Share holders have invested their money in the organization losing the alternative investment opportunities in anticipation of getting better return here. Other creditors also lent their money in anticipation of getting interest on their money in time. The organization can meet their expectations only when it maximizes its profits.
Profit earning is the main aim of every economic activity. Profits are required to cover the costs & survive, to run the business smoothly taking care of contingencies and to provide funds for growth. Profits serve as the measure of efficiency of an organization and indicate the risk bearing ability during unfavorable times. The objective of Profit maximization is in congruence with most of the businesses. It helps to maximize the socio-economic welfare.
The concept of economic profit is far removed from the accounting profit found in a company’s profit and loss account. While economic profit broadly equates to cash, accounting profit does not. There are many examples of companies going into liquidation shortly after declaring high profits. Polly Peck plc’s dramatic failure in 1990 is one such example. This leads us to the first of three fundamental problems with profit maximisation as an overall corporate goal. The first problem is that there are quantitative difficulties associated with profit.
Maximisation of profit as a financial objective requires that profit be defined and measured accurately, and that all the factors contributing to it are known and can be taken into account. It is very doubtful that this requirement can be met on a consistent basis. If five auditors go into the same company, the chances are that each will come out with a different profit figure.
The second problem concerns the timescale over which profit should be maximised. Should profit be maximised in the short term or the long term? Given that profit considers one year at a time, the focus is likely to be on short-term profit maximisation at the expense of long-term investment, putting the long-term survival of the company into doubt.
The third problem is that profit does not take account of, or make an allowance for, risk. It would be inappropriate to concentrate our efforts on maximising accounting profit when this objective does not consider one of the key determinants of shareholder wealth.
Shareholders’ dividends are paid with cash, not profit, and the timing and associated risk of dividend payments are important factors in the determination of shareholder wealth. When considered this fact together with the problems just discussed, one can only conclude that maximisation of profit is not a suitable substitute objective for maximisation of shareholder wealth. That is not to say that a company does not need to pay attention to its profit figures, since falling profits or profit warnings are taken by the financial markets as a sign of financial weakness. In addition, profit targets can serve a useful purpose in helping a company to achieve short-term or operational objectives within its overall strategic plan.
The following are the drawbacks of Profit Maximization as the objective of finance:
- The term ‘Profit is vague and is not clear. It means different things. It is not clear as to profits before tax or after tax or total profit or earnings per share. It leaves considerations of timing and duration undefined.
- Profit maximization objective ignores the time value of money.
- It does not consider the element of risk
- It exploits employees, customers and others
