A business organisation needs to set goals to determine the direction it is going.
Goals and objectives of a firm are used interchangably, however they are different from each other.
Goals are abstract and long term, whereas objectives are more specific
The goal describes the ultimate state that the company desires to attain. It does not specify how to get there. On the other hand, objectives are more specific, such as profit maximization, sales value maximisation or shareholder value naximization.
Objectives should be realistic, that is, attainable, measurable and timely.
Setting the objective is a necessary but an insufficient step in attaining a goal.
Quantified targets should be scheduled in time. There can be more than one target to realize an objective.
For example, the objective can be profit maximisation. The targets can be quantified as 20 % increase in net profits in the next period. Cutting down the operating expenses by 25 % and increasing the sales price by 5 % .
Most common objectives adopted by firms are as follows:
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Profit maximization
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Revenue / sales maximization
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Shareholder wealth maximization
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Stakeholder benefit maximization
1.Profit maximization:
Net profits can be simply expressed as:
Net Profits = Net Sales – Cost of Goods Sold – Operating expenses – Financial and other Nonoperating Expenses + Nonoperating Revenues – Taxes
What is maximum profit? How shall we know what level of profits are maximum?
It is more meaningful to express this objective as a ratio i.e. Net Profits / TotalAssets, in other words, return on assets, ROA, or Net Profits / Net Sales, net Profit Margin. If the ratio is greater than those of the competitors it can be concluded that the objective has been satisfied.
According to the above equation, net profits can be increased by increasing sales and /or decreasing expenses.
Sales = Amount sold x Unit Price
The level of sales depends on the market structure and the kind of competition in the market. In perfect competition, the price, being determined by the supply and demand, is given.
In monopolistic competiton, the price is determined by the monopolist. Monopolist has the absolute power to determine the amount to be sold which will maximize his/her profits.
In oligopolistic competition, price is determined by a few suppliers dominating the market.
Therefore, unless it is a monopolist or one of the dominant suppliers in an oligopolistic market, the firm does not have control over the prices.
The other course of action, that is more viable, is decreasing costs.
Trying to reduce the cost of materials may cause the quality of products to suffer and in turn have a decreasing effect on sales. Decreasing operating expenses such as general administrative and marketing expenses is more viable for the management. In economies characterized by scarcity of capital, excessive use of debt leads to a rise in the level of financial expenses which have the potential to cause losses even if the operating profits are positive.
The profit maximization objective forces the management to ignore the harm it gives to the environment. The reasons for this, is the nonexistence of techniques in measuring and recording the environmental costs. Another reason is, that costs incurred are immediate, whereas the harm done is a result of long term violation. What is the cost of lives lost due to air pollution caused by thermal power plants, or in mine collapses or earthquakes due to poor building stock ?
Unless the application of environmentally polluting technologies is prohibited and the private and public enterprises are forced to pay for the environmental damages they cause, managements evaluated on the basis of profitability will never undertake cost of preventing environmental pollution willingly.
2. Sales or market share maximization
Increasing the market share is another objective, which in the long run, may contribute to the profit maximisation and shareholder wealth maximization objective. This objective has been advocated by Baumol ( Baumol 1959).
Sales maximization actually means the maximization of sales revenue. A firm may adopt penetration pricing strategy which involves lower profit margins to increase the customer base. This may be a temporary policy. Increased market share increases the monopoly power of the firm and may enable the firm to employ higher prices and make more profit in the long run.
When sales are large, the firm can make use of economies of scale which leads to reductions in the unit cost of the products, and the profit margin increases.
Sales can be increased until marginal cost equals marginal revenue. This is the level of profit maximization. Increase in sales beyond this level does not contribute to an increase in the profits.
Marginal revenue equals zero at the level of minimum profits. Minimum profits serve as a constraint on the maximization of a firm’s revenue. Sometimes, oligopolist firms would like to increase sales beyond this point by employing lower prices, causing the profit margins to narrow down. Then they have to be satisfied with lower profits. Sales can be increased up to the level of minimum profits. This is the sales volume which reduces the marginal revenue to zero beyond which the firm will have a loss.
3. Shareholder Wealth Maximization
The objective of Shareholder Wealth Maximization asserts that management should act in the interest of the shareholders. It should employ policies which will contribute to increasing the wealth of the shareholders.
In view of the fact that the shareholders of the company supply the capital, they are considered principals, and the the managers are their agents who have to act in their best interests.
The role of shareholders differ in closely held and public corporations. The ownership structure of the company plays a determining role. When majority of the shares are concentrated in the hands of a small number of shareholders and the management is comprised by the major shareholders This results in a style of management whose aim is to further the benefits of the major shareholders. Then preventive action should be taken to protect the minor shareholders as well as the other stakeholders.
When the shares are distributed among a large number of investors, the company’s management is delegated to professional managers. This is a potential source of conflict between the shareholders and the management. The managers are liable to make decisions for their own benefit rather than contributing to the value of the shareholders benefits.
This conflict of interest between the management and the shareholders is called the
agency problem and the costs ensuing from this problem are called
agency costs ( Jensen and Meckling 2021). Agency costs increase the operating expenses and have a diminishing effect on net profits. The following are common examples of agency costs:
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Corporate expenditures that benefit the management at the expense of shareholders, such as, premiums based on sales volume, current year profits, or short term share price, perquisites like company cars, traveling expenses, expensive offices, representation expenses, business dinners, presents to the related parties, etc.
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Indirect expenses or losses arising from the purposeful or unconconscious neglect of the responsibilities that can be catastrophic, i.e. taking measures against potential work accidents, earthquakes, or air and water pollution. Management is apt to shy away from expenses that will diminish profits and these costs are usually transferrred to the society.
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Expenses arising from monitoring management actions to keep the principal-agent relationship aligned i.e. auditing costs.
Shareholder wealth maximization objective has the potential danger of being applied as a short term objective directed at increasing the current share price. This is in part due to the demands of the shareholders for the fulfillment of their short term goals.
Serving short term goals may hinder the long term profits.
3.Maximizing the benefits of The Stakeholders
Stakeholders are defined as groups whose benefits are affected by the actions of an organization and in turn can affect the benefits of other groups related to the organisation.
The term “stakeholders” cover, shareholders, employees, customers, suppliers, creditors. We could add to this list, the society and the environment .
According to the stakeholder theory, the aim of the firm is to reconcile the benefits of its stakeholders. This is a continuous and arduous process.
Can a corporation maximize the benefits of employees, customers, suppliers,
creditors and shareholders simultaneously?
To clarify the concept of stakeholder an important question need to be answered: Are all stakeholders equally important, or, are some of them more important than others? It is not easy to align the benefits of such diverse agroups. Let us consider the interests of the most common stakeholders:
The aim of the shareholders is to maximize the value of their investment in the company. The benefits of small shareholders may be contrary to those of the owners. They would prefer cash dividends whereas the owners or major shareholders would want to reinvest profits and limit the dividend distribution. Corporate governance principles involve measures to be taken into consideration fort he protection of small shareholders.
The aim of the creditors is to get a maximum possible return on the loans they give as well as getting the principal back at the maturity with the least possible risk. The high interest rates would contribute to this end. Nevertheless, this could lead to the insolvency of the company. It is more important to contribute to the survival of the company as a borrower. Otherwise, there is the danger of keeping the funds idle, which has a greater cost than reduced profits. So the short term goals of the financial instititution may constitute a hindrance to the realization of its long term goals.
Customers constitute another important group of the stakeholders. They desire to be able to purchaes the products they need at the most suitable prices. Up to a level, the firm can lower the prices without sacrificing the quality of its products. However this is a short run benefit. In an inflationary economy, where input prices increase continuously, the company is not able to keep up the low sales prices in the long run.
Likewise, the suppliers’ and the employees’ benefits do not coincide with each other and those of other groups’.
According to the stakeholder theory, the aim of the firm is to reconcile the benefits of its stakeholders. This is a continuous and arduous process.
Can a corporation maximize the benefits of employees, customers, suppliers,
creditors and shareholders simultaneously? It doesn’t seem possible.
The stakeholder theory does not have an objective function that can be maximized. The goals of some of the stakeholders, i.e. environment or society cannot be expressed quantitatively. Except for the shareholders, most of the stakeholders do not posess any legal status to put forward to the management.
Considering the risk incurred, the owners or major shareholders are subject to the burden of the risk the most. Based on this fact, many theorists defend that management should act to maximize their benefits.
The only stakeholders within the hierarchy of the corporation are the shareholders. They have the power to change the management in the short run. Therefore management feels obliged to realize their objectives which is the maximization of the value of their investment.
In the long run, all other stakeholder groups can be effective on the policies of management.
According to Jensen, maximizing the value of the firm will be beneficial for all the stakeholders, since the value of the firm comprises the value of debt as well as the value of equity. However, maximizing the value of the firm does not guarantee that the benefits of the small shareholders, employees, suppliers, society and the environment.
Stakeholder theory propounds the balancing of all stakeholders’ benefits. This is not realistic. The term balancing rules out the maximization.
When evaluated from a long run perspective , the ultimate aim of the firm is survival. Making profits, increasing the value of the firm and / or shareholder wealth are interim objectives to be reached in this course. Balancing the benefits of the stakeholders, constitutes the constraints and incentives which direct the management into the right track.
To reach this ultimate objective firms should make sustainable profits. Sustainability is the primary criterion in leading the management .
Prof.Dr.Nimet Hülya TALU TIRMANDIOĞLU
References
Baumol , William,
Business Behaviour.
Value and
Growth, Macmillan Company, New York,1959.
Freeman, Edward,R., John Mc Vea
, “ A Stakeholder Approach to Strategic Management”, https://www.researchgate.net/publication/228320877 , 2021), [Feb 11 2021].
Jensen, Michael, William H. Meckling, “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure”in In
The Modern Theory of Corporate Finance, ed. Michael C. Jensen and Clifford H. Smith Jr.,McGraw-Hill, 1984.
