The Importance of the Long-range Profit Goal

The importance of the long-range profit goal

We stated at the beginning of this webpage that the firm's success depends on its ability to generate a sufficiency of cash flows, symbolized by profit. The selection of a profit target for long-range planning purposes is not just a matter of fixing an arbitrary figure such as £5 million. A profit target of itself has little meaning: its significance appears when it is related to some other measurement, such as total assets employed, when it becomes a meaningful measure of performance. Thus, the return on capital employed (ROCE) which relates profits to assets employed provides an assessment of the significance of a profit target by means of the following formula:

ROCE = Planned net profit plus Planned total assets

There is general agreement that the ROCE is the most important performance measurement for long-range planning and for setting long-range profit targets. It is a common practice to compute the ROCE for each year covered by the long-range plan in order to show whether planned increases in annual profits will keep pace with annual increases in assets. This analysis also indicates the effectiveness with which management will be required to use corporate assets.

In recent years, the usefulness of ROCE measures has been questioned. We shall discuss the controversies involved in the use of ROCE later. Further difficulties are caused by the manner in which profits and assets might be defined and measured.

According to Drucker ( 2018), there are eight areas of activity to which the firm should direct its attention when formulating its objectives-market standing, innovation, productivity, physical and financial resources, profitability, manager performance and development, worker performance and attitude, and public responsibility. It is in these areas of activity that the several parties having a stake in the firm-shareholders, management, employees, government, customers and suppliers, and the local community-have vested interests. Of the eight areas listed above, profitability is the most important because it provides a means of achieving objectives in the other seven areas. Unless a firm achieves a satisfactory profit goal, it may not survive in the long-term.

The accountant's task is not to attempt the impossible by deciding what should be the maximum possible long-range profit on the basis of assumed long-range resources for planning purposes: his job is to quantify the size of the profit which is required as the profit objective. The required profit as a planning goal is never a theoretical ideal, such as 'the maximum long-term profit' or 'the maximum long-term return to shareholders', but represents rather the outcome of discussion as to what is a possible and desirable target for the time-span considered.

The longer the time-span envisaged as a planning period, the less reliable is the profit target selected as a planning objective. It is for this very important reason that we suggested earlier that the 'maximum long-term profit' is never a planning goal, for it falls beyond planner's vision. Instead a firm aims to earn a 'satisfactory' profit over the planning period.

As a guide to selecting the profit target, one of the most influential factors is the minimum rate of return expected by investors and creditors. A satisfactory profit ensures that debt and dividend payments may be made, thereby reducing the risks attached to investing in the firm.

If the profit target is set too low to provide a fair dividend for shareholders and sufficient retained profit to finance future expansion, the Stock Ex-change's dissatisfaction with performance will be reflected in the company's share price, which in turn will impede the firm's ability to raise fresh capital and undermine its financial standing with creditors. It is, therefore, desirable that the share price should reflect a satisfactory profit target, for the value of a company is represented by the market price of its shares. It is through capital gains, as these shares appreciate in value, that shareholders receive much of their return. The amount of takeover activity in recent years has drawn attention to the fact that management should be aware of the importance of the behaviour of share prices.

Another important factor in long-range profit planning arises from the need of firms to generate capital to finance expansion. Capital generated in this way represents a substantial portion of the capital required by established companies, and profit retentions for this purpose often amount to 50 per cent of net profit.

The firm is faced, therefore, with the unavoidable problem of selecting a long-range profit target which will be satisfactory as regards the various points which we have just discussed. This is a minimum requirement, and unless an attempt is made to attain this profit objective in the long-range plan, the plan itself cannot be regarded as satisfactory.

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Read on: The Preparation and Implementation of the Plan

The preparation and implementation of the plan

The selected strategy for the long-run will concentrate on the key factors for success and on the major decisions required. In particular, it will be concerned with basic issues such as the selection of the kinds of products or services which should be produced, their markets, the production process and its location, and the asset structure required.

Once the strategy has been selected, it has to be expressed in more detailed plans which then become the basis for action. Responsibility for implementing the plan will fall upon the... see: The Preparation and Implementation of the Plan