CHAPTER-2

BUSINESS OBJECTIVES OF ORGANIZATIONS

AUTHOR: DR. JASWINDER SINGH

BUSINESS OBJECTIVES

Business objectives refer to the purpose for which a business is established. In simple terms, business objectives are statements that enable various stakeholders of an organization, such as employees, managers, customers, and suppliers, to understand the underlying basis of business activities. An organization can be successful and survive in the longterm if it sets ef fective business objectives.

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CRITERIA FOR EFFECTIVE BUSINESS OBJECTIVES

Quantitative: Implies that business objectives should be expressed in terms of numbers . T ime specific: Implies that an organization should clearly mention the time period up to which a par ticular goal should be achieved. Realistic: Implies that an organization should set an objective that can be achieved within the given time and available resources. Under standable: Constitutes an impor tant characteristic of business objectives. The business objectives of an organization should not be complex and formulated in a comprehensible way. Flexible: Implies that the business objectives of organizations should be adaptable to change.

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CONCEPT OF PROFIT
Profit simply means a positive gain generated from business operations or investment after subtracting all expenses or costs. In economic terms, profit is defined as a reward received by an entrepreneur by combining all the factors of production to serve the needs of individuals in the economy faced with uncertainties. In a layman language, profit refers to an income that flows to investors. In accountancy, profit implies excess of revenue over all paid out costs. Profit in economics is termed as a pure profit or economic profit or just profit.

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T YPES OF PROFIT
Accounting Profit: Refers to a return that is calculated as a dif ference 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. The accounting profit is calculated as: Accounting Profit= TR -(W + R + I + M) = TR - Explicit Costs Economic Profit: Takes into account both explicit costs and implicit costs or imputed costs. Implicit cost implies the income that is foregone which an entrepreneur can gain from the next best alternative use of resources. Economic profit = Total revenue (Explicit costs + implicit costs)
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THEORIES OF PROFIT

Walkers Theory Clarks Dynamic Theory Hawleys Risk Theory Schumpeters Innovation Theory Knights Theory

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WALKERS THEORY RENT THEORY OF PROFIT

According to Walker , as rent is the difference between least and most fer tile land similarly, profit is the difference between earnings of the least and most efficient entrepreneurs . Profit is the rent of exceptional abilities that an entrepreneur possesses over others. An efficient entrepreneur is rewarded with profit as rent for his differential ability. Criticism: Fails to focus on the nature of profit Provides only a measure of profit Assumes that profits arise because of the superior or exceptional ability of the entrepreneur, which is not always true. Profit can also be the result of the monopolistic position of the entrepreneur.

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CLARKS DYNAMIC THEORY

Introduced by an American economist, J.B. Clark . According to Clark , profit does not arise in a static economy, but arise in a dynamic economy. Only normal profits are earned in the static economy. However, an economy is always dynamic in nature that changes from time to time. The dynamic world of fer s oppor tunities to entrepreneurs to make pure profits. The entrepreneur s, who successfully take advantage of changing conditions in a dynamic economy, make pure profit . Criticism: Prof. Knight criticized the dynamic theor y on the basis that only those changes that cannot be foreseen yield profits. He fur ther says, It cannot, then, be change, which is the cause of profit, since if the law of change is known, as in fact is largely the case, no profits can arise. Change may cause a situation out of which profit will be made, if it brings about ignorance of the future.

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HAWLEYS RISK THEORY

According to Hawley, profit is the reward of risk taking in a business. During the conduct of any business activity, all other factors of production i.e. land, labor, capital have guaranteed incomes from the entrepreneur. They are least concerned whether the entrepreneur makes the profit or undergoes losses. 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. Criticism: Profits arise not because risks are borne, but because the superior entrepreneurs are able to reduce them Another criticism is that profits are never in the proportion to the risk undertaken. Profits may be more in enterprises with low risks and less in enterprises with high risks
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KNIGHTS THEORY - UNCERTAINT YBEARING THEORY OF PROFITS

According to the theor y given by Prof. Knight , profit is a reward for the uncer tainty bearing and not the risk taking. According to Knight, risks are foreseen in nature and can be insured . Thus, risk taking is not a function of an entrepreneur, but of insurance organizations.

An entrepreneur gets profit as a reward for bearing uncer tainties.

Criticism: Assumes that profit is the result of uncer tainty bearing ability of an entrepreneur, which does not always hold true. The profit can also be the reward for other aspects, such as strong co -ordination and market share. Fails to show any relevance with the real world.
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SCHUMPETERS INNOVATION THEORY

Joseph Schumpeter propounded innovation theory According to this theory, profits are the reward for innovation. Profit is the cause and effect of innovations. In other words, it acts as a necessary incentive for making innovation. In general, innovation can take place in two ways, which are as follows:
Reducing the cost of production and earning high profit. The cost of production can be reduced by introducing new machines and improving production techniques. Stimulating the demand by enhancing the existing improvement or finding new markets.

Criticism: Ignores uncertainty as a source of profit Denies the role of risk in profit

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FUNCTIONS OF PROFIT
Tool for measuring performance Source of covering costs Aid to ensure future capital

Investment in research and development

Reward for shareholders Aid for economies Tool to stimulate government finances

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ISSUES IN MEASURING PROFIT

Two q u e s t i o n s a r i s e w h e n m e a s u r i n g p r o fi t :

Question W h i c h c o n c e p t ( a c c o u n t i n g p r o fi t o r e c o n o m i c p r o fi t ) s h o u l d b e u s e d f o r m e a s u r i n g p r o f i t ? Solution: Ac c o u n t i n g c o n c e p t o f p r o fi t i s u s e d w h e n a n e x a c t fi g u r e o f p r o fi t i s r e q u i r e a n d e c o n o m i c p r o f i t s h o u l d b e u s e d w h e n t h e p u r p o s e i s to m e a s u r e t r u e p r o fi t .
Question W h a t c o s t s s h o u l d b e o r s h o u l d n ot b e i n c l u d e d i n i m p l i c i t a n d e x p l i c i t c o s t s ? Solution Three types of costs pose problem: D e p r e c i a t i o n : M e a s u r i n g d e p r e c i a t i o n b e c o m e s d i f fi c u l t a s t h e r e a r e d i f f e r e n t m e t h o d s f o r measuring it. C a p i t a l G a i n s a n d L o s s e s : Ac c o r d i n g to a s o u n d a c c o u n t i n g p o l i c y, b o t h c a p i t a l g a i n s a n d l o s s e s s h o u l d n ot b e r e c o r d e d u n t i l t h ey a r e t u r n e d i n to c a s h . C u r r e n t v s H i s t o r i c a l C o s t s : C u r r e n t c o s t s a l way s t a ke i n to a c c o u n t c u r r e n t e c o n o m i c c o n d i t i o n s a n d H i s to r i c a l c o s t s i g n o r e i n fl a t i o n a n d d e fl a t i o n . T h e r e f o r e , t h e v a l u e s o f a s s e t s o r i nv e n to r i e s r e c o r d e d by t a k i n g i n to c o n s i d e r a t i o n h i s to r i c a l c o s t s a r e u n d e r s t a t e d .

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PROFIT MAXIMIZATION
Profit maximization is the most reasonable and productive business objective of an organization . Total profit () = Total Revenue(TR) Total Cost(TC) There are two conditions that must be fulfilled for profit maximization, namely, fir st order condition and second order condition.

First order condition

The first order condition states that first derivative of profit must be equal to zero.

=TR- TC Taking its derivative with respect to Q, / Q = TR/ Q -- TC/ Q= 0 This condition holds only when TR/ Q = TC/ Q Thus, the fir st -order condition for profit maximization is MR=MC.
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PROFIT MAXIMIZATION (CONTD.)

Second Order Condition
Requires that first order condition must be satisfied in case of decreasing MR and rising MC. It can be seen from Figure that MR and MC curves intersect at points P1 and P2. MR is less than MC at point P2, thus, the second order condition is satisfied at point P2.

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HYPOTHESES FAVORING PROFIT MAXIMIZATION

Profit is indispensible for organizations survival Profit helps in achieving other objectives Profit maximization has a greater predicting power Profits acts as measure for organizations ef ficiency

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ALTERNATIVE OBJECTIVES OF BUSINESS ORGANIZATIONS

Williamsons hypothesis of maximization of managerial utility function Marriss Hypothesis of Maximization of Organizations Growth Rate Rothchilds hypothesis of long-run survival and market share goals Entry prevention and risk avoidance

Baumals Hypothesis of Sales Revenue Maximization

Alternative objectives of business organizations

Cyert-March Hypothesis of Satisficing Behavior

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PROFIT PLANNING AND CONTROL

According to Peter Drucker, profit is a condition of sur vival. It is the cost of the future, the cost of staying in a business. Thus, profit should be planned and managed properly. Profit planning process : 1. Establishing profit goals 2. Determining expected sales volume 3. Estimating expenses 4. Determining estimated profit Profit control involves measuring the gap between the estimated level and actual level of profit achieved by an organization. Profit control process: 1. Comparing estimates with the goal 2. Using alternatives to achieve the desired profit
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RECAP
Business objectives refer to the purpose for which a business is established. Profit is defined as a reward received by an entrepreneur by combining all the factors of production to serve the needs of individuals in the economy faced with uncertainties. Accounting and economic profit are two different types of profit. Different profit theories are Walkers Theory Rent Theory of profit, Clarks Dynamic Theory, Hawleys Risk Theory, Knights Theory - uncertainty - bearing theory of profits, and Schumpeters Innovation Theory. The first order condition of profit maximization states that first derivative of profit must be equal to zero. The second- order equation requires that first order condition must be satisfied in case of decreasing MR and rising MC.

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