Profitability objective may be stated in terms of profits, return on investment, or profit to-sales ratios. According to profit maximization objective, all actions such as increase income and cut down costs should be undertaken and those that are likely to have adverse impact on profitability of the enterprise should be avoided. Advocates of the profit maximization objective are of the view that this objective is simple and has the in-built advantage of judging economic performance of the enterprise. Further, it will direct the resources in those channels that promise maximum return. This, in turn, would help in optimal utilization of society’s economic resources. Since the finance manager is responsible for the efficient utilization of capital, it is plausible to pursue profitability maximization as the operational standard to test the effectiveness of financial decisions.
However, profit maximization objective suffers from several drawbacks rendering it an ineffective decisional criterion. These drawbacks are:
(a) It is Vague
It is not clear in what sense the term profit has been used. It may be total profit before tax or after tax or profitability rate. Rate of profitability may again be in relation to Share capital; owner’s funds, total capital employed or sales. Which of these variants of profit should the management pursue to maximize so as to attain the profit maximization objective remains vague? Furthermore, the word profit does not speak anything about the short-term and long-term profits. Profits in the short-run may not be the same as those in the long run. A firm can maximize its short-term profit by avoiding current expenditures on maintenance of a machine. But owing to this neglect, the machine being put to use may no longer be capable of operation after sometime with the result that the firm will have to defray huge investment outlay to replace the machine. Thus, profit maximization suffers in the long run for the sake of maximizing short-term profit. Obviously, long-term consideration of profit cannot be neglected in favor of short-term profit.
(b) It Ignores Time Value factor
Profit maximization objective fails to provide any idea regarding timing of expected cash earnings. For instance, if there are two investment projects and suppose one is likely to produce streams of earnings of Rs. 90,000 in sixth year from now and the other is likely to produce annual benefits of Rs. 15,000 in each of the ensuing six years, both the projects cannot be treated as equally useful ones although total benefits of both the projects are identical because of differences in value of benefits received today and those received a year two years after. Choice of more worthy projects lies in the study of time value of future flows of cash earnings. The interest of the firm and its owners is affected by the time value or. Profit maximization objective does not take cognizance of this vital factor and treats all benefits, irrespective of the timing, as equally valuable.
(c) It Ignores Risk Factor
Another serious shortcoming of the profit maximization objective is that it overlooks risk factor. Future earnings of different projects are related with risks of varying degrees. Hence, different projects may have different values even though their earning capacity is the same. A project with fluctuating earnings is considered more risky than the one with certainty of earnings. Naturally, an investor would provide less value to the former than to the latter. Risk element of a project is also dependent on the financing mix of the project. Project largely financed by way of debt is generally more risky than the one predominantly financed by means of share capital.
In view of the above, the profit maximization objective is inappropriate and unsuitable an operational objective of the firm. Suitable and operationally feasible objective of the firm should be precise and clear cut and should give weightage to time value and risk factors. All these factors are well taken care of by wealth maximization objective.