This article is intended for general informational purposes only and does not constitute legal advice or an opinion on any issue. It should not be regarded as comprehensive or a substitute for professional advice.
Profit maximization is an approach that can enable efficient and sustained business growth. If you’re ready to expand your business, employing a profit maximization strategy may ensure that increased effort leads to increased net revenue.
What is profit maximization?
In economics, the "law of diminishing marginal returns" states that there’s a point in the production cycle where the cost of producing an additional unit diminishes the marginal returns that you’ll receive from it.
"Profit maximization" highlights where that point is – the optimum output at which your business is most profitable.
Example of profit maximization
Assume a shop owner is toying with the idea of keeping their shop open for an extra hour every day. The critical question for them to consider is: will the additional business hour cost less than the additional revenue generated by it?
If so, it’s financially prudent for the shop to remain open for an extra hour but, if not, the extra hour is costing the shop owner – even if they’re still making a gross profit.
Profit is maximized when marginal revenue (i.e. the additional revenue the shop generates for opening an extra hour) is equal to marginal cost (i.e. the additional cost the shop incurs for opening an extra hour).
Advantages of profit maximization
Profit maximization has a host of benefits including:
Improving long-term cash flow
Adopting a profit maximization approach is a good way to keep your operating cash flow healthy. Operating cash flow (also known as Cash Flows from Operations, or CFO) 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 flows. This in turn creates value for the business and presents an attractive proposition for investors.
Strategic business growth
When it comes to strategic business growth, timing is everything.
While it’s important to take your business to the next level, it’s equally important to know when to do so. It’s natural for small business owners to want to increase production quickly – often ahead of schedule. But the pitfalls of this approach include:
● Too many outlets opening too fast and not being sustainable.
● Cash being tied up in inventory that won’t sell.
● Employees working hours that don’t turn a profit.
Profit maximization can help business owners avoid these scenarios and ensure your decision-making is guided by figures – not faith or fear.
Lean business operations
A lean business machine is often an efficient one. Profit maximization cuts out the fat and allows businessowners to control their productivity levels and outputs.
Disadvantages of profit maximization
There are a few potential pitfalls when it comes to profit maximization:
Damaged brand reputation
Consumers may perceive companies engaging in profit maximization as being wholly motivated by profit, which can damage brand perception. Canadian consumers seek out brands that align with their values, so it’s important to communicate your brand purpose, whilst maintaining a focus on increasing profits.
Inferior products
Profit maximization can spell bad news for customers if a company supplies inferior products in order to maximize profits. While lowering the production costs will increase your gross profit in the short term, your customers will notice any decline in quality, which could ultimately drive them away.
Inflated prices
Similarly, customers may feel they have been handed a raw deal if a company hikes its prices to maximize profits.
5 tips on how to maximize your profits
To achieve profit maximization, your business can increase revenue, decrease costs or both.
Increase revenue
1. Run promotional campaigns to introduce your customer base to new products. Utilize social media or direct mail campaigns to publicize existing or upcoming promotions.
2. Review your product line and conduct a competitor analysis to ascertain whether customers consider your price point to be good value. This doesn't always mean lowering prices. For example, in some instances offering exceptional quality products can be a boon for businesses.
3. Engage your employees for improved productivity. It’s good business practice to be a good employer in general, but a positive workplace can also lead to easier hiring when it comes time to recruiting new employees.
Decrease costs
4. Reduce overheads by analyzing where money is being spent and where it can be saved, in order to maximize your operating profit.
5. Adopt time-saving and production-enhancing technology. Utilize new technologies to save time and find business efficiencies. This in conjunction with staff training and other time-saving strategies can help your business be more productive.
6. Utilize flexible financing when it makes sense. Assess your working capital to understand whether flexible financing can help maximize profit. For example, your business may be able to use a business credit card to invest in buying more product, thereby increasing revenue in increased sales. Be sure to analyze your finances before deciding whether a negative working capital strategy makes sense for you.
Testing and learning is an important tactic to use when it comes to ascertaining what profit maximization strategy will work best for your business.