Criteria of Setting the Standard of Reasonable Profit

The appropriate criteria should be prepared to set up the level of standard. According to Joel Dean, the criteria of setting the standard are as follows:
1. Capital Return:
This criterion is related to how much return should be earned to attract outside capital. Likewise, this criterion is related to acquiring adequate income required for adequate capital formation. The machines can be replaced and building, machine and working capital can be added from capital formation.


The firms should set the rate sufficient to attract outside capital or equity capital. Due to this, if new equity capital has to be issued it does not adversely affect the interest of the existing shareholders. Similarly, people are ready to buy immediately as soon as the equity capital is issued. This is possible provided adequate dividend is provided in past. For this, profit standard should be designed on the basis of the cost of new capital in the capital market. Although this standard seems to be theoretically popular, many imaginary and guess-based decisions will have to be made to set up the capital-attracting rate of return, for example:
  1. First, the capital-attracting rate depends on the ratio of the capital structure of the company like bond, preferred stock, and common stock.
  2. Second problems are whether to base the standard of earning on the cost of present capital or long run average cost.
  3. Third problem is to acquire the relevant indicator of the cost of capital of the company in the market. It is not a simple problem. Because, the cost of capital widely differ in different industries and private companies. Such differences arise due to the difference in growth prospect, cyclical stagnation, capital structure and ability of the management.
2. Plowback Rate: This criterion is related to how much earning is necessary spend on the development of the firm completely from retained profits. According to this criterion, adequate amount of total profit should be retained for the required growth rate without resorting to capital market. But since large retained earnings may encourage the competitors for entry it should be determined carefully. Beside, the retained earnings is in complete control of the management and can waste in project inside the company. If that amount is distributed to the shareholders that may to the high-earning project due to the competition in the capital market. Since plowback rate depend on the need of the company, competition, politics of the shareholders and public relations, it is more individualistic.

3. Normal Earning: This criterion is related to how much the companies or comparable firms have, normally earned. According to this criterion, profit should be equal to the earning made by the companies or industry in normal period. It is appropriate for the firm to compare with its past earning. For this, the past earning level of the company should be have been adequate to attract capital, shareholders should have been invited. Beside this, the profit of other industries with comparable output and risks may also be good standard. For this, care should be taken in the selection of comparable companies. Likewise, broad average of all industry or broad sample of the companies may also be used. Beside the problem of selecting comparable companies there is also the problem of determining normal period. Profit should not have occurred due to the reason such as war. Since there is fluctuation in the income of the companies the selection of the period is very important in setting standard.

4. Popular conceptions of reasonable profit:
This standard is related to what the normal persons regard as reasonable profit. The standard of reasonable profit may be based on the survey made to know the opinion of general public relating to fair profit. Such survey provides good profit standard. It has been found in the survey that some regard 10 percent on sale and some 25 percent profit margin as reasonable.

No comments:

Post a Comment