UNIT – 5

INTRODUCTION TO PROFIT MANAGEMENT

Profit management means the manipulation of financial statement items within the framework of accounting
standards that may be for the benefit of the company or for the benefit of the opportunity. There are many
incentives for profit management, for example managers use profit managers to pay less tax. This may be through
accruals, Or for managers to increase their rewards to manage profits and show more profits. Other incentives for
earnings management include attracting investors, reducing earnings fluctuations and keeping track of the
business and reputation of managers, etc.
Profit: Meaning and Definition:
Profit is the income received by the organizer. It is the reward for the services of an entrepreneur. A firm makes
profit when it receives a surplus after it has paid interest on capital, wages to laborers’ and rent for land. Profit,
in other words, is the residual income which is equal to the different between the total revenue and the total cost
of production.
In economic terms profit is defined as a reward received by an entrepreneur by combining all the factors of
production to serve the need of individuals in the economy faced with uncertainties. In a layman language, profit
refers to an income that flow to investor. In accountancy, profit implies excess of revenue over all paid-out costs.
Profit simply means a positive gain generated from business operations or investment after subtracting all
expenses or costs.
Concept of Profit:
The concept of profit entails several different meanings. Profit may mean the compensation received by a firm
for its managerial function. It is called normal profit which is a minimum sum essential to induce the firm to
remain in business. Profit may be looked upon as a reward for true entrepreneurial function. It is the reward
earned by the entrepreneur for bearing the risk. It is termed as supernormal profit analysis.
According to Henry Grayson, “profit may be considered as a reward for making innovations, a reward for
accepting risks and uncertainties, a result of imperfections in the market. Any one of these conditions or a
combination of them can give rise to economic profit”.
According to Prof. J.K. Mehta, “The element of uncertainty introduces a fourth category of sacrifice in the
productive activities of man in a dynamic world. This category is risk-bearing or uncertainty bearing. It is
remunerated by profit”.
Prof. H. Speight defines, “profit is commonly said to be a payment for risk bearing”.
Prof. Schumpeter defines, “profit is the reward for the work of entrepreneur or it is a payment for risks,
uncertainties and innovations”
Nature of Profit:
To know the nature of profit you have to understand the difference between ‘Business Profit’ and ‘Economic
Profit’.
Business profits are an accounting concept and represent the residual sales revenue to the owners of the firm after
making payments to all other factors or resources the firm uses. These payments to hired factors include the
wages to hired labour, interest on borrowed capital, rent on land and factory buildings and expenditure on raw
materials used by the firm. The expenditures on these factors or resources hired or purchased by the firms are call
explicit costs.
Business profit refers to the sales revenue of the firm minus its explicit costs. Thus
Business profits = Total sales revenue – Explicit costs
It is the concept of business profits that is generally used by the business community and accountants.
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. Thus, 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.
The economic profit represents the sales revenue of the firm in excess of both explicit and implicit costs.
Economic profits = Sales revenue – Explicit costs – implicit costs.
Alternatively, economic profit can be defined as follows:
Pure profit = Accounting profit-(opportunity cost + unauthorized payments)
In short-run profits or present value of the stream of expected profits in the future, economists assume that it is
economic profits that owner- entrepreneur or managers of corporations seek to maximise.
In long-run equilibrium economic profits will be zero if all firms work in perfectly competitive market. Then,
how does an economic profit, positive or negative, come into existence.
Characteristics of Profit:
1. It is the reward of bearing by the entrepreneur.
2. It arises only in the dynamic conditions of a market.
3. It is the reward of bearing uncertainties.
4. It arises only under the situations of imperfect competition. No profit can arise under prefect competition.
5. It is the reward of innovation.
THEORIES OF PROFIT
Theory of Entrepreneurial Compensation: This theory is based upon the assumption that an entrepreneur is
one of the essential factors of production and an essential part of an enterprise. He labours for the success and
progress of his enterprise. Profit is the Reward of such labour and sacrifice. These days this theory does not hold
true because management today is a separate Part of an enterprise and all these functions are performed by
management. It has nothing to do with the profit of the enterprise.
Theory of Risk and Uncertainty: In every business and industrial enterprise, there is an atmosphere of risk and
uncertainty, which are borne by the entrepreneur alone. He should get a reward bearing these risks and
uncertainties called profit. Profit is the drive which motivates an entrepreneur to bear the risks and uncertainties
of his enterprise. Prof. Knight has used the word uncertainty in place of the word “Risk”. According to him
business risks can be of two types: insurable risks and uninsurable risks. Insurable risks are those which can be
forecasted in advance and which can be insured. If a risk is insured, it is no more a risk because the business
enterprise has nothing to do with such risk. Uninsurable risks are those that cannot be forecasted and therefore,
cannot be insured. The uninsurable Profit is the reward of bearing these risks only. Though this theory of profit
determination is much better than the earlier theory, Yet it is not a complete or satisfactory theory.
Theory of Innovation: According to this theory propounded by ‘Schumpeter’, Profit arises due to regular
innovations of a business enterprise. The term “Innovation” Includes all the activities performed by an
entrepreneur to reduce the cost of production, to improved the quality of production, to present the product in a
new form, to improve the product, to make the product more useful and to improve the selling and distribution
efforts of the enterprise by using new and improved techniques.
Through innovation an entrepreneur tries to attract more and more customers to his product so that he can increase
the demand of his product in market and he may earn maximum profit through maximum sales. The process of
innovation should continue forever because as soon as an entrepreneur introduces some innovation, his
competitors copy it and its importance comes to an end.
This theory of profit determination rightly emphasizes upon innovation which is an important factor for the
success of an enterprise. However, it does not consider risks and uncertainties borne by an entrepreneur. Hence
this theory cannot be regarded as satisfactory.
Theory of Monopoly and Market Imperfections: According to this theory, an Entrepreneur can get profit only
under the situation of monopoly and market imperfections. He can earn profit by controlling the supply of his
product, by getting the advantage of ignorance of consumers and by fixing relatively high earning profit under
perfect competition.
To conclude, profit is the reward for enterprise which is an essential factor of production. Profit is paid to the
entrepreneur. It is the reward of bearing risks and uncertainties by an entrepreneur. It is the reward of taking pains
by an entrepreneur to run his business enterprise.
Factors Influencing Profit:
i. Risk-taking and Uncertainty bearing.
ii. Monopolistic control or Imperfections in the market.
iii. Element of Luck or chance.
iv. Innovations, and
v. Differences in Abilities of Entrepreneurs
Factors Limiting Profit:
Profit of the firm can be limited by a number of factors. In fact, modern firms themselves try to limit the profits
on account of number of reasons. The factors limiting the profits are as follows:
• Creation of competition,
• Creation of substitutes,
• Heavy Taxation,
• Increased Wages,
• Increasing the cost of Input,
• Ceiling on profits.
FUNCTION OF PROFIT
As pointed out by Peter F. Drucker, profit serves three main purposes:
i. Tool for measuring performance: Refers to the fact that profit generated by an organization helps
in estimating the effectiveness of its business efforts. If the profits earned by an organization are high,
it indicates the efficient management of its business. However, profit is not the most efficient measure
of estimating the business efficiency of an organization, but is useful to measure the general efficiency
of the organization.
ii. Source of covering costs: Helps organizations to cover various costs, such as replacement costs,
technical costs, and costs related to other risks and uncertainties. An organization needs to earn
sufficient profit to cover its various costs and survive in the business.
iii. Aid to ensure future capital: Assures the availability of capital in future for various purposes, such
as innovation and expansion. For example, if the retained profits of an organization are high, it may
invest in various projects. This would help in the business expansion and success of the organization.
Apart from aforementioned functions, following are the positive results of high profits:
i. Investment in research and development: Leads to better technology and dynamic efficiency. An
organization invests in research and development activities for its further expansion, if it earns high
profit. The organization would lose its competitiveness, if it does not invest in research and
development activities.
ii. Reward for shareholders: Includes dividends for shareholders. If an organization earns high profits,
it would provide high dividends to shareholders. As a result, the organization would attract more
investors, which are crucial for the growth of the organization.
iii. Aid for economies: Implies that profits are helpful for economies. If organizations generate high
profits, they would be able to cope with adverse economic situations, such as recession and inflation.
This results in stability of economies even in adverse situations.
iv. Tool to stimulate government finances: Implies that if the profits generated by organizations are
high, they are liable for paying high taxes. This helps government to earn high revenue and spend for
social welfare.
BREAK EVEN ANALYSIS
In business profit should not be left to chances. It should be properly planned. The Break-Even analysis is a useful
technique of profit planning and prediction. This analysis is principally concerned with cost-volume profit
analysis. In fact, break-even analysis is cost volume-profit relationship analysis. It magnifies a sales mix to the
profitability of the concern.
MEANING OF BREAK EVEN ANALYSIS
The term “break even analysis may be interpreted in two senses are narrow sense and broad sense”. In its narrow
sense, it refers to a system of determining that level of operation where total revenues equal total costs, i.e., it is
basically concerned with finding out the break-even point. In its broad sense, it denotes a system of analysis that
can be used to determine the probable profit at any level of operations.
The break-even analysis is based on certain assumptions which are as follows:
1. The principle of cost variability is valid.
2. All costs can be separated into fixed and variable components.
3. Behavior of different costs is linear.
4. Fixed costs will remain constant at all volumes and variable costs will fluctuate in direct proportion to volume.
5. Selling prices will remain constant at all volumes of sales.
6. Prices paid for input factors will remain the same.
7. Technological methods and efficiency of men and machines will not be changed.
8. Cost control will be neither strengthened nor weakened.
9. Production and sales will be synchronized.
10. Either there is only one product or if several products are being produced and sold, the sales mix will remain
constant.
11. Revenue and costs are being compared with a common activity base, e.g., sale value of production or units
produced.
12. The efficiency of plant can be predicted with accuracy.
BREAK EVEN POINT
The calculation of break-even point is the foundation stone of break-even analysis. It may be described as that
point of output and sales volume at which the company breaks even, i.e., the point at which sales revenue equals
the cost to make and sell the product and no profit or loss is reported. This is why this point is also called as “no-
profit, no loss point”.
In the words of M/s Keller and Ferrara, “the break-even point of a company or a unit of a company is the level
of sales income which will equal-even point is that point of activity (sales volume) where total revenues and total
expenses are equal, it is the point of zero profit and zero loss”.
Here, it is to be noted that if volume of output and sales is less than the break-even level, the business will incur
a loss. The business can be profitable only when this volume exceeds the breakeven level and higher the volume,
higher the profits.
METHODS OF CALCULATING THE BREAK EVEN POINT

Graphical Method:
Shows a linear break-even analysis. When price of a product remains the same, the organization expands its
production, thus, total revenue is linear to the output.

Let us learn this method through following Figure

As shown in Figure, TFC is equals to FE, which is a fixed cost line. The vertical distance between TC and TFC
line equals TVC. As quantity of output increases, the vertical distance between TC and TFC increases. This
implies that TVC increases with change in TC and TFC.

Until Qb of the quantity is produced, total cost exceeds the total revenue, which implies that an organization will
suffer losses if it produces less than Qb. At Qb output level, total revenue equals total cost. At this point, an
organization never makes profit nor loss implying that it is a break-even point. Thus, Qb is a break-even level of
output. Producing more than Qb will be profitable for organizations as TR is greater than TC.

Algebraic Method:
Helps in decision making problems of the organization. We know that profit is equal to difference between total
revenue and total cost.

Profit = TR – TC

TR = P*Q

TC = TVC + TFC

TC = AVC*Q + TFC (TVC is the variable cost per unit multiplied by the output produced and sold)

Let Qb is the break-even quantity at which TR = TC.

TR = TC

P. Qb = TFC + AVC. Qb

P.Qb – AVC.Qb = TFC

(P – AVC)Qb = TFC

Qb = TFC/ (P-AVC)

Thus, from the above equation, it can be said that the break-even quantity of output is determined by TFC, price
and variable cost per unit of output.

Contribution Analysis:
Refers to the analysis of incremental or additional revenue and costs of a business. Contribution is the difference
between total revenue and variable costs.

Fixed costs are addition to variable costs. Thus, TC line is parallel to the variable costs line. In the Figure-18, OQ
is the break-even point. TC minus VC equals FC. Below OQ, contribution is less than fixed cost whereas beyond
OQ, contribution exceeds faxed cost. The shaded portion between TR and VC is the contribution.

Profit volume (PV) ratio:

Refers to another method to find break-even point. The formula for profit volume ratio is:

PV ratio = (S-V)/S* 100

S = Selling price

V = Variable costs

Margin of Safety:
The margin of safety is defined as a difference between sales at a break-even point and total actual sales. This
term was given by Benjamin Graham and David Dodd in their book, Security Analysis. The margin of safety is
useful when the sales of organizations are at risk.

There are three measures of margin of safety used given as follows:

Margin of safety = (profit * sales)/PV ratio

Margin of safety = profit/PV ratio

Margin of safety = (Sa – Sb) *Sa * 100

Sa = Actual sales
Sb = Sales at break-even point

Let us study the working of margin of safety as follows:

TR = 20 Q

TC= 100 + 10 Q

Sa = 40

We know that TR = TC at break- even point.

Let’s substitute Sb in place of Q in TR and TC functions.

TR = 20 Sb

TC = 100 + 10 Sb

TR = TC (at break-even point)

20Sb = 100+ 10 Sb

Sb = 10

Thus, margin of safety = (20 – 10)/20 * 100 = 50%

The margin of safety can be increased by the following methods:

i. Increasing tire selling price, provided sales are not affected (this is possible in case of inelastic demand of
product)

ii. Increasing production and sales up to the capacity of the plant

iii. Reducing the fixed expenses or variable expenses

USES OF BREAK-EVEN ANALYSIS

i. Helps in determining the sales volume
ii. Forecasts profits if estimates of revenue and cost are available
iii. Helps in appraising the effects of change on volume of sales and cost of production
iv. Assists in making choice of products and determining product mix
v. Highlights the impact of increase or decrease in the fixed and variable costs
vi. Studies the effect of high-fixed costs and low variable costs
vii. Makes intra-firms profitability comparisons
viii. Helps planning of cash requirements for organizations effectively

LIMITATIONS OF BREAK-EVEN ANALYSIS

i. Fails to be applied effectively in the multiple products situation
ii. Fails to be implemented in the situation where cost and price cannot be ascertained and where historical data
is not available
iii. Assumes fixed costs to be constant
iv. Assumes that quantity of goods produced is equal to the quantity of goods sold, which may not be always true
v. Ignores changes in selling prices
vi. Ignores market conditions.

INFLATION

No words in Economics, as coulborn feels, are more trouble than inflation and deflation. Every one of us has a
rough idea that inflation is to do with rising prices. But there is no general agreement as to how it can be defined.
So we have mentioned below some of the definitions of inflation which are popular and associated with monetary
problems.

1. The most popular definition is, “Too much money chasing too few goods”.
2. The definition given by “The Economist” London and quoted with approval by coulborn follows: “Excess of
demand for everything over the supply of everything”.
3. Harry G. Johnson defines inflation, “as a sustained rise in prices”.
4. Gardner Ackley in his book „Macro – Economic Theory „defines inflation as “rising prices, not as high prices”.
5. The definition given by E.James in his article included in the book edited by Hague entitled inflation is as
follows: “inflation is a self perpetuating and irreversible upward movement of prices, caused by an excess of
demand over capacity to supply”.

Features:

When there is inflation in the country one can note the presence of the following features in the economy:
1. There will be a steady in the price level.
2. There will be a steady fall in the value of money.
3. There will be an increase in money supply.
4. There will be an increase in the money incomes of people.
5. Demand for goods will be generally on the increase.
6. Demand for commodities will be greater than the supply or commodities.
7. Employment opportunities on the economy will tend to increase.

According to Kurihara, inflationary rise of prices may take place due to three types of factors viz.,
(1) Demand factors
(2) Supply factors and
(3) Expectations,
kurihara means by demand, the demand for money to buy tings and by supply he means the available output over
which income can be spent. On the demand side, the factors that may bring about inflationary rise in price are:
(a) increase in money supply
(b) increase in the disposable income of people
(c) increase in consumer expenditures and business outlays, and
(d) increase in foreign demand.
On the supply side, the factors that may bring about inflation are:
(a) full employment
(b) shortage of labour, equipment and raw materials
(c) export of commodities subject to strong domestics demand
(d) wage-price spiral. Expectations play an important role in the spread of inflation.

TYPES OF INFLATION

According to A. J. Brown in his well-known book, ‘The Great inflation’, “inflation is a bewildering variety of
phenomena”. This means that inflation in a country at one time may be due to one reason, but at another time it
may be due to some other reason. In short, there are different types of inflation as explained below:

1. Keyes distinguishes between pure inflation and semi-inflation or bottleneck inflation. Inflation that takes
place after the stage of full employment is reached in the country is called pure inflation. Keynes refers
to pure inflation as inflationary gap.
2. Inflation that takes place even before the stage of full employment is reached in the economy is called
semi-inflation or bottleneck inflation occurs due to bottleneck in production and trade union activities.
3. On the basis of the period of its occurrence, inflation has been distinguished into (a) war-time inflation,
(b) post war inflation and (c) peace-time inflation.
4. During periods of war, governments tend to spend more: supply of goods required by people for their
consumption declines; there is an increase in money supply due to deficit spending by government. All
these factor result in steady rise in prices. We call it war-time inflation.
5. In the immediate post-war years, money in circulation tend to be as high as was during the period of war.
Shortages of goods continue. Government may have to spend huge sums on reparation operations. As a
result, prices continue to rise even after the war is over. We call it post-war inflation.
6. Even when a country is not at war with another country there is a possibility of steady rise in prices. This
may be due to an over issue of currency, huge spending by government. Demand for goods being in excess
of supply or increase in cost of production. We call it peace time inflation.
7. On the basis of factors that cause inflationary rise in prices we distinguish among (A) excessive money
supply inflation (B) deficit induced inflation (C) cost-push inflation and (D) demand-pull inflation.
8. If the total money supply increases factor than the total output of goods and services. It is sad to be
excessive money supply inflation. In this case, too much money will be chasing too few goods in the
economy.

If the increase in cost leading to the rise in price is due to an increase in the profits of the producers it is called
Profit Inflation.
If the increase in cost leading to rise in price is due to increase in the money in the wages of the laborer, it is
called Wage Inflation.

R. F. Harrod has talked of another kind of inflation. He calls it by the name of Latent Inflation. This situation
arises when the funds in the hands of business firms are not being spent not because of controls or rationing but
because these firms are not able to book fresh orders. As soon as the situation changes, these savings are let out.
This may generate inflation which is referred to as latent inflation.

Effects of Inflation:
Inflation produces mixed results. It is beneficial to a few and harmful to others. Keynes distinguishes between
the effects of rising prices
(a) on the distribution of wealth and income in the community and
(b) on production and employment in the economy.

Be effects on distribution of wealth, he means effects of rising prices on different classes, viz., (1) rentier class
(b) business class and (3) earning class.
Inflation is a great stimulant to business enterprise. The businessman, whether he is a manufacturer or merchant,
stands to profits greatly by rising prices.
So far as wage earners are concerned, it is true that they are able to get a rise in their wages during a period of
rising prices. But the order of increase in wage secured by them is seldom as high as the order of increase in
general price level. So wage earner lose during a period of rising prices.

Inflation affects farmers and consumers also. The farmers are affected favorably. For they are able to get higher
prices for the farm products.

Inflation affects consumers adversely. They have to pay higher prices for the goods they buy. Sir. C. N. Vakil
pass the following remark in his book entitled “Financial Burden of War on India” “Inflation may be compared
to a robber. Both deprive the victim of some possession with the difference that the robber is visible inflation is
invisible; the robber’s victim may be few at a time, the victim of inflation is the whole nation; the robber may be
dragged to court of law; inflation is legal”.

The effects of inflation on production and employment are favorable. Induced by the rising prices, the business
people expand their activities. Since prices are on the increase they are very optimistic about the future.

Inflation also affects the course of international trade of a country. In view of rising prices in the domestic
economy, exports tend to decline and imports tend to increase. As a result, there will be unfavorable balance of
payments. If unfavorable balance of payments for quite some time, the external value of the currency will tend
to decline.

Inflation and Economic Development : There is a controversy among economists whether inflation helps or
hinders economic development but after reading all In conclusion, it may be noted that a mild dose of inflation
may help capital formation and thereby assist economic development in the short period. But a policy of
continuous inflation may do more harm than good over a period of time.

Definition and Features of Deflation

Crowther defines deflation “As a state in which the value of money is rising i.e., prices are falling”. When there
is deflation in a country one can note the presence of the following features in the economy:
a) There will be a steady fall in the price level.
b) There will be a steady rise in the value of money.
c) There will be a decrease in money –supply
d) There will be a decrease in the money incomes of people.
e) Demand for goods will be generally on the decline.
f) In the initial stage the supply of commodities will be greater than the demand for commodities.
g) There will be widespread unemployment in the economy .
h) The producers will be pessimistic and as result investment activity will be at very low levels.

Cause:
Deflation may take place in an economy due to several reasons. It may occur due to decline in total spending in
the economy. Or it may be due to over production of goods. Or, it may be due to pessimistic attitude of investors
who are afraid of a bleak future for investment in the economy.

Effect of Deflation:
Deflation produces mixed effects. During a period of deflation the entire class of the people (viz., Property
owners, Landlords, Investors in securities and creditors) gain. The consumers also gain. But the debtors, farmers
and business people lose. Deflation producers adverse effects, on production and employment in the economy.
When there is a steady fall in the prices, the business people tend to be pessimistic. So, they curtail their output.
This leads to widespread unemployment in the economy. In view of its adverse effects on the general; level of
economic activities in the country, deflation is considered to be worse than inflation.

Deflation, however, proves to be beneficial to a country so far as its foreign trade is concerned. Since prices are
of the3 decline in the domestic economy, exports tend to rise and imports tend to decline. This may result in
favorable balance of payments. If this persists for some time, the external value of the currency will tend to rise.