Friday, May 28, 2010

Objective of a Firm

Conventional theory of firm assumes profit maximization is the sole objective of business firms. But recent researches on this issue reveal that the objectives the firms pursue are more than one. Some important objectives, other than profit maximization are:
(a) Maximization of the sales revenue

(b) Maximization of firm’s growth rate

(c) Maximization of Managers utility function

(d) Making satisfactory rate of Profit

(e) Long run Survival of the firm

(f) Entry-prevention and risk-avoidance

Optimization theories:
Profit Business Objectives:

Profit means different things to different people. To an accountant “Profit” means the excess of revenue over all paid out costs including both manufacturing and overhead expenses. For all practical purpose, profit or business income means profit in accounting sense plus non-allowable expenses.
Economist’s concept of profit is of “Pure Profit” called ‘economic profit’ or “Just profit”. Pure profit is a return over and above opportunity cost, i. e. the income that a businessman might expect from the second best alternatives use of his resources
Sales maximization
1.      Baumol's model of sales maximization/ Sales Revenue Maximization: 
According to Baumol, every business firm aims at maximization it sales revenue (price x quantity0 rather than its profit. Hence his hypothesis has come to be known as sales maximization theory & revenue maximization theory. According to baumol, sales have become an end by themselves and accordingly sales maximization has become the ultimate objective ofthe firm. Hence, the management of a firm directs its energies in promoting and maximizing itssales revenue instead of profit.

The goal of sales maximization is explained by the management’s desire to maintain the firm’s competitive position, which is dependent to a large extent on its size. Unlike the shareholderswho are interested in profit, the management is interested in sales revenue, either because largesales revenue is a matter of prestige or because its remuneration is often related to the size ofthe firm’s operations than to its profits. Baumol, however does not ignore the cost of production which has to be covered and also a margin of profit. In fact, he advocates the adoption of a price, which will cover the cost and also will yield a minimum rate of profits. That is, while the firm is maximizing its revenue from sales, it should also “enough or more than enough profits” to keep the shareholders satisfied. According to Baumol the typical digopolists objective can usually be characterized approximately as sales maximization output does not yield adequate profit, the firm will have to choose that output which will yield adequate profit even through it may not achieve sales maximization.
Sales Revenue Maximisation:   The reason behind sales revenue maximisation objectives is the Dichotomy between ownership & management in large business corporations. This Dichotomy gives managers an opportunity to set their goal other than profits maximisation goal, which most-owner businessman pursue. Given the opportunity, managers choose to maximize their own utility function. The most plausible factor in manager’s utility functions is maximisation of the sales revenue.

The factors, which explain the pursuance of this goal by the managers are following:.
  • First: Salary and others earnings of managers are more closely related to sales revenuethan to profits
  • Second: Banks and financial corporations look at sales revenue while financing the corporation.
  • Third: Trend in sales revenue is a readily available indicator of the performance of the firm.

2.     Marris’s model of managerial enterprise
Managerial Behaviour and the goals of management have long been identified by many as independent of the goals of shareholders . Two models have attempted to explain why the goals are different and how these goals are achieved; Baumol’s Theory of Revenue Maximisation and Marris’s Model of Managerial Enterprise . Initially the Two models will be briefly explained. Then, by reference to determinants of managerial remuneration, the empirical evidence of the occurrences of the determinants, the two models will be examined. This is to come to a conclusion on which model is best supported by the empirical evidence.

Marris’s model of managerial enterprise is based on the goal of the manager to increase the balanced growth of the firm . This balance is achieved by offsetting two opposite goals; Maximisation of the growth of demand for goods/services of the firm and maximisation of growth of capital. Both of these goals require opposite treatment of retained profit.

To maximise growth in capital the management must distribute as much profit as possible back to the shareholders. This keeps the shareholders content with their investment and they will not sell shares or remove the directors. It can result in rising share values and reduce the risk of the firm being taken over. This therefore appeals to the management’s main aims, job security by not being taken over or removed.

The flip side of the coin is to increase the demand customers have for the firm’s goods or services. This is achieved by using as much of the firms profits for investment and increase the firms growth. This would increase the management’s utility at the sacrifice of shareholder utility.

Marris’s model requires that these to aims be balanced to achieve the maximum use of retained profit use for investment and still keeping the shareholders content. To achieve this balance it is necessary to employ two constraints; Managerial constraint and Job security constraint.

The managerial constraint is set by the skills of the current management team or by the limit by which the management team can be increase to increase those skills. Therefore, this limit is the maximum growth achievable. R & D would also limit the growth of the firm. If new products or new designs of existing products can’t be produced, the product will only have a certain life cycle.

Job security constraint is set by the amount the manager has to do to reduce the chances of dismissal. The manager may have to distribute a certain amount of profits to share holders to keep them happy with the manager’s performance. It is also necessary to keep share prices at a high enough level to reduce the chance of take over. Reducing risky investments will have similar effects.

The effects of these constraints can be seen from figure 1 (see below) and it can be seen that a balanced growth point is where management feel the trade off between job security and maximisation of growth is most desirable. The y-axis on the graph shows the profit distributed to shareholders and the x-axis depicts the growth achievable from investment. The growth curve symbolises the managerial constraint. This is curved because the most profitable investments are undertaken first. Management can undertake a policy which would maximise growth (point B) but at the sacrifice of distributed profit which would risk job security. A more appropriate trade off may be point A where distributed profits are much higher and growth is reduced by a smaller amount.

Baumol’s Theory states that the goal of management is not profit maximisation (shareholder goal) but revenues maximisation (increased sales). Baumol gives several reasons for this belief . The reasons to focus on are to do with remuneration of management, job security and prestige (which undoubtedly can lead to increased or decreased remuneration).

Baumol feels there is evidence that directors’ salaries and slacks are more closely correlated with sales of the firm than profit. So it would follow from this that managers would maximise sales for self interest.

Job security in Baumol’s theory is shown from the desire of management to have satisfactory profits, apposed to maximised profits. Maximised profit in one year may look bad for management when in subsequent years profits are not at the same maximised level.

Prestige can come from high sales. This prestige can increase remuneration (from head hunting or shareholder retaining their services) or if bad, increase the threat of management being replaced or reduce remuneration.

To achieve sales maximisation managers have to calculate the conditions which will achieve the maximum revenue. This is not the same as profit maximisation. Point A represents profit maximisation. Point B represents the point where sales maximisation, point Z, appears on the profit ability curve. It can be seen that profit maximisation and sales maximisation are not normally the same thing. Point A is the desired position for the shareholder and point B is the desired position for, in Baumol’s theory, management.

However shareholders will require dividends to stay happy with the firm’s performance. In Baumol’s theory there an Operative profit constraint.

The operative profit restraint is the minimum amount of net profit that the shareholder will be satisfied with. If this restraint is active it may reduce the maximum sales the directors can achieve. If this operative profit constraint is active then output will be greater as a sales maximiser than a Profit maximiser. When a operative profit constraint is operative then the maximum sales drop to point Y and the intersection on the profitability falls to point C. It can be seen that management can be limited in their sales maximisation policy if operative profit is closer to the profit maximisation point.

Empirical Analysis
When discussing which model best reflect the reality of managerial behaviour it is necessary to examine what motivates managers and what determines there objectives. Focusing on remuneration as manager main motivation gives the opportunity to examine empirical evidence of what determines the amounts management receive.

Martin Conyon and Paul Gregg Examined 170 firms between 1985 and 1990 . They looked into what factors determined top directors’ pay. In conclusion of their results, it is commented that the results they received pointed to previous, earlier studies , which showed that directors’ pay had very little to do with corporate performance. Therefore, from this evidence, profit, considered a major factor in determining corporate, would not affect the directors’ pay. This would be consistent with Baumol’s model and to a certain extent Marris’s model too. Baumol’s theory identifies sales maximisation as the primary aim. Marris’s model identifies the importance of growth which is identified as a factor with similar directors’ pay correlations. Conyon and Gregg also found from there results that there seemed to definite correlation between increases in directors’ remuneration and increase in sales again consistent with Baumol’s model.

Paul Gregg, Stephen Machin and Stefan Szymanski, came to a similar conclusion in a later study (this study included the period from 1988 – 1991 when Britain was in recession). Higher sales had a direct correlation with high directors’ remuneration and identified growth as a primary salary driver.

David Shipley published a study in to pricing policies in British manufacturing firms in 1981 . Although his study was more specifically on the pricing policies his finding suggested that there was some support for profit maximisation in manufacturing firms’ management . The majority of firms in the study used multiple goals when setting pricing policies . This would not entirely be consistent with Baumol’s theory which states focus of management to maximise sales only and primarily. All other goals displayed by the study were, if not profit orientated, practiced under the premise that profit targets would be met. This is consistent with the operative profit constraint in Baumol’s theory and the job security constraint in Marris’s model. This study would point more towards Marris’s model as there is more emphasis on increasing profit if for no other reason than to improve the amount of money available to put into investment and improve growth while still satisfying shareholders.

While sales are quoted to be a major factor in managerial remuneration. It is also stated that this is not the only factor which would affect their pay. It is therefore assumed that manager’s should consider all factors that affect them. Baumol does not identify other factors which in his theory management should consider. It has been has been suggested that early studies do not reflect the current sensitivity of remuneration of management to performance of firms. This is closer to Marris’s model.

Size of firms has been identified as the most important factor in terms of remuneration. For the size of a firm to increase it must grow. Marris’s model identifies the importance of growth to management.

There have been articles and studies that point to the unreliability of empirical evidence on corporate governance and managerial remuneration factors. So many methodical issues relating to principal and agency theory have been identified as the reasons.

Only remuneration factors have been considered when examining the two models. This makes the discussion incomplete as factors such as corporate structure, managerial labour market factors and personal managerial preferences have not been discussed. There are other managerial behaviour models and theories which have not been included which may be more consistent with the empirical evidence gathered in studies referred to, such as Williamson’s model of managerial discretion. Also more detail explanations of the two models referred to may have allowed closer examination of empirical evidence. Due to these factors, the discussion is limited. However, as I feel that management has the greater ability to influence there pay and it could be argued this is the most important reward for anyone in employment; this was the most appropriate factor to use.

To generate a conclusion from the arguments in this discussion is difficult as with many studies and opinions no conclusive results have been shown. It is my opinion that although sales may be an important factor in remuneration, many other factors exist. Baumol’s theory does not allow for management to apply other factors to their management goals. Marris’s model identifies growth in general as an important factor to the agent (management) and shows the constant battle between satisfying the principal (shareholders) and achieving managements’ utility. This appears more consistent with the difficulties shareholders have in aligning their managements’ interests with their own.
3.     Williamson’s Model/ Maximization of Managerial Utility function:
                Williamson argues that managers have discretion in pursuing policies which maximize their own utility after a minimum profit is attained. A minimum profit level is necessary for job security of the manager.
                The manager utility function includes variables such as salary, security, status, prestige and professional excellence. It is expressed as
U= f(S, M, ID)
Where S = additional expenditure of the staff
M= Managerial emoluments
ID = Discretionary Investments
Non optimization theories:
1.  Cyert and March Behavioural Theory
1. The Firm as a Coalition of Groups with Conflicting Goals
based on a large multiproduct  group operating under uncertain conditions in an imperfect market - difference between ownership and control - firm treated as a multi-goal, multi-decision organisational coalition of managers, workers, share-holders, customers, suppliers, bankers.
2. Goal Formation – The Concept of the Aspiration Level
                Individuals may have (and usually do have) different goals to those of the organisation-firm.
3.  The Goals of the Firm: Satisficing Behaviour
Goals set by top management.
The main goals:
©  Production goal - smooth running.
©  Inventory goal - adequate stock of suitable raw material.
©  Sales goal - from sales department.
©  Share of the market goal – also from sales department.
©  Profit goal – shareholders, finances.
4   Means for the Resolution of Conflict
©     Conflict is inevitable. Nevertheless the groups and the firm as a whole may remain in a stable position - limited time to bargain, etc.  Behaviour, goals and decisions are largely based on past history.
5.  The Theory of Decision Making
©  - At Top Management Level
©    Resource allocation - implemented by the budget - share of budget taken by each department. Largely determined by bargaining power which is itself determined by past performance.
6.  Uncertainty and the Environment of the Firm
©  Two types of uncertainty:
©  - market (cannot be avoided)
©  - competitor's reactions (overcome by tacid collution, eg. trade associations)
2.  Maximisation of Firms Growth rate: Managers maximize firm’s balance growth rate subject to managerial & financial constrains balance growth rate defined as:
G = GD – GC
Where GD = Growth rate of demand of firm’s product & GC= growth rate of capital supply of capital to the firm.
In simple words, A firm growth rate is balanced when demand for its product & supply of capital to the firm increase at the same time.

The utility functions which manager seek to maximize include both quantifiable variables like salary and slack earnings; non- quantifiable variables such as prestige, power, status, Job security professional excellence etc.

Long run survival & market share: according to some economist, the primary goal of the firm is long run survival. Some other economists have suggested that attainment & retention of constant market share is an additional objective of the firm’s. the firm may seek to maximize their profit in the long run through it is not certain.
Entry-prevention and risk-avoidance, yet another alternative objectives of the firms suggested by some economists is to prevent entry-prevention can be:
1.     Profit maximisation in the long run
2.     Securing a constant market share
3.     Avoidance of risk caused by the unpredictable behavior of the new firms

Micro economist has a vital role to play in running of any business. Micro economists are concern with all the operational problems, which arise with in the business organization and fall in with in the preview and control of the management. Some basic internal issues with which micro-economist are concerns:
                      i.        Choice of business and nature of product i.e. what to produce
                     ii.        Choice of size of the firm i. e how much to produce
                    iii.        Choice of technology i.e. choosing the factor-combination
                    iv.        Choose of price i.e. how to price the commodity
                     v.        How to promote sales
                    vi.        How to face price competition
                   vii.        How to decide on new investments
                  viii.        How to manage profit and capital
                    ix.        How to manage inventory i.e. stock to both finished & raw material
These problems may also figure in forward planning. Micro economist deals with these questions and like confronted by managers of the enterprises.

1 comment: