Answer to Question #225856 in Finance for Anisha Radhika Kum

Question

Dan Levy is in partnership with three others in their business, Outdoor Camping World. (Outdoor World had been Dan’s business and Camping World had been run by the other three until they merged the businesses last year. They merged the names too, so they might keep all their old customers, even though it doesn’t make much sense.) Dan argues that the firm should maximise gross profit margins [(selling price – buying price)/ selling price] on each item of stock. (a) Do you think this is a valid financial objective? (b) Is this objective consistent with maximisation of partners’ wealth? (c) What problems do you see in operationalising this objective?

Answer 1

a)

This could be a valid operational financial goal if the goal of the firm was to maximize profits in the short run. However, gross profit maximization emphasizes on selling price maximization and buying price minimization with exclusion of other variables. Consequently, firms increase prices and reduce number of units sold. Also might lead to quality reduction to minimize cost.

b)

No. Gross profit margin maximization actions might do just that and not even maximize profit in the short term. Long term profits and patterns will not be maximized even if the short term profits are maximized.

c)

Selling price setting, quality and buying costs decisions need market demand information in order to trade off prices and quantity to be sold to maximize profits.