UNIT-7

Profit Management:
Nature
Scope
Theories of profit
measurement policies
Cost-Volume-Profit Analysis.
 Nature of Profit
• Profit is a residual sum which is contingent upon successful
management of risk
• There are different types of risks a business entrepreneur need
to face and manage them successfully
• Technical, cost uncertainties, demand uncertainties, market
uncertainties
• In order to earn profits a business man has to 1. select the risk
which he wishes to bear 2. manage them successfully
• Profits vary from industry to industry and from business to
business
• Greater the risk and uncertainty higher the profits
• Profits are high in those industries where i). Production
methods are changing and new techniques are adopted ii).
Long gestation period iii). The tasks are specialized.
• High profits when the business activity is brisk and low when
the activity is sluggish.
 Functions of Profit

• The basic function of profit is to provide businessman with an

incentive to produce what consumer wants at lowest possible
cost
• It includes innovation of new products and methods.
• According to Peter Drucker profit serves three main purposes.
1. Measure of performance
2. Premium to cover costs of staying in business
3. Ensuring supply of future capital
Profiteering and Profit-earning
Profiteering is the amount of profit made exceeds socially
acceptable limit by questionable methods. It is done by
creation of artificial shortages through hoarding or curtailing
production.
 Types of Profit
1. Accounting Profit
•It is total earnings of an organization. It is a return that is calculated as
a difference between revenue and costs, including both
manufacturing and overhead expenses.
•The costs are generally explicit costs, which refer to cash payments
made by the organization to outsiders for its goods and services.
•Explicit costs can be defined as payments incurred by an organization
in return for labor, material, plant, advertisements, and machinery.
•Accounting Profit= TR-(W + R + I + M) = TR- Explicit Costs
•TR = Total Revenue; W = Wages and Salaries R = Rent; I = Interest M=
Cost of Materials
•The accounting profit is used for determining the taxable income of an
organization and assessing its financial stability.
•Accounting profit is also called gross profit. When depreciation and
government taxes are deducted from the gross profit, we get the net
profit.
 Types of Profit
2. Economic Profit:
• Takes into account both explicit costs and implicit costs or
imputed costs. Implicit that is foregone which an entrepreneur
can gain from the next best alternative use of resources.
• Implicit costs are also known as opportunity cost. The
examples of implicit costs are rents on own land, salary of
proprietor, and interest on entrepreneur’s own investment.
• Economic profit = Total revenue-(Explicit costs + implicit costs)
• Economic profit is not always positive; it can also be negative,
which is called economic loss.
• Economic profit indicates that resources of a business are
efficiently utilized, whereas economic loss indicates that
business resources can be better employed elsewhere.
 Theories of Profit
• Profits of businesses depend on the successful management of
risks and uncertainties by entrepreneurs. These risks can be cost
risks due to change in wage rates, prices, or technology, and other
market risks.
• Different economists have presented different views on profit.
Some of the most popular theories are
• 1. Walker’s Theory
• 2. Clark’s Dynamic Theory
• 3. Hawley’s Risk Theory
• 4. Knight’s Theory
• 5. Schumpeter’s Innovation Theory
 Theories of Profit
1.Walker’s Theory (Rent theory of profit)
• An American economist, Prof F. A. Walker propounded the theory of
profit. “as rent is the difference between least and most fertile land
similarly, profit is the difference between earnings of the least and
most efficient entrepreneurs.”
• He advocated that profit is the rent of exceptional abilities that an
entrepreneur possesses over others.
• Profit is the difference between the earnings of the least and most
efficient entrepreneurs.
• Profit is also said to be the reward for differential ability of the
entrepreneur.
Criticism
• a. Provides only a measure of profit. The theory does not focus on the
nature of profit
• b. Profit can also be the result of the monopolistic position of the
entrepreneur.
 Theories of Profit
2. Clark’s Dynamic Theory
• Clark’s dynamic theory was introduced by an American economist,
J.B. Clark.
• Profit does not arise in a static economy, but arise in a dynamic
economy
• According to Clark, the role of entrepreneurs in a dynamic
environment is to take advantage of changes that help in
promoting businesses, expanding sales, and reducing costs. The
entrepreneurs, who successfully take advantage of changing
conditions in a dynamic economy, make pure profit.
• There are internal and external factors that make the world
dynamic.
• Regular changes involve fluctuations in trades that affect profits
• However Prof Knight criticized the dynamic theory on the basis
that only those changes that cannot be foreseen yield profits.
 Theories of Profit
3. Hawley’s Risk Theory
• The risk theory of profit was given by F. B. Hawley in 1893.
• According to Hawley, “profit is the reward of risk taking in a business”
• The greater the risk, the higher is the expected profit. The risks arise
in the business due to various reasons, such as non-availability of
crucial raw materials, introduction of better substitutes by
competitors, obsolescence of a technology, fall in the market prices,
and natural and manmade disasters. Risks in businesses are inevitable
and cannot be predicted.
• There is a criticism against this theory that profits arise not because
risks are borne, but because the superior entrepreneurs are able to
reduce them.
• The profits arise only because of better management and supervision
by entrepreneurs. Another criticism is that profits are never in the
proportion to the risk undertaken. Profits may be more in enterprises
with low risks and less in enterprises with high risks.
 Theories of Profit
4. Knight’s Theory
• Prof Knight propounded the theory known as uncertainty-bearing theory of profits.
According to the theory, profit is a reward for the uncertainty bearing and not the
risk taking. Knight divided the risks into calculable and non-calculable risks.
Calculable risks are those risks whose probability of occurrence can be easily
estimated with the help of the given data, such as risks due to fire and theft.
• The calculable risks can be insured. On the other hand, non-calculable risks are
those risks that cannot be accurately calculated and insured such as shifts in
demand of a product. These non-calculable risks are uncertain, while calculable
risks are certain and can be anticipated.
• According to Knight, “risks are foreseen in nature and can be insured”. Thus, risk
taking is not a function of an entrepreneur, but of insurance organizations.
Therefore, an entrepreneur gets profit as a reward for bearing uncertainties and not
for risks that are borne by insurance organizations.
Criticism
• a. Assumes that profit is the result of uncertainty bearing ability of an entrepreneur,
which does not always hold true. The profit can also be the reward for other
aspects, such as strong co-ordination and market share.
• b. Fails to show any relevance with the real world.
 Theories of Profit
5.Schumpeter’s Innovation Theory
• Joseph Schumpeter propounded a theory called innovation according to
which profits are the reward for innovation He advocated that innovation is
the introduction of a new product, new technology, new method of
production, and new sources of raw materials. This helps in lowering the
cost of production or improving the quality of production. Innovation also
includes new policy or measure by an entrepreneur for an organization.
• a. Reducing the cost of production and earning high profit. The cost of
production can be reduced by introducing new machines and improving
production techniques.
• b. Stimulating the demand by enhancing the existing improvement or
finding new markets.
• According to innovation theory, profit is the cause and effect of innovations.
In other words, it acts as a necessary incentive for making innovation.
Criticism
• a. Ignores uncertainty as a source of profit
• b. Denies the role of risk in profit
 Measurement Policies

• There are different methods of measuring accounting profits :

1. Depreciation : a. Straight line method b. Declining balances
method c. Sum of the years’ digits method
2. Valuation of Stock – a. FIFO b. LIFO c. Weighted Average
3. Amortization of Long-Term Intangible Assets
4. Treatment of Capital Gains and Losses
1. Depreciation
• In course of time the equipment, machines and buildings wear out
with time and usage.
• To measure the true income of the a business a charge is made
against the annual income of business which is called as
depreciation
• The depreciation charge varies from industry to industry.
 1. Depreciation
1. Straight Line method
 The asset is evenly wear out during its normal life. Depreciation
is provided on a uniform basis
 The amount of annual depreciation is obtained by dividing the
initial cost of the asset by the estimated life in years assuming
that there is no scrap value.
 If there is scrap value then it has to be deducted from the initial
cost before dividing by the estimated life in years.
2. Declining balances method
 Depreciation is provided at a uniform rate on the written down
value of the asset at beginning of the year.
 At the end of the estimated life of the asset there will be scarp
value as the residual value of the asset will not be zero.
 Depreciation

3. Sum of the years’ digits method

 It is similar to Declining balances method except that while the book value
remains constant the annual rate of depreciation changes.
 It is calculated as below:
1. Each digit of the years of estimated life is added and the resulting figure will
be the denominator of the fraction to find out the depreciation rate.
2. The numerator of the fraction for each year is expected life of the asset in
that particular year and this declines by one each year,
3. If asset’s cost is Rs. 1000 and life is 5.years and scrap value is Rs. 100.

Age of asset Rate of depn. Annual depn. Accumulated Book value

depn.
1 5/15=33 1/3% 300 300 700
2 4/15= 26 3/8% 240 540 460
3 3/15= 20% 180 720 280
4 2/15=13 1/3% 120 840 160
5 1/15= 6 2/3% 60 900 100
 2. Valuation of Stock
• There are 3. methods
• 1. FIFO ( First in First out)
• 2. LIFO ( Last in First out)
• 3. Weighted Average
 FIFO : It assumes that the units acquired first are
units to be issued first
 LIFO : It assumes that the units acquired last are
units to be issued first.
 Weighted average : It assumes that the goods
purchased are so intermingled that specific
identification is not possible. Valuation is done by
average cost.
 Valuation of Stock
A furniture store purchase 200 chairs for $10 and then 300 chairs for $20, and
at the end of an accounting period you have sold 100 chairs. The weighted
average costs, FIFO, and LIFO costs are as follows:

200 chairs @ $10 = $2,000 

300 chairs @ $20 = $6,000 
Total number of chairs = 500 

Weighted Average Cost: 

Cost of a chair: $8,000 divided by 500 = $16/chair
Cost of Goods Sold: $16 x 100 = $1,600
Remaining Inventory: $16 x 400 = $6,400
FIFO:
Cost of Goods Sold: 100 chairs sold x $10 = $1,000
Remaining Inventory: (100 chairs x $10) + (300 chairs x $20) = $7,000
LIFO:
Cost of Goods Sold: 100 chairs sold x $20 = $2,000
Remaining Inventory: (200 chairs x $10) + (200 chairs x $20) = $6,000
 3. Amortization of Long-Term Intangible Assets

• Intangible fixed assets can be classified in to

2.categories.
• 1. Those having limited life. Eg: Patents and
copyrights, leasehold, licenses and permits
• 2. Those having no such limited life. Eg : Trade marks,
Goodwill, preliminary expenses
• Those having limited life are written off faster than
their useful life.
• Patents- 16 years; copyrights- authors life plus
50.years. These assets are written off much earlier
than their life.
• Those having no such limited life like Goodwill, trade
marks are written off gradually over the period of
their life.
 4. Treatment of Capital Gains and Losses

• Conservative companies do not include capital

gains in the current profits.
• They would like to write off capital losses in the
current profits of the year in which the losses
occur.
• Therefore the profits are affected and will be
lower in case of conservative companies than
non conservative companies.
• In case of unrealized capital gains they should
not be included in profits.
• If there is revaluation of property , the gain is
transferred to capital reserve.
 Cost-Volume-Profit Analysis
• A break-even analysis is a financial tool which helps you to determine at what
stage your company, or a new service or a product, will be profitable. Break-even
is a situation where you are neither making money nor losing money, but all your
costs have been covered.
Break-even analysis is useful in studying the relation between the variable cost,
fixed cost and revenue.

Components of Break Even Analysis

• Fixed costs
Fixed costs are also called as the overhead cost. These overhead costs occur after
the decision to start an economic activity is taken and these costs are directly
related to the level of production, but not the quantity of production. Fixed costs
include (but are not limited to) interest, taxes, salaries, rent, depreciation costs,
labour costs, energy costs etc. These costs are fixed no matter how much you
sell.
Variable costs
Variable costs are costs that will increase or decrease in direct relation to the
production volume. These cost include cost of raw material, packaging cost, fuel
and other costs that are directly related to the production.
Calculation of Break-Even Analysis
• The basic formula for break-even analysis is driven by dividing the total fixed
costs of production by the contribution per unit (price per unit less the variable
costs).
Cost-Volume-Profit Analysis
 Cost-Volume-Profit Analysis
• For an example:
• Variable costs per unit: Rs. 400
• Sale price per unit: Rs. 600
• Desired profits: Rs. 4,00,000
• Total fixed costs: Rs. 10,00,000
• First we need to calculate the break-even point per
unit, so we will divide the Rs.10,00,000 of fixed costs
by the Rs. 200 which is the contribution per unit (Rs.
600 – Rs. 200).
• Break Even Point = Rs. 10,00,000/ Rs. 200 = 5000 units
• Next, this number of units can be shown in rupees by
multiplying the 5,000 units with the selling price of Rs.
600 per unit. We get Break Even Sales at 5000 units x
Rs. 600 = Rs. 30,00,000. (Break-even point in rupees)
End of Unit-7