UNIT VIII PROFIT MANAGEMENT

Introduction

Profit is the life blood of every business. Without profit no organization could survive
for a long period. It is regarded as an incentive for undertaking entrepreneurial
function. It is regarded as a reward for risk taking. It is the excess of total revenue
over total cost. In other words, it is the reward or return accruing to the entrepreneur
who is able to keep total revenue below total cost.

Thus, we can say, profit is the reward for entrepreneurial ability and goes to the
entrepreneur of the firm. According to Von Thunen, "profit is the residue after
deduction of interest, insurance for risk and wages for management." Thus, from
economic point of view, profit is residual of income over and above all economic
cost, both explicit and implicit, that results from the operation of a business. It is a
return to the entrepreneur for risk taking.
Nature of Profit Management
Profit may be defined as the reward earned by the entrepreneur for his two fold
services to production, namely management and risk-taking. The entrepreneur plans
the business, hires the services of land, labour and capital and organizes then to his
best ability. He pays rent, wages and capital at fixed rate. What remains after paying
those is called Profit. The amount of profit is thus uncertain.

According to Professor Knight, profit is the reward for uncertainty-bearing and not for
risk, taking in a business. According to him there are two kinds of risks which
entrepreneur has to bear? Some risks are of such a nature that they can be anticipated
to a fair degree of accuracy e.g. the risk of death, accident etc and so can be insured in
return for premium. The entrepreneur can include the payment made in the form of
premium in the total cost of production. So such risk which can be calculated and
inscribed should not entitle entrepreneur to a profit.
On the other hand, there are some risks which are unpredictable and unforeseen and
so they are non-insurable. For instance, if the demand for product of entrepreneur
suddenly comes down due to changes in fashions, tastes etc, then he may no be able to
cover his total costs of production.
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Scope of Profit
It looks at how these costs are interrelated to costs and revenue streams elsewhere in
the business. In looking at these you also need to be aware of the associated
opportunity-costs in reducing or increasing these costs, or if you change the ‘blend’ of
costs.
For example, increasing the level of automation on a production line will impact the
variable costs, as well as the fixed costs. However, it may enable a wider range of
products to be produced from the same production line and contribute to the creation
of new revenue streams.
Once you have a holistic understanding of your existing costs; and you are clear on
your outcomes, metrics and benefits/value; you need to priorities which costs to
address and how. In doing this considers:

1. The Scope of Managing the Costs – how extensive will this cost
management program be? If you work on a silo-basis you are likely to incur
costs in managing the costs, and are likely to reduce the benefits and returns
you are looking for.
2. Growth Opportunities – where are the current and future growth
opportunities? Where are they not? You need to manage costs carefully;
improper cost management can be detrimental and could damage the business,
or you could miss out on opportunities.
3. Long-term Commitment – are you willing and able to take a long-term
perspective. Short-term ‘slash-and-burn’ approaches associated with cost-
cutting tend to destroy value and capacity.
4. Manage the Change – how will you communicate this process/program
throughout the business and engage the workforce in it. Failure often comes
at the tactical level when people either implement poorly due to
misunderstanding what has to be done and why, or may be sabotaged through
passivity. You need to create commitment, not compliance.
5. Strategic Investments – be clear on what your strategic investments are,
those areas which are critical to sustained performance and profitability.
6. Understand Your Business Model – thoroughly understand the components
of your business model, how they integrate, and how the business model could
be improved.

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Theories of Profit
1. Wage Theory of Profit
This theory was given by American Economist Taussig which is well supported by
Davenport. According to this theory, profit is similar to wage, which is given to the
entrepreneur for the services rendered by him in the business. This theory explains the
similarity between labour and entrepreneur. Just as labour get wages for the services
rendered in the business, an entrepreneur gets profit in the business for providing
services in the business. Thus this theory give emphasis that profit is a type of wage
for the entrepreneur.
But this theory has ignored the fact that a labour does not undertake any risk whereas,
an entrepreneur always undertakes risk so he is liable to have profit. This theory also
ignores that a labour will always get wages under all circumstances i.e. wages are
always positive but this is not applicable in case of profit. Because profit may be
positive, zero, or negative.
Criticism
1. Wages are always positive, but it is not essential that profit is always positive. It
may be positive, zero, or even negative in dimension
2. Labour and entrepreneur are not similar. Labour is generally performing physical
task whereas, entrepreneur is undertaking mental exercise.
3. This theory does not explain the profit which is received by the shareholder, who is
not rendering any service.
4. Labour does not undertakes any risk, but an entrepreneur undertakes risk so there is
no similarity between labour and entrepreneur
2. Risk Theory of Profit
This theory was propounded by American economist Hawley in 1907. According to
this theory profit is the reward for risk taking. If any entrepreneur in business
undertakes risk, he is liable to have profit, and if he is not prepared to take any risk, he
is not liable to have profit. Thus, this theory is based on the basic principle that higher
the risk, higher the profit and lower the risk, lower the profit.
Criticism
1. There is no direct relationship between risk and profit
2. Profit does not arises due to risk taking rather accrues due to avoidance of risk
3. Profit does not arise due to all types of risk.
4. It does not measure the volume of profit.
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3. Uncertainty Bearing Theory of Profit
This theory was propounded by American economist F. H. Knight in the year 1927.
According to this theory profit is the reward for bearing uncertainty. This theory is
also known as Knight's Theory of profit, as he lays down the difference that profit
does not arise from all types of risk. So he divided risk under two heads namely -
foreseen and unforeseen risk.
Foreseen risk is those which can be predicted and can be provided for through
insurance. It includes risk of fire, threat, etc. whereas unforeseen risk refers to those
which cannot be predicted and cannot be got covered through insurance. Under this
we include government policy, business cycles, competitive risk, technical risk, etc
According to Prof Knight, profit does accrue from all types of risk. It arises due to
non – insurable risk. As this risk cannot be foreseen and no insurable company is
ready to cover these risks, these are called non-insurable risk or uncertainty bearing
risk
Criticism
1. Uncertainty bearing is not any factor of production.
2. Profit is not the only reward for uncertainty bearing.
3. This theory does not measure the volume of profit.
4. This theory explains only sudden and causal explanation of profit.
4. Dynamic Theory of Profit
This theory was propounded by American economist J.B. Clark. According to him,
profit always arises in a dynamic economy and not in a static economy. The basic
reason for arising profit in a dynamic economy is continuous changes in the economy.
In case of a static economy, there is no change in economy. The activities of the
previous year will be repeated in current year, as a result price will be equal to its cost
and there will be no profit.
According to Clark, there are five changes, which are continuously taking place in the
dynamic economy and they are responsible to have profit. They are
Continuous change in population
Continuous changes in techniques of production
Continuous changes in supply of capital
Continuous changes in structure of organization
Continuous changes in human want due to change in taste, preference, and
habit of the consumer.
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In the view of Clark, only those entrepreneurs will survive and develop and get profit
who will adopt these changes in order to satisfy consumer needs. Those entrepreneurs
who do not accept these changes will not survive and will not get any amount of
profit.
Criticism
1. Not every change does not bring profit.
2. Static economy does not exist in the real world.
3. This theory does not give any importance to uncertainty bearing and risk taking
4. It does not measure the volume of profit
5. Innovation Theory of Profit
This theory was given by American economist J.A.Schumpeter. This theory is very
much similar to Dynamic theory of Profit. But instead of adopting the five changes,
which are continuously taking place in the economy, this theory stresses more on
innovation. By innovation, Schumpeter means adopting new techniques of
production, as a result of which production cost would tend to decline and it will lead
to increase in profit.
If a firm wants to increase the level of profit, it can do this by two ways
it can either increase the price of the product or
try to reduce cost of production
The first strategy is not appropriate, due to increase in competition in the market. If
the firm increases the price of the product, the other rival will not increase the price,
as a result, the demand will fall, which will further reduce the profit margin.
The second way is much better way to increase the volume of profit. This profit will
arise to the firm continuously, until the firm does not accept this innovation. Thus, it
can rightly remark that the profit which accrues due to innovation now lapses away.
Thus, this theory explains that profit accrues to the firm only because of innovations
and not due to any other reason.
Criticism
1. This theory ignores risk factor of the entrepreneur.
2. Profit does not accrue due to innovations only.
3. This theory fails to measure volume of profit.
4. This theory relates to short period only.

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6. Marginal Productivity Theory of Profit
This theory explains that reward for each and every factor of production can be
decided by marginal productivity of that factor of production. The theory assumes
entrepreneurial ability is also factor of production.
According to this theory, the value of entrepreneurial ability i.e. profit is decided by
his marginal productivity. As marginal productivity curve for a factor of production is
demand curve for that factor, in the same manner marginal productivity curve is
demand curve for entrepreneur.
The supply of entrepreneurial ability is scarce, and it depends on how much they earn
in an industry or his income i.e. transfer income and opportunity cost. It cannot be
increased or decreased easily and at once. Able entrepreneur's demand is more and
earns high profit and vice versa. Supply being scarce, entrepreneurs earn huge profit
due to higher marginal productivity.
Under conditions of perfect competition, profits of an entrepreneur tend to equal to his
marginal productivity. But when we analysis this theory we find that perfect
competition is no where found in the real world. Perfect competition is a myth.
Criticism
1. This theory assumes all entrepreneur of same type with equal skill is wrong
2. This theory is one sided. It gives much emphasis on demand side and ignores
supply side.
3. This theory is based on assumption of perfect competition and in real practices
Perfect competition does not exist
4. This theory does not consider windfall profit
5 It is difficult to determine marginal productivity of entrepreneur because in case but
in case of a there is only one entrepreneur.
Measurement Policies
Generally it is believed that firms only have profit maximization. Moreover, the
volume of profit made by it is regarded as a primary measure of its success. A firm
may follow many policies which may reduce short-run profit in order to establish a
better long-run situation. Development of new markets, R&D expenditure, etc., fall
into these types of policies.
The factors that limit profits can be classified into two groups.
1. Internal factors
2. External factors.
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The factors which largely arise from the firm’s own operations are called internal
limiting factors. These factors are not often recognized as profit limiting factors
because their impact on cutting down profits is quite indirect.
The profit limiting factors which arise from external sources are easily recognized and
planned for by the management.
1. Types of Internal factors
The limiting factors which arise due to the firm’s operations and indirectly
result in reduction of profits are:
Management’s reluctance to change – In order to ensure the security of their
job, managers normally do not wish to take very risky adventures, through
these may promise a high rate of profit. They only act to maintain the profit
rate and thus ace as risk averters,
Building a reputation – Some management try to build a reputation for their
firms, irrespective of the level of profits they earn. They do so with an idea to
make their firms as leaders in the industry.
Preferences of liquidity – Many a time, a firm needs to enter new areas of
production. Some firms avoid entering into new ventures to maximize profits
because that would require increased investment in fixed assets, thus reducing
liquidity. For such firms sound financial conditions are more important than
maximum profits.
2. Types of External factors
Those factors which are beyond the control of the firm and force the firm to
abandon the profit maximizing goals are:
Company’s goodwill – A company may choose to limit profits in order to
create an impression of charging fair prices.
Aiming at entry-barrier – In order to preserve its monopoly position a firm
may prefer lower profits rate would that deter entry of new firms into the
industry. In such a case, firm is advised to follow a price policy in line with
the rest of the industry rather than exploit the situation for quick and high
profits.
To limit demands of labour unions – In industries having strong trade
unions, a high profit rate would invite demands for higher wages on the
ground that these demands do not adversely affect the firm.

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 In an inflationary situation, the firms can easily meet such demands, but they
cannot do so in recessionary conditions.
To avoid legal problems – Anti-trust legislations prohibit excessive profit
earning by the firms. In order to avoid these anti-trust legislations, the firms
may limit their profits.
Setting profit standards
Though the firms do not always seek to maximize profits, it cannot be denied that
profit-earning is the only meaningful measure of corporate success and managerial
effectiveness. Given these measures, it is desirable to employ some kind of profit
yardstick to know what is an acceptable performance of an enterprise from the point
of view of shareholders and the management itself.

Cost – Volume – Profit Analysis

Cost – Volume – Profit analysis is a technique for studying the relationship between
cost, volume and profits. Profits of an undertaking depend upon a large number of
factors. But the most important of these factors are the cost of manufacture, volume of
sales and the selling prices of the products.
In the words of Herman C. Heiser, “the most significant single factor in profit
planning of the average business is the relationship between the volume of business,
costs and profits”.

CVP analysis expands the use of information provided by breakeven analysis. A

critical part of CVP analysis is the point where total revenues equal total costs (both
fixed and variable costs). At this break-even point, a company will experience no
income or loss. This break-even point can be an initial examination that precedes
more detailed CVP analysis.

BREAKEVEN ANALYSIS
The study of cost-volume-profit relationship is often referred as BEA. The
term BEA is interpreted in two senses. In its narrow sense, it is concerned with
finding out BEP; BEP is the point at which total revenue is equal to total cost. It is the
point of no profit, no loss. In its broad determine the probable profit at any level of
production.

Break-even analysis is that part of Cost-Volume-Profit Analysis which tells us about

the level of sales at which revenues equals expenses thus showing a zero net income
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more precisely, such a sales point is called Break-Even Point. CVP analysis is
sometimes referred to simply as break-even analysis. This is unfortunate because
break-even analysis is just one part of the entire CVP analysis. Profit planning of each
firm begins with break-even analysis.

Break Even Chart

It is a graphical representation of costs at different levels as shown below-

Assumptions:
1. All costs are classified into two – fixed and variable.
2. Fixed costs remain constant at all levels of output.
3. Variable costs vary proportionally with the volume of output.
4. Selling price per unit remains constant in spite of competition or change in the
volume of production.
5. There will be no change in operating efficiency.
6. There will be no change in the general price level.
7. Volume of production is the only factor affecting the cost.
8. Volume of sales and volume of production are equal. Hence there is no unsold
stock.
9. There is only one product or in the case of multiple products. Sales mix
remains constant.

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Merits:
1. Information provided by the Break Even Chart can be understood more easily
then those contained in the profit and Loss Account and the cost statement.
2. Break Even Chart discloses the relationship between cost, volume and profit.
It reveals how changes in profit. So, it helps management in decision-making.
3. It is very useful for forecasting costs and profits long term planning and
growth
4. The chart discloses profits at various levels of production.
5. It serves as a useful tool for cost control.
6. It can also be used to study the comparative plant efficiencies of the industry.
7. Analytical Break-even chart present the different elements, in the costs –
direct material, direct labour, fixed and variable overheads.
Demerits:
1. Break-even chart presents only cost volume profits. It ignores other
considerations such as capital amount, marketing aspects and effect of
government policy etc., which are necessary in decision making.
2. It is assumed that sales, total cost and fixed cost can be represented as straight
lines. In actual practice, this may not be so.
3. It assumes that profit is a function of output. This is not always true. The firm
may increase the profit without increasing its output.
4. A major draw back of BEC is its inability to handle production and sale of
multiple products.
5. It is difficult to handle selling costs such as advertisement and sale promotion
in BEC.
6. It ignores economics of scale in production.
7. Fixed costs do not remain constant in the long run.
8. Semi-variable costs are completely ignored.
9. It assumes production is equal to sale. It is not always true because generally
there may be opening stock.
10. When production increases variable cost per unit may not remain constant but
may reduce on account of bulk buying etc.
11. The assumption of static nature of business and economic activities is a well-
known defect of BEC.

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 Various variables used in BEP, they are:-
1. Fixed cost
2. Variable cost
3. Contribution
4. Margin of safety
5. Profit volume ratio
6. Break-Even-Point

1. Fixed cost: Expenses that do not vary with the volume of production are known
as fixed expenses. Eg. Manager’s salary, rent and taxes, insurance etc. It should be
noted that fixed changes are fixed only within a certain range of plant capacity.
The concept of fixed overhead is most useful in formulating a price fixing policy.
Fixed cost per unit is not fixed.
2. Variable Cost: Expenses that vary almost in direct proportion to the volume of
production of sales are called variable expenses. Eg. Electric power and fuel,
packing materials consumable stores. It should be noted that variable cost per unit
is fixed.
3. Contribution: Contribution is the difference between sales and variable costs and
it contributed towards fixed costs and profit. It helps in sales and pricing policies
and measuring the profitability of different proposals. Contribution is a sure test to
decide whether a product is worthwhile to be continued among different products.

Contribution = Sales – Variable cost

Contribution = Fixed Cost + Profit.
4. Margin of safety: Margin of safety is the excess of sales over the break even
sales. It can be expressed in absolute sales amount or in percentage. It indicates
the extent to which the sales can be reduced without resulting in loss. A large
margin of safety indicates the soundness of the business. The formula for the
margin of safety is:
Profit
Present sales – Break even sales or
P. V. ratio
Margin of safety can be improved by taking the following steps.
1. Increasing production
2. Increasing selling price

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5. Profit Volume Ratio is usually called P. V. ratio. It is one of the most useful
ratios for studying the profitability of business. The ratio of contribution to sales is
the P/V ratio. It may be expressed in percentage. Therefore, every organization
tries to improve the P. V. ratio of each product by reducing the variable cost per
unit or by increasing the selling price per unit. The concept of P. V. ratio helps in
determining break even-point, a desired amount of profit etc.

Contribution
The formula is, X 100
Sales
6. Break – Even- Point: If we divide the term into three words, then it does not
require further explanation.
Break-divide
Even-equal
Point-place or position
Break Even Point refers to the point where total cost is equal to total revenue.
It is a point of no profit, no loss. This is also a minimum point of no profit, no
loss. This is also a minimum point of production where total costs are
recovered. If sales go up beyond the Break Even Point, organization makes a
profit. If they come down, a loss is incurred.

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