Baumol’s Sales Revenue Maximization Model

Sales maximization model is an alternative model for profit maximization. This model is developed by Prof. Boumol, an American economist. This  alternative goal has assumed greater significance in the context of the growth of Oligopolistic firms.

Baumol’s sales revenue maximization model  highlights that the primary objective of a firm is to maximize its sales rather than profit maximization. It states that the goal of the firm is maximization of sales revenue subject to a minimum profit constraint. The minimum profit constraint is determined by the expectations of the share holders. This is because no company can displease the share holders.

“Though businessmen are interested in the scale of their operations partly because they see some connection between scale and profits, I think management’s concern with the level of sales goes considerably further. In my dealings with them I have been struck with the importance the oligopolistic enterprises attach to the value of their sales. A small reversal in an upward sales trend that can quite reasonably be dismissed as a random movement sometimes  leads to a major review of the concern’s selling and production methods, its product lines, and even its internal organizational structure.” – Baumol

It is to be noted here that maximization of sales does not mean maximization of physical sales but maximization of total sales revenue. Hence, the managers are more interested in maximizing sales rather than profit. The basic philosophy is that when sales are maximized automatically profits of the company would also go up. Hence, attention is diverted to increase the sales of the company in recent years in the context of highly competitive markets.

Maximizing sales revenue is an alternative to profit maximization and occurs when the marginal revenue, MR, from selling an extra unit is zero. The notion that business firms (especially those operating in the real world) are primarily motivated by the desire to achieve the greatest possible level of sales, rather than profit maximization. On a day-to-day basis, most real world firms probably do try to maximize sales rather than profit. For firms operating in relatively competitive markets, facing relative fixed prices, and relatively constant average cost, then increasing sales is bound to increase profits, too. Moreover, according to the notion of natural selection, even firms that seek to maximize sales, those that also maximize profit will remain in business. The primary responsibility of a marketing or sales manager is to achieve sales targets over a given time period. In addition to achieving sales targets, a sales manager is expected to maximize sales to provide growth and increase profits. Sales maximization is an activity that concentrates on revenue transactions and can be accomplished by employing various sales strategies and programs. The thought that maximizing sales will help maximize profits is not always true. An increase in sales is associated with an increase in cost of goods sold and other expenses. Sales maximization programs can be implemented for many reasons and at various times, but they are not done continuously. The start of a business, during lean seasons and at times when there is excess inventory are examples of those times. Sales managers may refrain from maximizing sales without the consent of general managers to avoid a possible shortage of business resources such as inventory and manpower.

Rationalization of Baumol’s Sales Revenue Maximization Model

  1. There is evidence that salaries and other earnings of top managers are correlated more closely with sales than with profits.
  2. The banks and other financial institutions keep a close eye on the sales of firms and are more willing to finance firms with large and growing sales.
  3. Personnel problems are handled more satisfactorily when sales are growing. The employees at all levels can be given higher earnings and better terms of work in general.
  4. Large sales, growing over time, give prestige to the managers, while large profits go into the pockets of shareholders.
  5. Managers, prefer a steady performance with satisfactory profits to spectacular profit maximization projects. If they realize maximum high profits in one period, they might find themselves in trouble in other periods when profits are less than maximum.
  6. Large growing sales strengthen the power to adopt competitive tactics, while a low or declining share of the market weakens the competitive position of the firm and its bargaining power vis-à-vis rivals.

Arguments Against Sales Maximization Model

In defence of this model, the following arguments are given.

  1. Increase in sales and expansion in its market share is a sign of healthy  growth of a normal company.
  2. It increases the competitive ability of the firm and enhances its influence in the market.
  3. The amount of slack earnings and salaries of the top managers are directly  linked to it.
  4. It helps in enhancing the prestige and reputation of top management,  distribute more dividends to share holders and increase the wages of workers  and keep them happy.
  5. The financial and other lending institutions always keep a watch on the sales revenues of a firm as it is an indication of financial health of a firm.
  6. It helps the managers to pursue a policy of steady performance with  satisfactory levels of profits rather than spectacular profit maximization over  a period of time.

Managers are reluctant to take up those kinds of projects  which yield high level of profits having high degree of risks and uncertainties.  The risk averting and avoiding managers prefer to select those projects which ensure steady and satisfactory levels of profits.

Types  of  Baumol’s Sales Revenue Maximization Models

Prof. Boumol has developed two models. The first is static model and the second one is the dynamic model.

The Static Model of Sales Maximization

This model is based on the following assumptions.

  1. The model is applicable to a particular time period and the model does not  operate at different periods of time.
  2. The firm aims at maximizing its sales revenue subject to a minimum profit  constraint.
  3. The demand curve of the firm slope downwards from left to right.
  4. The average cost curve of the firm is unshaped one.

The Dynamic Model of Sales Maximization

In the real world many changes takes place which affects business decisions of a firm. In order to include such changes, Boumol has developed another dynamic model. This model explains how changes in advertisement expenditure, a major determinant of demand, would affect the sales revenue of a firm under severe competitions.

Assumptions of dynamic model:

  1. Higher advertisement expenditure would certainly increase sales revenue  of a firm.
  2. Market price remains constant.
  3. Demand and cost curves of the firm are conventional in nature.

Generally under competitive conditions, a firm in order to increase its  volume of sales and sales revenue would go for aggressive  advertisements. This leads to a shift in the demand curve to the right.  Forward shift in demand curve implies increased advertisement  expenditure resulting in higher sales and sales revenue. A price cut may  increase sales in general. But increase in sales mainly depends on  whether the demand for a product is elastic or inelastic.

A price reduction policy may increase its sales only when the demand is  elastic and if the demand is inelastic; such a policy would have adverse  effects on sales. Hence, to promote sales, advertisements become an  effective instrument today. It is the experience of most of the firms that  with an increase in advertisement expenditure, sales of the company  would also go up.

A sales maximizer would generally incur higher amounts of advertisement  expenditure than a profit maximizer. However, it is to be remembered  that amount allotted for sales promotion should bring more than  proportionate increase in sales and total profits of a firm. Otherwise, it will  have a negative effect on business decisions

Thus, by introducing, a non-price variable in to his model, Boumol makes  a successful attempt to analyze the  behavior  of a competitive firm under  oligopoly market conditions. Under oligopoly conditions as there are only a  few big firms competing with each other either producing similar or  differentiated products, would resort to heavy advertisements as an  effective means to increase their sales and sales revenue. This appears to  be more practical in the present day situations.

Implications of  Baumol’s Sales Revenue Maximization Model

Implication of sales maximization theory of Baumol is that price would be lower and output greater under sales maximization than under profit maximization. This is because total and output revenue is maximized at the price output level is positive where marginal revenue is zero, while at the profit maximization level of output marginal revenue is positive, given that marginal costs are positive. Under sales maximization with a minimum profit constraint, output will be greater and price lower than under profit maximization objective. If this is true that oligopolists seek to maximize sales or total revenue, then the greater output and lower price will have a favorable effect on the welfare of the people.

As explained above, another implication of sales maximization objective is more advertising expenditure will be declined under it. Further, under sales maximization objective of oligopolists, price is likely to remain sticky and the firms are more likely to indulge in non price competition. This is what actually happens in oligopolistic market situations in the real world. Another significance of Baumol’s Sales Revenue Maximization Model  is that there may be conflict between pricing in the long and short run. In a short run situation where output is limited, revenue would often increase, if prices were raised, but in the long run it might pay to keep price low in order to compete more effectively for a large share of the market. This price policy to be followed in the short run would then depend on the expected repercussions of short run decisions on long run revenue.

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