Profit Maximisation vs Wealth Maximisation

Profit Maximisation vs Wealth Maximisation

In a simple world, profit maximisation and wealth maximisation would seem like the same thing but there are marked differences between the two approaches. The two can certainly go hand in hand and are by no means mutually exclusive. We can find key differences in their time horizon, approach to risk, bench-marking, time value of money and measurement techniques among other things. To distinguish between the two, we must first define them separately.

Profit maximisation

Profit is a financial gain, especially the difference between the amount earned and the amount spent in buying, operating, or producing something. Therefore profit maximisation is the desire to increase the advantage gained between the amount earned by a business and the amount spent in the process of producing their product. Profit is measured annually in business through the income statement though it can be measured in the interim.

 

Wealth maximisation

Wealth is the abundance of valuable possessions or in our case money. Wealth maximisation is focused on increasing the abundance of the owners of the business by increasing the value of the business. It goes without saying that to this a business needs to be profitable however profitability does not immediately equate to wealth building. In a company structure, the value of the company is measured through the value of the shares which is influenced by many factors chief amongst which are the expected future cash flows of the business.

Differences Between Profit Maximisation And Wealth Maximisation

With the two terms clearly defined we can start to look at profit maximisation and wealth maximisation compared to each other.

 

Time Horizon

Profit is measured on an annual basis, each year the company measures its performance and reports through the income statement. Therefore profit maximisation is a relatively short term and recurring exercise. Wealth maximisation, on the other hand, takes a long term view and realistically has not cut off date. It is a continuous rather than a recurring exercise. Time horizon also illustrates that wealth maximisation involves planning far into the future as not all efforts pay off immediately. It is plausible that amounts invested this year may only start paying off in many years to come.

 

Measurement Methods

Profit is measured in monetary terms. Therefore in profit maximisation, the outcome is expressed in monetary terms as to just how much profit was made or is intended to be made. Wealth is also stated in monetary terms as we have stated it is stated through share price or business valuation. The key difference comes in the techniques used to arrive at share valuation. The value of an asset is the present value of the sum of its future cash flows. The value of a business is not only the profit or cash flow it is expected to bring in the current year but also includes the expected future cash flows of the business. Due to the time value of money, the future cash flows must be discounted to arrive at a present value for them. Therefore unlike profit maximisation, wealth maximisation uses discounted cash flow techniques in its valuation and measurement.

 

Income Statement Versus Balance Sheet

Profit is measured in the annual income statement and appears at the bottom of it. Profit maximisation in this regard is an income statement item. One of the factors that directly impact share value is how much of the profit earned in a year is retained within the company. The higher the profit retention the more financial power the business has to chase other profitable ventures in the future. Profits may, of course, be paid out to shareholders through dividends. Wealth maximisation can be considered a balance sheet item as retained earnings appear in the balance sheet.

 

Outlook

Profit is measured within a definite period while the concept of wealth is enduring value in abundance. The goal of profit maximisation has a clear outlook and can be readily expressed in clear terms. A company can, for example, set a profit target or a desired percentage increase within the period. Wealth, on the other hand, is not as clear and is much more of a broad outlook. In publicly traded companies profit is a result of operations and internal to the company while the share price is impacted by many factors, the majority of which are outside of the control of management. Wealth maximisation is, therefore, a broad outlook rather than a specific number.

 

Approach To Risk

Risk is the probability of an adverse outcome occurring. Whilst there certainly are risks to profit, profit maximisation does not consider risk in its outlook. As we stated before profit maximisation has a short time horizon and this means that for the most part conditions are likely to be stable. However, wealth maximisation has a multiple period outlook into the future and as much must have risk at the forefront of all decisions because the impact, in the long run, can be much bigger because of how far away in the future cash flows may be. It is easier to make a profit in an uncertain environment than it is to accumulate wealth.

 

Operations Versus Strategy

Profit can be maximised in limited ways in a company. Profit can be maximized through selling more products, selling them at a higher price or reducing the costs involved in operating. You can have a combination of all three methods in a profit maximisation strategy. Wealth on the other can be increased through a variety of means including increased capitalization or earnings retention, investments, passive income and other assets. Companies can derive a lot of value from the ownership of other companies or assets such as patents or royalties. Possession of such assets can increase the valuation of a companies shares even if such assets are not in use by the company. Wealth maximisation is a matter of strategy where profit maximisation is a matter of operations.

 

It is abundantly clear that while profit maximisation and wealth maximisation go hand in hand they are certainly not the same thing. They have points of intersection. Profit maximisation is ultimately a short term exercise carried out in a single period but repeatedly done. Wealth maximisation on the other hand is a long term multi-period strategy that organisation is always involved in.

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