Getting the most value out of business activities by maximising profits is critical in a challenging economic climate. When business leaders efficiently allocate resources in ways that generate the best returns, it provides long-term financial stability and sets a foundation for sustained growth.
Employing a profit maximisation strategy shores up extra resources that can be reinvested in new opportunities, enabling businesses to enter new markets, expand within existing ones, and improve cash flow and revenue growth.
What is profit maximisation?
Profit maximisation entails generating the highest possible business profit after costs are subtracted. Maximisation of profit, which is a goal for many companies to maintain long-term growth, is typically achieved by increasing revenue and reducing costs.
The concept is economically tied to the law of diminishing marginal returns, which states that adding extra production factors – such as hiring more workers or increasing working hours – can eventually yield lower gains in output from each new unit of production. Profit maximisation seeks the optimum balance of input and output that make businesses the most profitable.
A company’s profit is maximised when the revenue gained by including an additional production factor (marginal revenue) is equal to or greater than the cost of introducing that additional production factor (marginal cost).
For example, say a clothing factory finds 10 workers is the optimal number to produce a batch of sweaters. Adding more workers to produce the same batch of sweaters could change production dynamics, resulting in a less efficient process, higher labour costs, and ultimately diminished returns. Profit maximisation seeks to avoid such scenarios by pinpointing the most effective use of resources.
BUSINESSES SHOULD CAREFULLY CONSIDER THE POTENTIAL CONSEQUENCES OF PRICE CHANGES BY CONDUCTING MARKET RESEARCH TO DETERMINE IF AN INCREASE IS WARRANTED.
Example of profit maximization
Imagine a local hardware store owner is toying with the idea of keeping the shop open for an extra hour every day. The critical question for the owner to consider is whether the additional revenue generated by that extra hour exceeds the total expenses incurred.
If so, it’s financially prudent for the shop to remain open for an extra hour. If not, the extra hour is costing the shop owner more, even if the business is still making a gross profit (the direct income from sales minus the costs of goods sold). When determining how to maximise profit, the hardware store owner must also consider net profit, which takes into account all other costs, such as utilities and staff wages.
Advantages of profit maximisation
Profit Maximisation allows a company to remain fiscally strong, so it can meet its financial obligations, reinvest in growth, and navigate unexpected economic challenges. The benefits of maximising profits include:
Improved long-term cash flow
Adopting a profit maximisation approach can be a good way to keep operating cash flow healthy. Operating cash flow is the amount of cash that a business generates from its core operations, minus the cost of running those operations.
A business that ensures the marginal cost never exceeds the marginal revenue is primed to generate positive cash flow.
Strategic business growth
A small business with a healthy profit margin and cashflow is in a better position to attract investors and secure loans. This funding allows the company to invest in strategic growth initiatives, like creating new products or expanding into new geographic locations.
For example, a small software development startup might streamline its project management process, finding ways to shorten deadlines and trim costs. This may allow the business to invest in researching and developing an upgraded software product that appeals to a new client base and produces an additional revenue stream.
Lean business processes
Profit maximisation strategies often motivate companies to adopt lean business processes by implementing efficient practices, reducing unnecessary costs, and making the most of their resources. By cutting out fat and reducing waste at every level, a business can focus its energy on boosting productivity and profit margin.
A local grocer, for instance, might lower its inventory levels to avoid losing excess products to spoilage, or a car manufacturer may employ just-in-time manufacturing, sourcing materials from suppliers only when they are needed for production, to reduce storage costs and waste. Both instances can maximise profit, so long as neither hinders the company’s ability to meet customer demand.
Disadvantages of profit maximisation
Profit maximisation comes with a variety of potential pitfalls that small businesses should be aware of, including:
Inferior products
Profit maximisation is counterintuitive if a company supplies inferior products or uses cheaper, lower-calibre materials solely to make more money. While decreasing production costs can increase gross profit in the short term, customers are bound to notice any decline in quality, which could ultimately drive them away.
Inflated prices
If a company hikes its prices to maximise profits, customers may choose alternative products and services that offer a better value. To manage this risk, businesses should carefully consider the potential consequences of price changes by conducting market research to determine if an increase is warranted.
Damaged Brand Reputation
If consumers think businesses are cutting corners to make more money, it can damage brand reputation. Today’s consumers seek out companies whose values align with their own, so it’s important to strike a balance between maximising profits and running a responsible, ethical business with a clear brand purpose that benefits society.
How to maximise profits
To achieve profit maximisation, businesses can increase revenue, decrease costs, or both. It’s important to strike the right balance to achieve profit maximisation goals.
How to increase revenue for profit maximisation
Businesses should consider a variety of strategies to increase their revenue, including:
- Employing effective marketing campaigns: cost-effective marketing campaigns that effectively communicate sharp brand messages are great for attracting new customers. Look at what similar businesses have done for inspiration and think about how you could do something new and creative.
- Expanding sales: businesses may decide to enter new markets, seek additional customer segments, or upsell and cross-sell by offering additional items or premium versions of products or services.
- Adjusting prices: a company may need to raise prices to ensure a healthy profit is made on each sale, while staying competitive.
- Spending more on quality: sometimes businesses need to spend more on improving products and services to increase profit. For instance, a family-run ice cream shop might decide to use more expensive, higher-quality ingredients to differentiate itself from its competitors, attracting customers who are willing to pay a premium for a fresher, tastier dessert.
- Investing in customer retention strategies: loyalty programs that reward regular customers encourages repeat business.
- Taking care of employees: If business leaders want to improve productivity, they should prioritise employees’ well-being and seek staff input to ensure that workers are not negatively impacted by process changes and other efforts to maximise profits.
How to decrease costs for profit maximisation
Maximising profits often means reducing costs. Companies can take several steps to lower their expenses, including:
- Reducing overhead: when cutting costs, it’s important to trim unnecessary expenses that don’t reduce the quality of products and services. This requires creating a clear picture of the business’s cost structure and identifying where value is generated and lost. For example, if shipping delays on certain materials are slowing down production, would it make better financial sense to manufacture some materials in-house, rather than rely on suppliers?
- Adopt time-saving technology: incorporating technology to automate repetitive tasks can improve efficiency, reduce labour costs, and allow staff to focus on higher-level work. While there may be an up-front cost, your business could save time and money in the long run.
- Streamline processes: identifying and eliminating bottlenecks and redundancies within processes enhances productivity, reduces costs, and allows products to get in the hands of consumers faster.
- Outsource certain functions: employing contractors to handle certain tasks that are not central to the business may save on labour costs, office space, utilities, and equipment expenses.
Key takeaways
When done effectively, maximising profits by increasing revenue and reducing costs provides short-term relief and long-term success. Businesses that carefully craft strategies to help achieve the maximisation of profits, without sacrificing the quality of products and services, will continue to innovate, grow, and thrive.