Baumol’s “Sales Maximisation Hypothesis?” Essay

Custom Student Mr. Teacher ENG 1001-04 12 February 2017

Baumol’s “Sales Maximisation Hypothesis?”

To what extent does empirical evidence on corporate objectives support the predictions of Baumol’s “Sales Maximisation Hypothesis?”

In Neo-Classical Economic theory of a firm, the owners of a firm are involved in the day to day running of the firm, and therefore their main desire is profit maximisation. In reality firms are most likely run by managers and not by the owners. Because of this there is a lack of goal congruence between the two. Baumol (1959) suggests that manager controlled firms are more likely to have sales revenue maximisation as their main goals rather than profit maximisation favoured by shareholders.

He shows that there are several explanations for the managerial emphasis on sales maximisation rather than maximising profits: sources of debt closely monitor sales of firms and are more willing to finance firms with growing or large sales figures; lay- off necessitated by fall in sales leads to industrial unrest and unfavourable investment climate; and with decreased sales (and consequently decreased market power) the firm enjoys lesser powers to adopt effective competitive tactics. As well as managers’ power and prestige and even salaries are more closely correlated with sales as to profits. Judged in this perspective, sales maximisation can be said to be the independent objective in managerial decision making, where ownership and management are clearly separated.

This review of evidence will examine the advantages and limitations of Baumols theory on sales-maximisation. The majority of empirical evidence shows that there little correlation between the remuneration of top managers and the profit performance of their companys, instead sale revenue is seen as the major contributor to the salaries of managers. McGuire et al. (1962) tried to test Baumols contention that managers salaries are much more closely related to scale of operations of the firm than with profitability. They devised simple correlation coefficients between executive income and sales revenue and profits over the seven-year period 1953-9 for 45 of the largest 100 industrial corporations in the US. Their research showed that the correlation between salaries and sales was much greater than with profits. They recognise that there are serious limitations with using simple correlation analysis and the fact that correlation does not necessarily imply causation. Due to this the research they done cannot be proved to be conclusive. D. R. Roberts found that executive earnings are correlated closely with the size of sales and not the level of profits. He used a cross section of 77 american firms for the period 1948-50.

This evidence supports Baumols claim that managers have strong reason to pursue expansion of sales rather than increase profits. Conyon and Gregg (1994) produced a study of 177 firms between 1985 and 1990, it showed that pay of the top executives in large companies in the UK was most strongly related to relative sales growth (i.e. relative to competitors). They also found that it was only weakly related to a long term performance measure (total shareholder returns) and not at all to current accounting profit. Furthermore, growth in sales resulting from takeovers was more highly rewarded than internal growth. This evidence supports baumols presumption that sales maximisation is better related than profit, to executive rewards and corporate performance. Profitability and executive pay appear to be largely unrelated, suggesting that other managerial objectives might be given priority e.g. sales revenue. However total remuneration packages for top executives may be linked to profitability, helping to align the interests of managers’ more closely to the interests of shareholders.

Shipley (1981), in a major study concluded that only 15.9% of 728 UK firms questioned are true profit maximisers. The majority of the firms answered that the aim of their firms is for satisfactory profits. Hornby (1994) conducted a study off 77 Scottish companies and found that only 25% of the respondents are profit maximisers according to the ‘Shipley test’. And again the majority of the firms preferred satisfactory profits to profit maximisation. Although the study tells us little about sales maximisation, Shipley found that it was ranked fourth among principle pricing objectives, and nearly half the firms included sales revenue as at least part of their set of objectives. Larger companies were the ones that cited sales revenue as their principal goal. Since larger companies have a greater separation between ownership and management control, this lends support to Baumols theory. Marby and Siders (1966/7) computed correlation coefficients between sales and profits over 12 years, 1952-63, for 120 large American organisations. Zero or negative correlations between profits and sales would support Baumols hypothesis.

The findings showed positive significant correlations between sales revenues and profits. This does not necessarily contradict Baumols hypothesis as sales and profits are positively correlated in Baumols model up to the point of maximising profits. Even when they concentrated on ‘reliable’ data from 25 companies which they thought had been operating at scales of output beyond the levels corresponding to maximum profit. Correlations between profits and sales were still mostly positive. This evidence is interpreted as refuting the sales-maximisation hypothesis. These studies argue the case for and against Baumols theory of sales-maximisation. Although there have been many studies conducted to test Baumols hypothesis, the empirical evidence is not conclusive in favour for or against the sales-maximisation hypothesis.

Many argue that Baumols theory has many flaws, such persons are M H Peston and J R Wildsmith. Behavioural theory opposes the idea of a firm seeking to maximise any objective. Management are more likely to hold a set of minimum targets to hold the various stakeholder groups in balance. In practice, profit maximisation in the long term is a major goal for firms, but sales revenue is an important short term goal, though even here a profit target may still be part of the goal set. A widely used technique in the management of larger firms, portfolio planning, would seem to support the behaviourist view that no single objective will usefully help predict firm behaviour in a given market.

In Neo-Classical Economic theory of a firm it suggests, the owners of a firm are involved in the day to day running of the firm, and therefore their main desire is profit maximisation. Managers are supposed to maximise shareholders wealth by investment means such as CAPM, NPV and ARR. This is the traditional means for the modern day manager to increase shareholder wealth. Agency theory explains that shareholders and managers have a relationship which is crucial to the modern firm. Managers run the company on behalf shareholder and shareholders will reward them with high salary. However this is not always the case as human nature dictates that self-interest, wealth, and power will come into the equation. Managers may start building empire, maximise sales and take on long term and complicated projects which only they understand and this will make it difficult for shareholders to sack them.

This is typical of most western economies and former chief executive officer of News international James Murdoch argues in Mctaggart lecture 2007, the only reliable perpetual guarantor of independence is profits signalling that maximising profits is the only compass to measure success. This is reflective of the neoclassical economic theory and this essay will examine the advantages and limitations of sales maximisation. . argument for the theory of sales maximisation but there is serious limitations and that is the behavioural difference between long run profit maximisation and sales maximisation that there are no conclusive econometric tests as the difference is very subtle.

Therefore there has to be more future research into testing what the key differences are between sales and profits. Also there has to be one to one interviews into the psychology of Managers in the firms that they running as some argue for profits whilst some argue for sales e.g. James Murdoch speech. The use of postal questionnaires for use in studies can bring evidence that is not In summary that is conducted for Baumols hypothesis empirical evidence is not conclusive in favour for and against the sales maximisation hypothesis.

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