Hearing the word “PROFITS” in Business
can make any business owner felicitous, creating more enthusiasm for doing
work.
And why not? Is making profits and
earning money in the business is not the sole aim of any commercial activities?
According to research by one of the
leading market research firms in United states, one of the top priorities of
business owners in their daily commercial activities is to create profit
maximization.
So, what is this profit maximization
all about?
According to economics, profit
maximization is the short or long procedure executed by the business to
finalize the price, input and output levels that may lead to highest profit for
the firm.
To better understand this profit
maximization, Let’s have a glimpse over Jack business of selling t-shirts of different
varieties as per the taste of the customers.
Jack perspective on profit maximization
is very clear and distinct.
According to Jack, as total profit in
business equals revenue minus cost
(Total Profit = Revenue – Cost),
he
graphically plots each of the variables that is revenue and cost as functions
of the level of output.
So the next thing Jack does is that he
finds the level of output that maximizes this difference that is Revenue minus
cost.
He also noticed that this can done with
table of values instead of graph.
Secondly, Jack suggests that if little
knowledge of mathematical calculus is enhanced by the business owner, one can
use that to maximize profits with respect to output level.
Jack have a clear explanation on the
difference between short and long run profit maximization that is in long run,
the quantity of all inputs including physical capital are choice variables.
Where as in short run the amount of
capital is predetermined by past investment decisions.
In Both the cases, the inputs of labour
and raw materials is there for sure.
Jack also knows about the two types of
costs which his business gets during the firm activities.
That two type of costs are: Fixed costs
and Variable costs.
Fixed costs occurs only during the
short run in business at any level of output.
Jack fixed costs includes as
instruments maintenance, rent and wages of other workers.
Fixed costs cannot be increased or
decreased in the short run and generally maintained.
As contrary, Variable costs differs and
depends on level of output and the product generation.
Materials and inventory that are
consumed during the production are the types of variable costs.
Fixed costs and Variable costs totally
contributes to Total costs of the business.
After understanding these metric, will
it be not a good decision to know more about profit maximization rule, formula,
limitations and applications?
So, starting with profit maximization
rule, if Jack choses its business to maximize the profits, the level of output
must be selected such that Marginal cost (MC) is equal to Marginal Revenue
(MR).
In very simple words, MC = MR. This
equation is profit maximization rule.
Actually, Marginal costs (MC) is the
increase in cost by production of one more unit of good.
While, Marginal Revenue (MR) is the change
occurring in Total revenue due to change in rate of sales by one unit.
So, Profit for Jack business occurs at
the most important gap between total revenue and total costs.
Profit = Total Revenue – Total costs
Jack often thinks about a question that
why is the output chosen only at MC =MR?
He analyses and found that if MC <
MR, then for each of surplus unit produced, revenue will be greater than the
cost, so that production is more.
If MC > MR, then for each of surplus
unit produced , the costs will be greater than revenue, so production is less.
He noticed that the rule is very
versatile and it can be applied to operation hours of the business. Also, it
can be applied to advertising and marketing.
Jack also pulled out the limitations of
the profit maximization rule in his business.
He checked that it is not easy to know
exact Marginal revenue and Marginal costs of the products which are sold last.
Another flaw is demand factors as it is
very difficult to keep the effect of price change on demand.
Also, the biggest drawback is
increasing prices to maximize profits in short run may bring in more businesses
in the market.
This was a short guide on profit
maximization and hope it adds value in your business.
Thank you.
