goods.

But if the firms indulge themselves, their investment policy cannot be said to be dictated by

profitability.

i) Legal Restrictions on Profit-Making:

In mixed developing economies like India, there are very many enterprises—public

utilities, development institutions etc. that are legally forbidden to maximize their profits.

5. Criticisms of the Profit Maximisation Theory:

The profit maximisation theory has been severely criticised by economists on the following

grounds:

j) Profits Uncertain:

The principle of profit maximisation assumes that firms are certain about the levels of their

maximum profits. But profits are most uncertain for they accrue from the difference between the

receipt of revenues and incurring of costs in the future. It is, therefore, not possible for firms to

maximise their profits under conditions of uncertainty.\

k) No Relevance to Internal Organisation:

This objective of the firm bears little or no direct relevance to the internal organisation of

firms. For instance, some managers incur expenditures apparently in excess of those that would

maximise wealth or profits of the owners of the firm. They are observed to emphasize growth of

total assets of the firm and its sales as objectives of managerial actions.

l) No Perfect Knowledge:
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The profit maximisation hypothesis is based on the assumption that all firms have perfect

knowledge not only about their own costs and revenues but also of other firms. But, in reality,

firms do not possess sufficient and accurate knowledge about the conditions under which they

operate. At the most, they may have a knowledge about their own costs of production, but they

can never be definite about the market demand curve. They always operate under conditions of

uncertainty and the profit-maximisation theory is weak in that it assumes that firms are certain

about everything.

m) Empirical Evidence Vague:

The empirical evidence on profit maximisation is vague. Most firms do not rank profits as

the major goal. The working of modem firms is so complex that they do not think merely about

profit maximisation. Their main problems are of control and management. The function of

managing these firms is performed by managers and shareholders rather than by the entrepreneurs.

They are more interested in their emoluments and dividends. Since there is substantial separation

of ownership from control in modern firms, they are not operated so as to maximise profits.

n) Firms do not bother about MC and MR:

It is asserted that the real world firms do not bother about the calculation of marginal

revenue and marginal cost. Most of them are not even aware of the two terms. Others do not know

the demand and marginal revenue curves faced by them. Still others do not possess adequate

information about their cost structure. Empirical evidence by Hall and Hitch shows that

businessmen have not heard of marginal cost and marginal revenue. After all, they are not greedy

calculating machines. As aptly put by C.J. Hawkins: “To argue that all firms aim to do nothing
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else but maximise profits has not better basis in logic or intuition as to argue that all students aim

only to maximise examination marks”.

o) Principle of Average-Cost Maximises Profits:

Hall and Hitch found that firms do not apply the rule of equality of MC and MR to

maximise short run profits. Rather, they aim at the maximisation of profits in the long run. For

this, they do not apply the marginalistic rule but they fix their prices on the average cost principle.

According to this principle, price equals AVC +AFC + profit margin (usually 10%). Thus the main

aim of the profit maximising firm is to set a price on the average cost principle and sell its output

at that price.

p) Static Theory:

The neo-classical theory of the firm is static in nature. The theory does not tell the duration

of either the short period or the long period. The time-horizon of the neo-classical firm consists of

identical and independent time periods. Decisions are considered as temporally independent. This

is a serious weakness of the profit maximisation theory. In fact, decisions are” temporally inter-

dependent. It means that decisions in any one period are affected by decisions in past periods which

will, in turn, influence the future decisions of the firm. This inter-dependence has been ignored by

the neo-classical theory of the firm.

q) Not applicable to Oligopoly Firm:

As a matter of fact, the profit-maximisation objective has been retained for the perfectly

competitive, or monopolistic, or monopolistic competitive firm in economic theory. But it has been

abandoned in the case of the oligopoly firm because of the criticisms leveled against it. Hence the
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different objectives that have been put forth by economists in the theory’ of the firm relate to the

oligopoly or duopoly firm.

r) Varied Objectives:

The basis of the difference between the objectives of the neo-classical firm and the modem

corporation arises from the fact that the profit maximisation objective relates to the entrepreneurial

behavior while modem corporations are motivated by different objectives because of the separate

roles of shareholders and managers. In the latter, shareholders have practically no influence over

the actions of the managers. As early as in 1932, Berle and Means suggested that managers have

different goals from shareholders. They are not interested in profit maximisation. They manage

firms in their own interests rather than in the interests of shareholders. Shareholders cannot have

much influence on managers because they do not possess adequate information about companies.

The majority of shareholders cannot attend annual general meetings of companies and thus give

their proxies to the directors. Thus modern firms are motivated by objectives relating to sales

maximisation, output maximisation, utility maximisation, satisfaction maximisation and growth

maximisation.

1.6 Break even techniques

1.6.1 Introduction to Break-Even Analysis:

Break-even analysis is of vital importance in determining the practical application of cost

functions. It is a function of three factors, i.e., sales volume, cost and profit. It aims at classifying

the dynamic relationship existing between total cost and sale volume of a company. Also known

as “cost-volume-profit analysis”. It helps to know the operating condition that exists when a
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company ‘breaks-even’, that is when sales reach a point equal to all expenses incurred in attaining

that level of sales (Morano, P., & Tajani, F. (2017). Therefore “breakeven point may be defined as

that level of sales in which total revenues equal total costs and net income is equal to zero.” This

is also known as no-profit no-loss point. This concept has been proved highly useful to the

company executives in profit forecasting and planning and also in examining the effect of

alternative business management decisions.

1.6.2 Contents of Breakeven techniques

a) Break-Even Point:

In business accounting, the break-even point refers to the amount of revenue necessary to

cover the total fixed and variable expenses incurred by a company within a specified time period.

This revenue could be stated in monetary terms, as the number of units sold or as hours of services

provided. The break-even point also can be considered as the point in time when revenue forecasts

are exactly equal to the estimated total costs. This is where a company’s losses end and its profits

start to accumulate. At this point, a project, product or business is financially viable.

b) Determination of Break-even Point:

The formula for calculating the break-even point is

Вreak Еven Рoint – Total Fixed Cost/Contribution Margin Per Unit

Contribution margin per unit can be found out by deducting the average variable cost from the

selling price. So the formula will be

BEP = Total Fixed Cost/Selling Price – AVC

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Example:

Suppose the fixed cost of a factory in Kes. 10,000, the selling price is Kes. 4 and the average

variable cost is Kes. 2, so the break-even point would be

ВЕР = 10,000(4-2) = 5,000 units. It means if the company makes the sales of 5,000 units, it would

make neither loss nor profit.

c) Managerial Uses of Break-Even Analysis:

To the management, the utility of break-even analysis lies in the fact that it presents a

microscopic picture of the profit structure of a business enterprise. The break-even analysis not

only highlights the area of economic strength and weakness in the firm but also sharpens the focus

on certain leverages which can be operated upon to enhance its profitability. It guides the

management to take effective decision in the context of changes in government policies of taxation

and subsidies.

Example:

A company has the capacity to produce goods worth of Kes. 40 crores a year. For this has

incurred a fixed cost of Kes. 20 crores, the variable costs being 60% of the sales revenue. Now

company is planning to incur an additional Kes. 6 crores in feed costs to expand its production

capacity from Kes. 40 crores to Kes.60 crores. The survey shows that the firm’s sales can be

increased from Kes. 40 crores to Kes. 50 crores. Should the firm go in for expansion?

ВЕР at present capacity = Fixed cost/ Margin Contribution% = Kes. 10 crores/ 40% = Kes

25Crores
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ВЕР at the proposed capacity = Kes 16 crores/40%= Kes 40 crores.

Increase in break-even point = Kes 40 crores - Kes. 25 crores = Kes. 15 crores.

Thus we can infer that the firm should go in for expansion only if its sales expand by more than

Kes. 15 crores from its earlier level of Kes. 40 crores.

1.6.3 Limitations of Breakeven techniques

Important limitations which ought to be kept in mind while using break-even analysis:

1. In the breakeven analysis, we keep everything constant. The selling price is

assumed to be constant and the cost function is linear. In practice, it will not be so.

2. In the break-even analysis since we keep the function constant, we project the future

with the help of past functions. This is not correct.

3. The assumption that the cost-revenue-output relationship is linear is true only over

a small range of output. It is not an effective tool for long-range use.

4. Profits are a function of not only output, but also of other factors like technological

change, improvement in the art of management, etc., which have been overlooked

in this analysis.

5. When break-even analysis is based on accounting data, as it usually happens, it may

suffer from various limitations of such data as neglect of imputed costs, arbitrary

depreciation estimates and inappropriate allocation of overheads. It can be sound

and useful only if the firm in question maintains a good accounting system.
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6. Selling costs are especially difficult to handle break-even analysis. This is because

changes in selling costs are a cause and not a result of changes in output and sales.

7. The simple form of a break-even chart makes no provisions for taxes, particularly

corporate income tax.

8. It usually assumes that the price of the output is given. In other words, it assumes a

horizontal demand curve that is realistic under the conditions of perfect

competition.

9. Matching cost with output imposes another limitation on break-even analysis. Cost

in a particular period need not be the result of the output in that period.

10. Because of so many restrictive assumptions underlying the technique, computation

of a breakeven point is considered an approximation rather than a reality.

1.7 Profit volume analysis

Profit volume analysis, also known as cost-profit-volume analysis, is the process of

calculating the profits of a business at different volumes, or revenue levels. Break-even analysis,

a component of profit volume analysis, is simply the calculation of the revenue level at which a

business shows neither a profit nor a loss. Generally, profit volume analysis involves five steps.

1) Set of range of business volumes for which you examine costs and profits.

This step is probably one of the most critical because all the information you input unit

sales price, variable costs, fixed costs, and costs varying with profits is usually valid only over a
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limited range of volumes. By carefully considering the relationships between costs and changes in

volume over a specific range, you can increase the accuracy of your analysis.

2) Calculate the unit sales price, the amount for which you sell your product or service.

For example, if you build and sell single family homes and your average sales price is Kes 100,000,

your unit sales price is Kes 100,000.

3) identify the costs that vary with revenue, the variable costs.

Typically, it’s easiest to express and calculate these variable costs either as an amount

determined per unit or as an amount determined as a percentage of revenues. For example, if you

build houses, many of your costs are best described as an amount per house. For example, your

land costs might average Kes15,000 per house and your material costs and your labor costs each

might average Kes 40,000. Other costs, however, are better described as a percentage of revenues.

For example, you might calculate sales commissions as 7% of the sales price and a state sales tax

as 1 1/2% of the sales price. The key assumption for the purpose of profit volume analysis,

however, is that within the range of business volumes you define, the variable costs change

proportionally, based on revenue.

4) Determine your fixed costs.

Fixed costs are those that stay constant, within the range of business volumes you define.

You label these costs “fixed,” not because you cannot change them, but because small to moderate

changes in revenue don’t change them. Examples of fixed costs are salaries of administrative

personnel, office rent, and business insurance.

5) Calculate your profits and any costs that vary with profits.
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Examples of these costs are income taxes and profit-sharing plans. The precise

determination of income taxes and similar costs requires detailed tax accounting. But you might

be able to estimate these income taxes and costs by applying an appropriate percentage to the

profits before income taxes and other costs that vary with profits. You can calculate the

contribution margin (the revenues minus the variable costs) and profit at any volume within the

range for which your inputs are valid. Although the analysis is only as good as your assumptions

and is subject to the inevitable inaccuracies that creep into any projection of the future, profit

volume analysis allows you to see roughly what happens to your profits over the likely range of

business volumes.

Conclusion

Maximising profits is said to be the objective of all firms. Indeed, it's not always easy for

the management to find out which are the right decisions that would maximise them. For instance,

short-run profits can be easily pumped up by avoiding maintenance, discretionary costs,

investments, that however are necessary of on-going competitiveness, as you can experiment

with this free business game. In reality, firms do have profits targets, and sometimes they pay

managers for reaching them, but the goals of firms are broader than profits alone. Proceeding with

other determinants of profits, rising prices of competitors, better sales conditions and skills, a

higher overall price level allow for higher prices of the considered firm's products, thus

increase nominal profits to the extent that costs are inelastic, i.e. they rise less than proportionally

to revenues. Generally, there is need for all firms to have right skills and knowhow on profit

management in order to for enhanced business management.

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