Theories of profit

Innovation theory of profit by Schumpeter Profits reward to innovators for their innovative ability Innovation is a distinctive function Innovator is a person with vision, originality and drive When innovator succeeds, he makes profits or else he incurs losses. Successful innovator earns more than a conventional businessman difference in their earnings is known as innovators profits.

Innovation can be divided into 2 broad categories: Those innovations which reduce the cost of production changes the production function Those innovations which increase the demand for the product changes the demand or utility function Every new contemplated innovation requires a new combination of factors or reallocation of resources. Innovation profits are temporary in nature Profit is both the cause and the effect of innovations

Critical review: Narrow view of the entrepreneurial functions. Entrepreneurs profit is a result of innovation and notrisk bearing it is the capitalist who bears the risk not the entrepreneur

Risk and uncertainty bearing theory of profit by Knight

Risk inherent in a business are of two kinds: 1. Insurable risks a) risk of loss of assets from natural factors b) risk of theft, robbery, etc. 2. Non- insurable risks a) competition risks b) risks of market conditions c) risks of technological change d) risks of public policy Knight calls these non- insurable risks as uncertainties

Points to be noted about Knights theory of profit: 1. The most significant function of an entrepreneur is to bear risk and uncertainty which is rewarded by profit. profit emerges due to uncertainty about the changes in underlying conditions and not because of changes themselves. different rates of profit earned by different firms in the same industry reflect the differences in their capabilities of bearing risk and uncertainty

2. Profit is an income for both uncertainty- bearing and organization of business in a stationary state neither uncertainty nor organizational activities exist Profit can arise only in a dynamic state 3. There is a distinction between risk and uncertainty

Weaknesses of Knights theory: Uncertainty bearing is not the only determinant of profit This theory attempts to raise uncertainty bearing to the status of a full- fledged factor of production Monopoly producer earns profit even without bearing uncertainty

Monopoly theory of profit

Monopolistic situation gives rise to profits both in static and dynamic conditions Monopolist manages to make profits by virtue of his monopoly power. Monopolist raises price by restricting his level of output and thereby makes profit Monopoly is a matter of degree only Monopoly power is also exercised by the producers in monopolistic competition and oligopoly Due to product differentiation an element of monopoly power creeps into the market that yields an extra profit for the supplier

Thus, profits are the result of market frictions and imperfections. Profits exist because of disequilibrium and imperfect competition Profits tend to persist because the economy can rarely adjust instantaneously to changes in cost and demand conditions

Marginal Productivity Theory of profit put forward by Prof. Chapman profit is determined by marginal productivity. The marginal revenue productivity curve is the demand curve for the entrepreneur. The supply of entrepreneur depends on their revenue earnings of the entrepreneur. MRP of the entrepreneur cannot be calculated because there is only 1 entrepreneur in a firm. It cannot be increased to 2or cannot be reduced to half. Marginal revenue productivity of entrepreneurship can be found in an industry as their number can be varied.

Profit as Rent of Ability ( Rent Theory)

propounded by NW Senior & JS Mill but Prof. Walker fully developed the rent theory. able entrepreneurs earn more profit than normal entrepreneurs He regards profits as the rent of ability. there are different grades of entrepreneurs. firms which are managed by marginal entrepreneurs earn no profit. These firms are called firms managed by marginal entrepreneur. Firms managed by entrepreneurs who are very efficient & bright, who command extraordinary organizing ability, earn more profits than mediocre firms.

Accounting profit and Economic profit

Accountants measure profit as a difference between total receipts and total payments Economists calculate profit as accountants profit minus imputed costs Though accounting theory believes that true profit can be ascertained only after the business has been fully terminated, in practice the accountants arbitrarily allocate cost and revenue to each year to calculate profit.

Measurement of Profit
Depreciation reduction in the value of an asset used for business purposes during certain amount of time due to usage, passage of time, wear and tear, technological outdating or obsolescence etc. to measure the true income of a business a charge is made against the annual income of the business called depreciation. different methods of measuring depreciation as depreciation is an important internal source of capital, the amount & the method of depreciation becomes significant as a tool of capital formation.

Evaluation of inventory / stock FIFO Method LIFO Method Base Stock Method Standard Price Method Weighted Average Method.

Capital Gains & Losses capital gain is a profit that results from investments into a capital asset this profit cannot be recognized as a business profit as it is not a revenue profit & does not recur regularly since it is profit derived out of capital items, it is treated differently in the business operations. it cannot be used for declaring the dividend as in the case of revenue profits. capital losses cannot be charged to the revenue profit heavily. it is written off proportionately charging to the revenue profit over the years.

Deferred Revenue Expenses Will initially be recorded as an asset but is expected to become an expense over time and/or through the normal operations of the business Intangible fixed assets can be classified into 2 categories. - Those having a limited life e.g. patents & copyright, licenses and permits (will be written- off before the expiry of useful life) - Those having no such limited life. E.g. Trade Marks, Goodwill, Preliminary Expenses (treatment is more complicated difference of opinion whether the assets should be written off at all or not and if to be written off, what should be the period for their amortization?)

Investment There are different methods to evaluate investment proposals in terms of their returns.

Policies of profits
In economic theory the basic assumption is that the firm aims at maximizing profits In practice, firms do not always try to maximize profits for the following reasons: 1. Attainment of industry leadership 2. Forestalling potential competition 3. Preventing governments intervention 4. Maintaining consumer goodwill 5. Restraining demand for wage increases 6. Accent on the liquidity of the firm 7. Avoiding risk 8. Changed business structure

9. Other objections: Profit max. might lead to inequality of income and wealth It is vague and non- operational - short or long- term profits? profit before or after tax? total profits or profit per share? total operating profit or profit accruing to shareholders? Ignores timing of returns Ignores risk Conflict between short run and long run profits

Profit policies
main motive of the businessman is to make profits. should not be at the point of exploitation of consumers. firm while making maximum profits, should also satisfy the requirements of the consumers. profit earning is the only meaningful measure of corporate success & managerial effectiveness. Various criteria may be applied to decide the acceptable rate of profit or rate of return ( aims of profit policy) 1) Profit to attract Capital 2) Earnings by the competitors standard 3) Historical rate of profit standard 4) Development standard 5) Shareholders purchasing power standard

Alternative profit policies

K. Rothschild Primary motive of an enterprise is long-run survival Decisions aim at maximizing the security of the organization Desire for a secure profit is a dominant motive in oligopolistic industries. M. Reder Maximize profits Maintain financial control of the firm

Donaldson and Lorsch Career managers preferred policies that favoured long term stability and growth of their enterprises To assure survival, self-sufficiency and success top managers strive to conserve and augment corporate wealth Top managers seek maximization of wealth W. Fellner Firms are interested in safety margins

T. Scitovsky Introduced leisure as a variable Depending on his character the entrepreneur may choose to maximize profit and forego leisure or choose total leisure and forego all profit or a combination of profit and leisure. W.W. Cooper Introduced liquidity as a variable Business attempt to maintain liquidity to ensure firms financial position and to retain control

H.A. Simon Entrepreneur may not care to maximize profits but may want to earn a return that he regards as satisfactory He will attempt only to make satisfactory profits rather than maximize profits W.J. Baumol Has extensive management consulting experience Firms attempt to maximize sales subject to profit constraint i.e., profits do not fall short of the minimum level which is just on the borderline of acceptability

Profit planning
A firm has to plan its profits by having a thorough knowledge about the relationships of cost, price & volume. The most important method of determining the cost-volumeprofit relationship is that of Break-even analysis Break-even Analysis studies the relationship between volume & cost of production on the one hand, & the revenue & profits obtained from the sales on the other hand. Martz, Curry & Frank A break-even analysis indicates at what level cost & revenue are in equilibrium. The break even point is that point of activity where the total revenue & total costs are equal.

Break- even point in terms of physical units Fixed Costs = -----------------------------------contribution margin per unit

Break- even point in terms of sales value Fixed costs ---------------------------------contribution margin ratio

The Break Even Chart Break-even chart is very useful in the break-even analysis as it helps the management in predicting the profit or loss implications at different levels of sales. The horizontal axis shows output & the vertical axis shows costs & revenue. TR curve is drawn as a straight line from the origin because every unit of output contributes constant amount to total revenue. TC curve is straight line starting from the Y axis because TC includes FC & VC. The Break-even point is the point of intersection between TR & TC curves.

The Concept of Contribution Margin Contribution Margin is the difference between receipts (TR) & variable expenses (TVC). Sales Revenue variable cost -----------------------Contribution ------------------------

minus

Managerial uses of Break-Even Analysis Safety Margin Volume needed to attain Target Profit Change in Price Change in Costs ( Change in Variable Costs & Fixed Costs) Make or Buy Decisions - quality - assurance of supply - defense against monopoly Advertising Decisions Choosing promotion mix

To Expand Capacity or Not Drop and / or Add Decision Equipment Selection Effect of Alternative Prices Improving profit performance - increasing the volume of sales - increasing the selling price - reducing the variable expenses per unit -reducing the fixed cost Production planning

Profit-Volume (P/V) Analysis or Cost-volume Profit analysis Profit-volume or Cost-volume Profit analysis is the result of attempts to apply the break-even analysis to situations of multi-product firms, where break-even charts are constructed separately for the different divisions or the products of the firm.

Measurement of P/V Ratio

Profit Forecasting & Control Three Approaches to profit forecasting: Spot Projections: projecting the entire profit & loss statements for a specified future period by forecasting each important element in the profit & loss statement. Environmental Analysis: It relates the Companys profit to the general economic trends that prevail in the economy during the relevant period. Break-even Analysis: The break-even Analysis is a powerful tool for profit planning & management control. It shows the functional relation of revenue & cost to output. Out of the three, Break-even Analysis is the most important tool of profit forecasting.