Standards of reasonable profits are determined when a firm chooses to make only reasonable profits rather than to maximize its profit. The questions that arise in this regard are as follows:
- What form of profit standards should be used?
- How should reasonable profits be determined?
These questions can be understood after going through the following explanatory points.
Forms of Profit Standards
Profit standards is determined in terms of the following:
- Aggregate money terms
- Percentage of sales, and
- Percentage return on investment.
All these standards are determined for each product separately. Among all the forms of profit standards, the total net profit of the firm is more common than other standards. But when the purpose is to discourage the competitors, then the target rate of return on investment is the appropriate profit standard, provided the cost curves of competitors’ are similar. The profit standard in terms of ratio to sales is not an appropriate standard because this ratio varies widely from firm to firm, even they will have the same return on capital invested. These differences are following:
- Vertical integration of production process
- Intensity of mechanization
- Capital structure
Setting the Profit Standard
The following are the important criteria that are considered while setting the standards for a reasonable profit.
1. Capital-Attracting Standard
An important criterion of profit standard is that it must be high enough to attract external capital such as debt and equity. For example, if the firm’s stocks are sold in the market at 5 times their current earnings, it is necessary for a firm to earn a profit of 20 per cent of the total investment But there are certain problems associated with this criterion, which are as follows:
- Capital structure of the firms such as the proportions of bonds, equity and preference shares, which affects the cost of capital and thereby the rate of profit.
- If the profit standard is based on current or long run average cost of capital or not. The problem in this case arises as it may also vary widely from company to company.
2. Plough-Back Standard
This standard is appropriate in case company depends on its own sources for financing its growth. This standard involves the aggregate profit that provides for an adequate plough-back for financing a desired growth of the company without resorting to the capital market. This standard of profit is used when liquidity is to be maintained by a firm and a debt is to be avoided as per the profit policy of the firm. This standard is socially less acceptable than capital attracting standard. From society’s point of view, it is more desirable that all earnings are distributed to stockholders and they should decide the further investment pattern. This is based on a belief that an individual is the best judge of his resource use and the market forces allocate funds more efficiently. On the other hand, retained earnings which are under the control or the management are likely to be wasted on low-earning projects within a business firm. But to choose the most suitable policy among marketing and management the abilities of the management and outside investors are to be considered. This helps in estimating the earnings prospects of a firm.
3. Normal Earnings Standard
Another important criterion for setting standard of reasonable profit is the normal earnings of firms of an industry over a period. This serves as a valid criterion of reasonable profit, provided it should take into consider the following points:
- Attracting external capital
- Discouraging growth of competition
- Keeping stockholders satisfied.
When average of normal earnings of a group of firms is used, then only comparable firms are chosen. However, none of these standards of profits is perfect. A standard should, therefore be chosen after giving due consideration to the existing market conditions and public attitudes. Different standards are used for different purposes because no single criterion satisfies all conditions of the customers.