MANAGERIAL
ECONOMICS
CHAPTER 3.1
THE GOAL OF MAXIMUM PROFIT
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:
1. With TC constant, increase TR
2. With TR constant, decrease TC
3. 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
THE OPTIMUM COMBINATION
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.
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:
Selling Costs Sales Profits
A. (1st Stage) P 2,000 P 10,000 P 8,000
B. (2nd Stage) 4,000 15,000 11,000
C. (3rd Stage) 6,000 18,000 12,000
D. (4th Stage) 8,000 19,000 11,000
E. (5th Stage) 10,000 19,800 9,800
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.
THE OPTIMUM COMBINATION
Example B:
Sales Volume Revenue Total Costs
Price Profits
(units) from Sales (P1 per unit)
A P 10 P 1,000 P 10,000 P 1,000 P 9,000
B 8 2,000 16,000 2,000 14,000
C 6 3,000 18,000 3,000 15,000
D 4 4,000 16,000 4,000 12,000
E 2 5,000 10,000 5,000 5,000
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.
