THE GOAL OF MAXIMUM PROFIT

● Profitability is the only means to attain financial viability. In the absence of

profit, any firm will hardly be able to fulfill its responsibilities to different
stakeholders. Hence, profit is not considered a corporate objective in
itself, but a requirement for the attainment of objectives.

PROFIT

● The difference between total revenue from the sales of goods and
services and the total costs incurred in producing and selling these goods
and services.

Profit = Total Revenue – Total Cost or Pr = TR - TC

PROFIT MAXIMIZATION

● Given the formula, there are three possible approaches/ways of

increasing profit:

A.With TC constant, increase TR

B. With TR constant, decrease TC
C.Increase TR and decrease TC

Approach 1: With TC constant, increase TR

● When a businessman tries to increase total revenue by promoting sales,

total costs can hardly be expected to remain constant.
● Sales may have risen precisely because more inputs (and therefore
higher costs) went into the production and marketing of more goods that
were sold.

Approach 2: With TR constant, decrease TC

● When a businessman reduces his costs (which be accompanied by less

inputs), total revenue may not remain constant.
● It could very well decrease also because of reduced selling effort and/ or
decreased production. It is therefore, not clear whether profit will rise if
total costs are decreased.

Approach 3: Increase TR and decrease TC

● This approach seems to be the best of both worlds. In fact, it is the
simplistic advice of a number of management consultants. “Increase
revenue and decrease costs!” Let us, therefore, see how economic
analysis opens new horizons in profit planning to the firm manager.
THE OPTIMUM COMBINATION

● How do firms usually attains a preferred level of profit? One very common
practice is to determine the price of a commodity based on the firm’s
average cost plus a fixed mark-up; that is,

Price per unit = Average Cost + Mark-up

● Since average cost is defined as the cost incurred in producing a single

unit, then pricing a commodity at any level above average cost yields
profit. In the last formula, profit per unit is the difference between price
and average cost that is,

Profit (or Mark-Up) = Price per unit - Average Cost

● Total profit, in turn, equals profit per unit times total quantity sold.

OPTIMIZATION
● The firm’s cost accountant tells the manager how much each unit costs
and the manager simply applies the formula to determine price and
subsequently total profit.
● By applying economic analysis, firms can attain still higher levels of profits
even beyond the projected mark-up rate. The firm manager must have a
clearer understanding of the concept of optimization.

● The rationale behind optimization can be stated as follows:

-As the revenue and cost increase simultaneously, though at different
rates, the combination that yields maximum profit (the optimum combination)
is that which corresponds to the level of production at which the difference
between revenue and cost is greatest.

THE OPTIMUM COMBINATION

The

illustration shows that profit does not necessarily increase with greater
revenue. If cost rises faster than revenue, profit declines.

THE OPTIMUM COMBINATION

EXAMPLE A:

It is clear from this example that only by choosing combination C will the firm
manager be maximizing total profits. To be contented with other combinations
just because they, too, yield profits would not be optimizing. And this is the
case when a fixed mark-up rate is the basis for profit. It is clear also that more
sales does not necessarily mean more profits.

EXAMPLE B:

Since we assumed that demand is present, a price of P10, though resulting in

less sales volume, yields a profit of P9 per unit. An analysis of various
alternatives shows that profits is not maximum in either case. Some price
level between these two extremes corresponds to our optimum combination of
sales and costs. In our example, this price is at P6 where profit is maximized
at P5 per unit.

OPTIMIZATION

● These examples are hypothetical. Actual situations are not as simple as

these, but they serve to illustrate the concept of optimization