Md. Taijul Islam Id:2015-3-95-105

2. "Profit maximization is the main objective of a firm "Dissxus this statement with the help of an example. An assumption in classical economics is firms seek to maximize profits. Profit = Total Revenue – Total Costs

Therefore, profit maximization occurs at the biggest gap between Total revenue and total costs. A firm can

maximize profits if it produces at an output where Marginal revenue (MR) = Marginal cost (MC).

Profit maximization is the main aim of any business and therefore it is also an objective of financial

management. Profit maximization, in financial management, represents the process or the approach by which

profits (EPS) of the business are increased. In simple words, all the decisions whether investment, financing, or

dividend etc are focused to maximize the profits to optimum levels.

Profit maximization is the traditional approach and the primary objective of financial management. It implies

that every decision relating to business is evaluated in the light of profits. All the decision with respect to new

projects, acquisition of assets, raising capital, distributing dividends etc are studied for their impact on profits

and profitability. If the result of a decision is perceived to have positive effect on the profits, the decision is

taken further for implementation.

Diagram of Profit Maximisation

To understand this principle look at the above diagram. If the firm produces less than Q1, MR is greater than

MC. Therefore, for this extra output, the firm is gaining more revenue than it is paying in costs. Total revenue

will increase. Close to Q1, MR is only just greater than MC, therefore, there is only a small increase in profit.

But, profit is still rising.However, after Q1, the marginal cost of the output is greater than the marginal revenue.

This means the firm will see a fall in its profit level.

Profit Maximisation for a monopoly

In this diagram, the monopoly maximizes profit where MR=MC – at Qm. This enables the firm to make

supernormal profits (green area). Note the firm could produce more and still make normal profit. But, to

maximize profit, it involves setting higher price and lower quantity than a competitive market.

Therefore, for a firm profit maximization involves selling a lower quantity and at a higher price.

Profit Maximization in Perfect Competition

In perfect competition, the same rule for profit maximization still applies. The firm maximizes profit where

MR=MC. For a firm in perfect competition, demand is perfectly elastic, therefore MR=AR=D.

Limitations of Profit Maximization

In the real world it is not so easy to know exactly your marginal revenue and marginal cost of last goods sold.

For example, it is difficult for firms to know the price elasticity of demand for their good – which determines

the MR.

It also depends on how other firms react. If they increase price, and other firms follow, demand may be

inelastic. But, if they are the only firm to increase price, demand will be elastic (see: kinked demand curve and

game theory.

However, firms can make a best estimation. Many firms may have to seek profit maximization through trial and

error. e.g. if they see increasing price leads to a smaller % fall in demand they will try increase price as much as

they can before demand becomes elastic

It is difficult to isolate the effect of changing price on demand. Demand may change due to many other factors

apart from price.

Firms may also have other objectives and considerations. For example, increasing price to maximize profits in

the short run could encourage more firms to enter the market; therefore firms may decide to make less than

maximum profits and pursue a higher market share.

Profit Maximization Theory / Model: The Rationale / Benefits:

Profit maximization theory of directing business decisions is encouraged because of following advantages

associated with it.

Profit Maximization or Maximization of Profits Economic Survival: Profit maximization theory is based on

profits and profits are a must for survival of any business.

Measurement Standard: Profits are the true measurement of viability of a business model. Without profits, the

business losses its primary objective and therefore has a direct risk on its survival.

Social and Economic Welfare: The profit maximization objective indirectly caters to social welfare. In a

business, profits prove efficient utilization and allocation of resources. Resource allocation and payments for

land, labor, capital and organization takes care of social and economic welfare.

Md. Imrul Hasan Id: 2015-3-95-086

3. An analytical tool frequently employed by managerial economists is the breakeven chart, an important application of cost functions. Break-even analysis is a technique widely used by production management and management accountants. The breakeven chart illustrates at what level of output in the short run, the total revenue just covers total costs. Generally, a breakeven chart assumes that the firm’s average variable costs are constant in the relevant output range; hence, the firm’s total cost function is assumed to be a straight line

Break-even analysis calculates the volume of-production at a given price necessary to cover all costs. To explain how break-even analysis works, it is necessary to define the cost items.

Fixed costs: Fixed costs which are incurred after the decision to enter into a business activity is made, are not directly related to the level of production. Fixed costs include, but are not limited to, depreciation on equipment, interest costs, taxes and general overhead expenses. Total fixed costs are the sum of the fixed costs.

Variable costs: Variable costs change in direct relation to volume of output. They may include cost of goods sold or production expenses, such as labor and electricity costs, feed, fuel, veterinary, irrigation and other expenses directly related to the production of a commodity or investment in a capital asset. Total variable costs (TVC) are the sum of the variable costs for the specified level of production or output. Average variable costs are the variable costs per unit of output or of TVC divided by units of output.

Total variable and fixed costs are compared with sales revenue in order to determine the level of sales volume, sales value or production at which the business makes neither a profit nor a loss (the "break-even point"). The point at which neither profit nor loss is made is known as the "break-even point" and is represented on the chart below by the intersection of the two lines.

A breakeven point defines when an investment will generate a positive return. The point where sales or revenues equal expenses. Or also the point where total costs equal total revenues. There is no profit made or loss incurred at the break-even point. This is important for anyone that manages a business, since the breakeven point is the lower limit of profit when prices are set and margins are determined.

Explanation with example: Figure shows the breakeven chart of a firm. Here, it is assumed that the price of the product will not be affected by the quantity of sales. Therefore, the total revenue is proportional to output. Consequently, the total revenue curve is a straight line through the origin. The firm’s fixed cost is Rs. 500, variable cost per unit is Rs. 4 and the unit sales price of output is Rs. 5. The breakeven chart, which combines the total cost function and the total revenue curve, shows profit or loss resulting from each sales level. For example, Figure shows that if the firm sells 200 units of output it will make a loss of Rs. 300. The chart also shows the breakeven point, the output level that must be reached if the firm is to avoid losses. It can be seen from the figure, the breakeven point is 500 units of output. Beyond 500 units of output the firm makes profit.

Breakeven charts are used extensively for managerial decision process. Under right conditions, breakeven charts can produce useful projections of the effect of the output rate on costs, revenue and profits. For example, a firm may use breakeven chart to determine the effect of projected decline in sales or profits. On the other hand, the firm may use it to determine how many units of a particular product it must sell in order to breakeven or to make a particular level of profit. However, breakeven charts must be used with caution, since the assumptions underlying them, sometimes, may not be appropriate. If the product price is highly variable or if costs are difficult to predict, the estimated total cost function and revenue curves may be subject to these errors. We can analysis the breakeven output with familiar algebraic equations.

TR=P*Q

TC=FC+AVC+Q

At BEP, TR=TC

P*Q= FC+AVC+Q

Q=FC/(P-AVC)

Here Q stands for breakeven volume of output. Multiplying Q with price (P) we get the breakeven value of output. In the case of our example given in Figure 9.7, FC = Rs. 500, P = Rs. 5 and AVC = Rs. 4. Consequently, Q=500/(5-4)=500

Therefore, the breakeven output (Q) will be 500 units. Similarly, the breakeven output value will be Rs.2500 (P * Q = Rs. 5* 500).

Assumptions of Cost-volume-profit based on breakeven analysis: Cost-volume-profit analysis is a simple but flexible tool for exploring potential profit based on cost strategies and pricing decisions. Cost-volume-profit (CVP) analysis expands the use of information provided by breakeven analysis. This BEP can be an initial examination that precedes more detailed CVP analysis.

Variable

cost

Fixed

cost

Break even

point

Cost-volume-profit analysis employs the same basic assumptions as in breakeven analysis. The assumptions underlying CVP analysis are:

1. The behavior of both costs and revenues in linear throughout the relevant range of activity. (This assumption precludes the concept of volume discounts on either purchased materials or sales.)

2. Costs can be classified accurately as either fixed or variable. 3. Changes in activity are the only factors that affect costs. 4. All units produced are sold (there is no ending finished goods inventory). 5. When a company sells more than one type of product, the sales mix (the ratio of each product to total sales) will

remain constant.

Figure 1 Cost-Volume-Profit Analysis, Production = Sales

One of the most essential assumptions of CVP is that if a unit is produced in a given year, it will be sold in that year. Unsold units distort the analysis. Figure 2 illustrates this problem, as incremental revenues cease while costs continue. The profit area is bounded, as units are stored for future sale.

Unsold production is carried on the books as finished goods inventory. From a financial statement perspective, the costs of production on these units are deferred into the next year by being reclassified as assets. The risk is that these units will not be salable in the next year due to obsolescence or deterioration.

Figure 2 Cost-Volume-Profit Analysis, Production > Sales

While the assumptions employ determinate estimates of costs, historical data can be used to develop appropriate probability distributions for stochastic analysis. The restaurant industry, for example, generally considers a 15 percent variation to be "accurate.

APPLICATIONS

While this type of analysis is typical for manufacturing firms, it is also appropriate for other types of industries. In addition to the restaurant industry, CVP has been used in decision-making for nuclear versus gas- or coal-fired energy generation.

Link the highly regulated banking industry, CVP has been useful in pricing decisions. The market for banking services is based on two primary categories. First is the price-sensitive group. In the 1990s leading banks tended to increase fees on small, otherwise unprofitable accounts. As smaller account holders have departed, operating costs for these banks have decreased due to fewer accounts; those that remain pay for their keep. The second category is the maturity-based group. Responses to changes in rates paid for certificates of deposit are inherently delayed by the maturity date. Important increases in fixed costs for banks include computer technology and the employment of skilled analysts to segment the markets for study.

Even entities without a profit goal find CVP useful. Governmental agencies use the analysis to determine the level of service appropriate for projected revenues. Nonprofit agencies, increasingly stipulating fees for service, can explore fee-pricing options; in many cases, the recipients are especially price-sensitive due to income or health concerns. The agency can use CVP to explore the options for efficient allocation of resources.

Project feasibility studies frequently use CVP as a preliminary analysis. Such major undertakings as real estate/construction ventures have used this technique to explore pricing, lender choice, and project scope options.

BENEFITS OF BREAK-EVEN ANALYSIS

The main advantage of break-even analysis is that it explains the relationship between cost, production volume and returns. It can be extended to show how changes in fixed cost-variable cost relationships, in commodity prices, or in revenues, will affect profit levels and break-even points.

Break-even analysis is most useful when used with partial budgeting or capital budgeting techniques.

The major benefit to using break-even analysis is that it indicates the lowest amount of business activity necessary to prevent losses.

LIMITATIONS OF BREAK-EVEN ANALYSIS

It is best suited to the analysis of one product at a time; but difficult to find out the relation when product item is more than one. It may be difficult to classify a cost as all variable or all fixed; and There may be a tendency to continue to use a break-even analysis after the cost and income functions have changed.