Maria Peloponisiou~ 5 min Reading time | 13. Jan 2020
Understanding profit maximization can help smart business owners make the best decisions for the growth of their business, based on its potential for and limitations on growth. Business growth can happen by little spurts or by leaps and bounds, and it depends on both the market and the business owner to determine precisely when. While most of us don’t have much influence over the market, there are some things a savvy business owner can do to help their business grow as efficiently as possible.
What is Profit Maximization?
You may have heard of the law of diminishing returns, which is an economic principle that states that there’s a point in production where the expense of producing something becomes higher than the returns you’ll receive. Profit maximization is about knowing where this point is, so you can increase productivity when it makes financial sense to do so. Basically, profit maximization determines the point of output at which you’re most profitable.
If someone with a retail store decides to keep their store open for another hour each day, a crucial question for them to ask themselves would be: will the additional hour of operation cost less than the amount of additional revenue I’ll stand to gain? If so, it makes sense to stay open an hour longer—but if not, the additional hour may be costing the business owner, even if they’re still making a profit at the end of the day.
How Do You Calculate Profit Maximization?
Profit maximization is calculated by determining the ratio of marginal revenue to marginal cost. It is optimized when marginal revenue is equal to marginal cost (MR = MC).
Marginal revenue is the amount of additional revenue you’ll make for an extra unit of production, while the marginal cost is the additional cost you’ll incur for that extra unit of production. Marginal revenue often stays the same, since often products will usually be sold at a fixed cost.
How Do You Calculate the Marginal Cost?
To calculate the marginal cost, divide the change in total cost by the change in total output to get a price per unit of output.
For example, a potter who spends an extra £140.00 on materials and time to make an additional 20 bowls will have a marginal cost of £7.00 per bowl. If she then decides to increase her production, but it costs £200.00 in time and materials to make another 20 bwls, the marginal cost for that increment of production will have increased to £10.00 per bowl. If you have accounting software like Billomat, you can take a look at your existing ledger accounts to calculate your marginal revenue.
In the example of the retail store, it may cost them an extra £100.00 in wages and operating costs to stay open for an extra hour (£100.00 of marginal cost)—but they may make £120.00 during that extra hour (£120.00 of marginal revenue). The manager may look at the data and decide to stay open for an additional two hours, and in the second hour, makes £100.00, so their marginal cost is equal to their marginal revenue. Perhaps staying open for a third hour would only bring in £80.00, or would require hiring another employee, in which case the marginal cost would be higher than the marginal revenue, and therefore not a good business decision.
What You Have to Consider
It’s important to note that sometimes it’s extremely difficult to calculate the exact marginal revenue and marginal cost, especially when revenue depends on sales to the public. Anyone in retail, for example, will know that their sales depend not only on how much they charge, but on market demand for that product, which can be difficult to determine accurately. Even if you can’t calculate these numbers exactly, it’s still useful to know what factors you control that can affect them—for example, if you give your employees a raise, it will increase your marginal costs, thereby increasing your ideal marginal revenue. Increasing the markup on a product will increase your marginal revenue—but if it affects sales of the product, it may decrease it as well.
Another important note is that marginal cost and total cost are different concepts; while total cost factors in fixed and variable costs, marginal cost is only a calculation of the difference between the variable costs incurred by two different levels of production. It may seem like a small distinction, but knowing this can help you focus on the relevant numbers when you’re doing the math.
In the example of a retail store, there may be some fixed costs (monthly rent, for example) that shouldn’t factor into whether or not to stay open an extra hour. It would be easy for an inexperienced businessperson to view staying open for another hour as a way to make the most of their monthly rent without considering the associated variable costs, and thus losing money by staying open longer.
Why is Profit Maximization Important?
It’s important to grow your business, but equally important to know when to do it. Business growth needs to be strategic and understanding profit maximization will help you find the best possible strategy for success. It can be tempting for eager owners of new businesses to want to expand production too quickly; this can lead to too many stores opening too fast, money tied up in inventory that won’t sell, and workers putting hours in that don’t turn a profit. It can also be easy for a business owner to worry about spending money on production equipment, when doing so might actually make them more money in the long run.
The concept of profit maximization can help new business owners avoid these common pitfalls, and let the numbers drive their business decisions, rather than optimism or fear. Even if you don’t know what the exact numbers will be, the best estimate is always better than the best assumption.