Departing from pure profit maximisation

James Mansell, offers this discussion on some of the reasons why businesses frequently move away from a strategy of pure profit maximisation

How realistic is the working assumption that businesses in markets are organisations that seek to maximise profits?

The theory of the firm indicates that Businesses are enterprises looking solely for the largest possible profit. However in reality there are often mixed motives which create a situation which is not as clear cut as the original theory suggests. Intertwined with the desire for profit are the objectives of the management (often at odds with those of the shareholders) and other stakeholders. Other tactics may also be followed by firms, such as revenue maximisation or pursuit of increased market share, most often ‘satisficing’ occurs, in which enough profits are produced to sedate equity holders but not as much as could be achieved as predicted when MR=MC.

The stock market’s valuation of a business is often regarded as the gospel truth. To come to this figure market analysts look at a multitude of different factors, a particularly important one is Earnings per share (EPS) which varies depending on the underlying profit of the company and the amount of shares in issuance. If a firm does not strive to increase its profit; the market capitalisation will consequently suffer inferior valuations than what could have other wise been achieved as the EPS is not growing at a suitable rate. Profit is often one of the most prevalent factors in valuing a business, and if managers or shareholders deviate from maximising it they are losing the possibility of growth in value of their equity. This shows that the intention to maximise profits has apparent positive effects, for the value of the business as well as the size of the dividend.

Alignment of the interests of managers with those of the shareholders often involves incentivisation. The fact that incentivisation is needed in the first place shows that the underlying goal of a business is not always ‘to maximise profits’. For example at Enron, the infamous energy giant, senior executives such as Andrew Fastow and Jeffery Skilling concealed the true nature of their balance sheet from their shareholders. They did this using mark to market accounting methods and other financial instruments appropriately named ‘Raptors’. Their objective wasn’t to maximise profit, instead the objective was warped by the egotistical nature of company’s inherent culture into pure selfishness. In this case they had strayed from the job which they were tasked with by the shareholders and changed the direction of the company into an ultimately self-destructive destination.

Social enterprises don’t aim to maximise profits, instead they seek to maximise social benefit from the action which they are involved with. These are not a minority section of business; social enterprises generate £24 billion and employ over 450,000 people with another 300,000 volunteers helping out. Certain social enterprises such as the Co-op endeavour to maximise employee benefit, in this case the business is worker owned. However the employees could be portrayed as the shareholders and in the process the social enterprise is maximising profit, just the profit is being directed to the labourers instead of owners of equity

The working assumption that businesses profit maximise is cast in doubt when other strategies are examined. Revenue maximisation is generally employed by firms facing a cash flow problem, departure from profit maximisation is necessary because in the short run money is needed to stay afloat and out of insolvency. This was demonstrated by the actions of Lehman brothers before the company went into administration, for they accepted smaller margins on their products in order to gain greater liquidity. Though this was too little too late and the subsequent paralysis of the credit markets meant they were unable to meet their obligations

Some businesses are or aspire to become profit maximisers; this is especially applicable in the case of firms which are taken over by private equity. Kohlberg Kravis Roberts is a well known private equity company with assets of over $60 billion. They aim to maximise the return on the investment they made, to do this often requires maximising the possible profit of their target company. This strategy is pursued because it will guarantee them a large return on their money, and maintains the profitability of leveraged buyouts.

In the vast majority of cases companies often do not fulfil the ideal of maximising their profits; instead they depart from that principle and often pursue another one. This departure can often be to the detriment of shareholder value (as was the case in examples such as Enron and Royal Bank of Scotland). However the approach of increasing market share often has positive long term implications for the bottom line, as was the case with Tesco under the leadership of Sir Terry Leahy. The assumption that most businesses profit maximise is fallible, each pursue the right course of action appropriate for the conditions at hand, which might be to the benefit or detriment of stakeholders, shareholders and management.