About two years ago, we sat in the lecture room in the philosophy department at Wits. It was 10 am, and our cohort had dwindled from 20 to about 11 master’s candidates. Our professor walked in and began the class by writing a question on the board and asking us to write a short essay about it. She gave us about 20 minutes, after which debate ensued. On one occasion, the question was, “Should businesses seek to maximise profit?”
The knee-jerk answer is yes. After all, without surplus value, a business cannot invest in future products and services, nor can it absorb unfavourable market conditions. Moreover, it cannot yield a return for its investors. However, this is not how philosophers and scholars use the term profit maximisation:
Suppose you bought tomatoes for R1 and sold them for R1.50. In each transaction, your business would make a 50c profit, and under those conditions it would make sense to increase sales volumes. However, the more units sold, the more complicated the business would become. It would incur greater transport costs, payroll, and spoilage, and it would attract competitors. All of this affects the cost of doing business. At the same time, it would gain other advantages like reputation or control of distribution channels, giving it the power to choose better prices per unit sold. In other words, the conditions under which more tomatoes could be sold would change.
The technical terms used are marginal revenue (MR) and marginal cost (MC). Marginal refers to the changes in cost or revenue at Quantity A compared to Quantity B, or Price A compared to Price B. That is to say, what conditions emerge when selling one million tomatoes per day compared to only selling one hundred? It could be that at a million tomatoes, the business no longer makes a profit because it must invest in infrastructure at a cost that the market is unable to absorb. I encountered this problem in 2021 when I was invited to turn around a private school. The quality of education and facilities envisaged was constrained by the market’s willingness and ability to support the costs. Unaware of this constraint, the board had invested over R40 million into the school, hired teachers even when there were insufficient children in a given class, and therefore operated at marginal costs far exceeding marginal revenue (MR<MC). The shareholders were therefore paying into the school every month to keep it going.
When I joined, I realised that the school could not support the revenue levels needed to operate as envisaged. This is not rocket science. But the problem was that we could not scale down the school because the investments had already been made, and it would damage reputation. In other words, we had to attack the problem from both sides — reduce marginal costs where we could, and find new ways to lift marginal revenue. I shaved salaries by 30% across the board to reduce marginal costs. Then we began negotiating a Back-a-Child campaign, in which companies directed their CSI funds to augment fees and therefore increase marginal revenue. The latter was not fully realised because I went on sabbatical. Nevertheless, it was a battle to lower marginal costs while increasing marginal revenue to reach profit maximisation once again.
This is what founders often overlook. They get so engrossed in operations that they overlook the fundamentals. For example, Uber launched in South Africa in 2013. The drivers who pounced on the opportunity early made good money. Some introduced additional cars and paid them off quickly while enjoying healthy returns. Over time, more and more drivers joined Uber and competition rose. Taxi associations protested and imposed restrictions, while Uber phased out older vehicles to maintain its standards and to create room for its own vehicles, which it rents out to drivers at a premium of approximately R3,000 per week. More recently, fuel prices have increased, and roads in Johannesburg have worsened, further raising marginal costs for drivers. Uber has also increased its commission to 40% on some occasions — significantly more than the 25% charged at the beginning.
In other words, the point at which marginal revenue met marginal costs (or profit was maximised) was higher on the demand curve and favoured drivers in the beginning. Over time, marginal revenue dipped, and marginal costs increased, but the tipping point went unnoticed. Today, I think marginal revenue has fallen below marginal cost (MR<MC), which is why drivers work longer hours for less. Without the principles discussed, unproductive tactics may appear attractive. For instance, drivers picket at Uber’s offices for better rates, but the problem is a broader complex of unfavourable conditions.
I used Uber as an example, not to undermine the drivers or to insinuate their incapacity. But I ride Uber almost every day and speak to the drivers. This is what inspired me to reflect on their plight.
The point is that profit maximisation is not about charging the highest price possible or selling the greatest number possible. Profit maximisation is about realising that the point at which marginal revenue meets marginal cost differs for every business, shaped by how much power it holds over its price or costs. Two tomato stands at the same market will have a different profit-maximisation point depending on how they are configured. Without an appreciation of profit maximisation, Tomato Stand A could mistakenly want to outsell Tomato Stand B, only to find that it does so at a loss. This was the problem with our school in Limpopo. Shareholders envisaged a premium private school in a rural environment, i.e. where marginal revenue fell below marginal costs.
Profit maximisation reveals several CEO levers. For instance, should you expand, i.e. increase marginal revenue? Should you take on a more defensive strategy to rein in marginal costs? Should you acquire competitors and increase power over price — the De Beers strategy? Should you diversify through mergers and acquisitions to hedge against volatile prices, as Sibanye-Stillwater did? Should you pivot to another market where profit is maximised at a higher price with fewer units produced — the Woollies strategy? Or should you operate at a lower price point that other companies cannot survive — the Shoprite strategy? All these questions weigh on CEOs. If answered incorrectly, hundreds and sometimes thousands of people lose their jobs. The upside is also true: leaders who carefully assess profit (and perhaps more accurately, profit potential), not to drool over the prospect of making more money, but to ascertain market conditions, often create prosperity for themselves and their stakeholders. This is what profit maximisation is about.
Until next week,
Vusi.
P.S. Many readers ask for my permission to share these articles with friends. The answer is an emphatic no! Do not share. Rather, keep these articles as a secret weapon to apply when needed. I joke. Please feel free to share.
