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Profit management nature scope theories of profit measurement policies

Profit Theory of Firm: To understand the theory of the firm, it is necessary to know the nature of profits.

  1. Profit planning of each firm begins with break-even analysis. Aid to ensure future capital.
  2. Implies that if the profits generated by organizations are high, they are liable for paying high taxes.
  3. According to him, the greater the risk, the higher is the expected profit. This helps in lowering the cost of production or improving the quality of production.
  4. Analysis of monetary policy, fiscal policy, industrial policy, foreign trade policy and other direct controls also help in forecasting business climate.

How profit management nature scope theories of profit measurement policies profits arise, what determines the volume of profits or stream of expected future profits are important issues that require explanation in this regard. Profits or expected profit stream from a productive activity or an investment play a crucial role in decision making by managers.

Therefore, it is necessary to first explain the difference between business profits and economic profits. Business profits are an accounting concept and represent the residual sales revenue to the owners of the firm after making payments to all other factors or resources the firm uses. These payments to hired factors include the wages to hired labour, interest on borrowed capital, rent on land and factory buildings and expenditure on raw materials used by the firm.

The expenditures on these factors or resources hired or purchased by the firms are call explicit costs. Business profit refers to the sales revenue of the firm minus its explicit costs.

In their calculation of economic profit, the economists deduct not only explicit costs but also implicit costs from the sales revenue of the firm. These self-owned factors must be paid if they are too employed by the firm in its own production process otherwise they will be employed elsewhere on hired basis.

Thus, economists take into account the normal rate of return on capital used by the owner of the firm in its own business and the transfer earnings of the owner-entrepreneur as costs of doing business. The risk adjusted rate of return on capital is the minimum return that is necessary to attract or retain it in business and is equal to what the owner could earn from investing in other firms.

Similarly, the opportunity cost of the entrepreneurial effort made by the owner entrepreneur is the salary that he could earn in his next best activity say, as the manager of another firm.

Likewise, the opportunity costs of other self-owned factors or inputs such as land, buildings used by the owner-entrepreneur in his own business will be counted as implicit costs.

The economic profit represents the sales revenue of the firm in excess of both explicit and implicit costs.

Profit: Types, Theories and Functions of Profit

While explaining maximisation of short-run profits or present value of the stream of expected profits in the future, economists assume that it is economic profits that owner- entrepreneur or managers of corporations seek to maximise.

The concept of economic profits brings into sharp focus the question why such profits which is over and above the normal rate of return on equity capital and reward for entrepreneurial ability in case of owner-entrepreneur, exists and what is its role in a free enterprise system. In long-run equilibrium economic profits will be zero if all firms work in perfectly competitive market.

  • Leads to better technology and dynamic efficiency;
  • These payments to hired factors include the wages to hired labour, interest on borrowed capital, rent on land and factory buildings and expenditure on raw materials used by the firm;
  • Apart from aforementioned functions, following are the positive results of high profits;
  • According to innovation theory, profit is the cause and effect of innovations;
  • Profits of businesses depend on the successful management of risks and uncertainties by entrepreneurs;
  • In other words, it acts as a necessary incentive for making innovation.

Then, how does an economic profit, positive or negative, come into existence. Role and Functions of Profits: Profits play an important role in a free market economy. Profits perform two important primary roles in such an economy. First, profits serve as a signal to change the rate of output or for the firms to enter or leave the industry. Second, profits play a critical role in providing incentive to introduce innovations and increase productive efficiency and take risks.

Thus, high economic profits being earned in an industry serve as a signal that consumers want more of the commodity being produced by that industry. These profits indicate to the firm to expend output of the commodity and for the new firms to enter the industry to gain a share of economic profits that exist in the industry.

As a result, more resources will be allocated to the output of that industry. On the other hand, below normal profits in an industry serve as a signal that either less output of the industry is demanded by the consumers or inefficient production methods are being used by the firms.

7 Important Scopes of Managerial Economics

In response to the lower demand for the product the firms will reduce their output and also some firms will leave the industry. As a result, some productive resources will be released from that industry and made available for the production of other goods. If the lower profits are due to the inefficient production and organisation, this will induce firm to improve efficiency by changing the production methods or make organisational changes to reduce costs.

Profit: Types, Theories and Functions of Profit

Profit motive drives a free-market economy. Although it has been observed that sometimes managers and entrepreneurs in a free market system are swayed by greed and avarice, and break laws to make money or profits by exploiting the consumers or workers but in general profits perform useful function of sending signals for changing levels of output of various products and for reallocation of resources among them.

Profit: Types, Theories and Functions of Profit

Secondly, above normal rate of profits in a free enterprise system is an essential reward for introducing innovations and taking risks.

No entrepreneur will introduce new products or more efficient of production methods or undertake investment in risky projects unless there is prospect of making profits. Some firms continue to earn above-normal rate of profit year after year as they are continually introducing new products, new production methods and providing good customer services.

In the economy changes in demand for the product often occur due to cyclical and structural changes. Besides, new strategies of rival firms also affect the demand for the product of a firm. All these uncertain and unanticipated changes involve a good deal of risk.

An important function of economic profits is to reward entrepreneurs for taking these risks involved in making investment and organising factors for the production of products. However, in some cases firms are also able to make supernormal profits by virtue of their having monopoly power.

  1. But in this world of uncertainty expectations are not always realized.
  2. An organization needs to earn sufficient profit to cover its various costs and survive in the business. The risks arise in the business due to various reasons, such as non-availability of crucial raw materials, introduction of better substitutes by competitors, obsolescence of a technology, fall in the market prices, and natural and manmade disasters.
  3. Their monopoly power may be due to some legal patent and license obtained from the government, the economies of large scale production, exclusive control over essential raw materials which prevent the other firms from producing the same product or service. A major draw back of BEC is its inability to handle production and sale of multiple products.
  4. On the other hand, non-calculable risks are those risks that cannot be accurately calculated and insured such as shifts in demand of a product. Knight divided the risks into calculable and non-calculable risks.

Their monopoly power may be due to some legal patent and license obtained from the government, the economies of large scale production, exclusive control over essential raw materials which prevent the other firms from producing the same product or service. These enable the monopoly firms to charges higher prices and thereby make large economic profits.

Therefore, even in free-market economies steps are taken to prevent the emergence of monopolies through anti-trust laws or Competition Acts as recently enacted in India. Of course, monopolies are legally permitted if they are needed in public interest.

Profit: Types, Theories and Functions of Profit

For example, in several cities Government grants license to some firms to provide public utility services such electricity, gas, telephone etc. In these cases of legal monopolies government regulates them and fix reasonable prices to be charged by them from the public but at the same time ensures fair return or normal profits to them on their investment.