Baumol’s Sales Revenue Maximization Model (Theory)| Objectives of Business

Baumol’s Sales Revenue Maximization Model (Theory)

Baumol raised questions on the validity of profit maximization as an objective of the firm. He emphasized that in competitive markets, firms would rather aim to maximize revenue through maximization of sales - the management of a firm might opt for sales revenue maximization to maintain or increase its market share, ensure survival, and discourage competition. According to this model, sales volumes, and not profit volumes, determine market leadership in competition. He argues that a firm seeks a certain level of profit and within that constraint aims at maximum sales. The ‘certain level of profit’ presumably means the level of profit considered satisfactory by the shareholders. This certain/minimum level of profit is regarded as the profit constraint.   He further stressed that in large organizations, management is separate from owners. Hence, there would always be a difference in managers’ goals and owners’ goals. Because of this dichotomy, managers choose to maximize their own utility function. 

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Sales maximization theory asserts that managers attempt to maximize the firm’s total revenue, instead of profits.

The sale is maximized in terms of revenue (currency) and not in terms of physical units of goods and services. This is because many firms are engaged in multiple products, and these products may not be additive in physical terms or/and may have different values per unit. Moreover, sales volumes are a better indicator of a firm’s position in the market, and growing sales strengthen the firm's competitive spirit. 

Real-life instance:

Starbucks plans to boost US sales in five charts - CNBC

Why managers pursue this goal? Why is sales maximization important?

Since the manager’s salary and other benefits are largely linked with sales volumes rather than profits, Baumol hypothesized that managers generally attach their personal prestige to the company’s revenue or sales; hence they rather attempt to maximize the firm’s total revenue, instead of profits. 

The factors which explain why managers pursue this goal are the following:

1. Salary and other earnings of managers are more closely related to sales revenue than to profits.
2. Banks and financial corporations look at sales revenue while financing corporation.
3. The trend in sales revenue is a readily available indicator of the performance of the firm. It helps in handling the personnel problem.
4. Increasing sales revenue enhances the prestige of managers while profits go to the owners.
5. Managers find profit maximization a difficult objective to fulfill consistency over time and at the same level. Profits may fluctuate with changing conditions. 
6. Growing sales or company's revenue strengthen the competitive spirit of the firm in the market and vice versa. 

Baumol has proposed two basic sales maximization models-

1. Single product, without advertising

2. Single product, with advertising

Baumol’s Theory of Sales Revenue Maximization

Why earning a minimum level of profit is necessary?

Managers pursue the objectives of sales revenue maximization, provided they earned the minimum level of profits expected by the shareholders. Earning of this minimum level of profits expected by the shareholders.

Earning this minimum level of profits is necessary to:

1.  Provide an adequate return on the capital employed by the shareholders.
2. For plowing back of profits: for replacement of assets and expansion of the firm.
3. For maintaining its creditworthiness/ rating in the financial markets.
4. To steady and stabilize the prices of the firm's shares listed on the stock exchange.
5. Managers' salaries and fringe benefits tend to change in the same direction of change in sales.
6. An increase in sales brings a reputation and goodwill to the management.
7. Growing sales revenue is on indicator that the firm is offering an attractive marketing mix (the product, price, distribution, and promotion) to the buyers.
8. The shareholders assume that increased sales volume will result in the economics of scale and lower production costs.
9. Financial institutions are more willing to provide credit to firms whose sales are increasing.
10. The employees can be given higher wages and other benefits and also better working conditions when sales re increasing over time.
11. Greater sales increase a firm's market power, which enables them to have more favorable distribution arrangements with suppliers and intermediaries.

Assumptions of Baumol's Model

The assumptions of this model are:

1. The firm pursues the objective of sales revenue maximization subject to minimum profit constraint.
2. Price of the product is constant.
3. Production costs are independent of advertising.

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Criticisms of Baumol's Model

Baumol's model has been criticized for:

1. Unrealistic assumptions
2. Interdependence in decision making ignored
3. Fails to establish industry equilibrium
4. Ignores actual and potential competition
5. The price implications of a change in advertising have not been considered explicitly.
6. The empirical validity of the sales revenue maximization objective is concerned; factual evidence are inconclusive.
7. It has also been also argued that, in the long run, sales maximization and profit maximization objective converge into one.

What is the difference between profit maximization and revenue maximization?

Comparing the sales revenue maximization objective with the profit-maximizing objective of a firm:

1. The firm which follows the objective of sales revenue maximization produces a higher output level than a profit-maximizing firm.
2. The price charged by a sales revenue maximizing firm is lower than the price charged by a profit-maximizing firm.
3. The sales revenue maximizing firm earns a lower level of profits than a profit-maximizing firm.

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