Profit maximization decision criteria


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Profit maximization decision criteria:

Under this approach, actions that increase profits should be undertaken and those that decrease profits are to be avoided. In specific operational terms, the profit maximization criterion implies that the investment, financing and dividend policy decisions of a firm should be oriented towards the maximization of profits.

The rationale behind profit maximization as a guide to financial decision making, is due to the following reasons:

  1. Profit is a test of economic efficiency. It provides the yardstick by which economic performance can be judged.
  2. It leads to efficient allocation of resources as resources tend to be directed to uses, which in terms of profitability are the most desirable.
  3. It ensures maximum social welfare. This is so because the quest fro value drives scarce resources to their most productive uses and their most efficient users. The more effectively resources are deployed; the more robust will be the economic growth and the rate of improvement in the standard of living.

 

The profit maximization criterion however has been questioned and criticized on several grounds. It suffers from the following limitations:

  1. Profit in absolute terms is not a proper guide to decision making. It has no precise connotation. It should be expressed either on a per share basis or in relation to investment. Also, profit can be long term or short term, before tax or after tax, it may be the return on total capital employed or total assets or shareholders equity and so on. If profit maximization is taken to be the objective, which of these variants of profit should a firm try to maximize? Therefore, a loose term like profit cannot form the basis of operational criterion for financial management.
  2. It leaves considerations of timing and duration undefined. There is no guide for comparing profit now with profit in future or for comparing profit streams of different durations.
  3. It glosses over the risk factor. It cannot, for example, discriminate between an investment project, which generates a certain profit of Rs. 50,000, and an investment project, which has a variable profit outcome with an expected value of Rs. 50,000.

 


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