Competitive business models from the perspective of profitability

Competitive business models from the perspective of profitability

The central element in a company’s long-term goals is maximising owners’ wealth and profit. However, the question may arise what profit is, how to measure it and what factors determine its rate. The present study summarises the possible answers to these questions, especially from the angles of corporate goals, financial planning, corporate capital structure and competitiveness, with a special emphasis on the contents of the 2020 publication entitled “Am Gewinn ist noch keine Firma kaputtgegangen”, a gap filler in this area.

Keywords: profit maximisation, competitive business model, capital structure, profitability, financial planning

Introduction

It can be generally stated that profit is one of the most important measures that gives information about a company’s operations and profitability , which is based on the continuous operation of the company and the correct control environment (Zéman and Lentner, 2018, Zéman et. al. 2018). As a result, it is not surprising that there are hardly any professional publications dealing with the topics of management and economy that do not include the issue of profit (Abdussalam & Darun, 2017; Csernyák & Konecsny, 2013; Forgács & Futó, 2014; Jouida, 2017; Kharisya, 2017; Liow, 2010; Szücs, 2015; Voulgaris et al., 2002; Borzán et.al,2011). However, it has to be noted that recently there have not been a single publication – let it be a professional article or book – that is devoted exclusively to profit and its different aspects. Therefore, the 2020 publication entitled “Am Gewinn ist noch keine Firma kaputtgegangen”, which deals with topics such as what profit is and is not, how it can be measured, what the relationship between profit and corporate success is, etc., is truly a gap filler.

According to Herman Simon (2020), profit is a basic necessity in companies’ lives, as it enables the company to meet the needs of all interested stakeholders – such as employees, suppliers, financial institutions, other creditors, and the state. Thus, profit can only be defined as financial result after tax. Resulting from the above logic, any other measures, such as EBIT or EBITDA, are not considered as profit, which is optimal in a competitive macroeconomic environment (Lentner, 2007).

At the same time, profit brings up the question of how important it is in business to pursue profit maximisation. However, it has to be clarified first what is understood by profit maximisation. Maximisation of profit can only mean the opposite of wasting, since companies seek to provide their services with minimum resource input, that is, preferably without waste or “performance failure”. Put differently, they seek to realise the best possible performance by the specific use of their resources. The maximisation of profit, therefore, is the minimisation of waste. When a company performs well, it is almost always beneficial to the employees, the suppliers, the banks, the local authorities and the state. As Robert Bosch put it: “I don’t pay good wages because I have a lot of money; I have a lot of money because I pay good wages.”

Corporate objectives and profit maximisation

In many cases, there is a very close relationship between profit, profit generation and corporate objectives for growth. Underlying the relationship is the basic system of corporate goals, according to which economic operators are interested in the so-called double value-creation, and realisation of profit generation. If all these objectives are met, they entail corporate growth. Therefore, it can be said that companies also prioritise the growth factor. According to Katits (2002), we can talk about corporate growth if the present capacity exceeds the previously used capacity and/or if it concerns a newly acquired and used capacity. Company leaders identify the concept of growth with increasing turnover. Given all these, the management insists on increasing turnover rates in every year, every quarter and every month, almost forgetting that expanding revenue from sales is not the only and last means for measuring corporate growth and for ensuring the long-term profitability of the company. Other indicators of growth realisation are the number of employees at the company (“the quantity and quality of human capital”), the growth in the amount of company-owned tangible assets; or even the growth of the organisational structure or the development of the organisational culture may serve as growth indicators.

Here you can also add the level of development of enterprise systems for motivating and stimulating personnel. These systems are just able to bring organizational culture to a new qualitative level, and also increase the cost of human capital. Suffice it to recall the system for organizing repair services at Ford plants.

Several forms of corporate growth are present, for example, in efficiency and over-performance, in the financial, organisational and human sense (Hortoványi, 2009).

Naturally, profit maximisation and growth objectives are present to varying degrees in the corporate culture of different national economies. It is our impression that, for instance, German businesses regard objectives such as general corporate growth, turnover, quantity, market shares, employment or competition more important than profit orientation. In Hungary, previous research has shown profit maximisation as the result. However, the COVID-19 pandemic survey has revealed a shift in this respect among Hungarian businesses. The research sought to answer the question of what priorities companies identify based on the lessons learnt from the corona virus epidemic. It can be concluded that the vast majority of companies aim at sustainable economic safety (90%), rather than short-term profit maximisation (10%).

The rate of profit, according to Herman (2020), is mostly determined by the following factors: price, sales volume and costs. In many cases the question arises, which of these is the most efficient in influencing the rate of profit. Based on the flexibility criterion in economics – which takes the percentage increase in profit for a 1% change of a certain profit factor as the basis – it can be said that price ranks first followed by costs.

Profit and profit rate also show differences by national economies. Herman Simon has shown is several of his studies that in Germany profit levels are relatively low, which brings up the question, what the reason might be for this phenomenon. The answers to this question are rather speculative, yet thought provoking (Herman, 2020).

1. One of the basic reasons may be, e.g. defining a “bad” corporate objective, such as maximising sales or revenue. Only approximately a quarter of companies we asked in several studies state that profit maximisation is the most important factor in their business. About half of them prioritise volume orientation though. As it is expressed by the board of directors for one of the leading German car manufacturers: “When our market shares drop by 0.1 percent, it has to be accounted for. However, when profit drops by 20%, nobody cares.” It all depicts a widespread problem: in everyday business life sales, sales volume or market share objectives often dominate, followed by employment objectives.
2. German companies profit more primarily in the traditional sectors of industry, and less so in newer sectors, which could provide substantial extra, profit.
3. Further reasons could be wasting and excessive diversification.
4. There are large numbers of start-up businesses in Germany, out of which only a few are able to make a breakthrough in a short period of time, in comparison with the successful American and Chinese start-ups. Underlying factors could be the lack of venture capital and the small size of the domestic market, as well as the lower level of entrepreneurial spirit.

These short diagnoses shall evidently result in intervention, measures taken, for example, consistent profit orientation, higher involvement in newer industries, faster reduction of overcapacity, avoiding fragmentation, strengthening sizing ability and nurturing the entrepreneurial spirit.

Efficiency is a natural result of profit-oriented management, but public service, non-profit-making operators and civil society organisations taking over public tasks also have to be considered when dealing with this topic. There is a growing number of these bodies and the purpose of their creation is to expand applied resources from external sources by means of profitable management. How can efficiency, efficient management be defined in the case of these economic operators? Could it be said that profit is not an important management objective and what really counts is customer satisfaction? It is clear that the indicators of efficiency, profitability are not always applicable. What is the product in the case of these companies? The satisfied citizen, the recovered patient, the amount of services and not the per capita revenue, return on sales, etc. There are often alternative ways to measure efficiency, but the need for measuring is clear, even if the methods differ. In this case, the need for profit is rather controversial. Does cost management have its limitations, since it may risk the quality of service provision? Can the market be expanded? Answering these questions is always the responsibility of the organisation management. They have to find the optimal conditions, the cost and income structure which provides resources for the operations and profit for the development and the long-term provision of ever improving services. We believe that the non-profit-making sector deserves a separate study from this angle, but, due to the growing number of such organisations, we found it important to mention them. We regard this area of study a priority as the competitiveness of a given country is strongly influenced by the operation of healthcare, educational and social organisations.

Financial planning and corporate capital structure serving profit maximisation

As mentioned above, one of the long-term corporate goals, that is, the central issue of corporate strategy is how the company can create value for the owners (Czakó-Reszegi, 2010; Tomchuk et al., 2018; Shakirova et al., 2019). For this reason, we could say that the – broadly defined – aim of the corporate management, beside growth, is maximising owner assets and profit (Bélyácz, 2007). To achieve these goals company leaders have to make several operational and strategic decisions. Chikán (2013) divides them into two groups: firstly, acquiring the resources needed for successful operations, secondly, efficient distribution of resources among investments enabling the realisation of the corporate strategy. Considering that corporate capital costs are determined by the applied financing decisions, it is evident that these two areas, namely, investment and financing decisions are closely related (Balla, 2002). The synchronisation of the two areas is manifested in the form of financial planning, which serves forecasting, informative, orienting and controlling functions as well (Zéman et. al, 2016, Volkart – Wagner, 2014; Virág, 2013; Sokil et al., 2018; Shah et al., 2020), thereby ensuring the efficient use of resources and the retention of liquidity so that potential financial difficulties can be avoided (Hezam et al., 2017). In addition, Oláh and his co-authors (2020) point out that during planning and forecasting, making economic and financial calculations and while planning and taking measures in connection with production policy and corporate financial management, all kinds of risks also have to be taken into consideration.

Corporate financing therefore involves resource estimation, supporting and making decisions related to financing (Gyulai, 2011), both on the operational and strategic levels, as well as all the fundraising and repayment measures, and the development of payment, information, controlling and safeguarding relationships between the acquiring company and the contributor(s) (Katits et al., 2017; Ślusarczyk et al., 2020). According to Tóth and his fellow authors (2017b), the availability of adequate resources is inevitable for corporate growth and maintaining competitiveness. This requires “active investment policies and […] proper financial management from company owners and leaders.” In conclusion, it can be stated that the decisions made by the financial management have an influence on all the functional areas of the company, and affect corporate growth, competitiveness, effectiveness and efficiency (Johnson et al., 2015), the acquisition of required resources and their efficient use.

Management requires relevant information in the areas of planning, decision-making, leadership, performance measurement and control as well (Laáb, 2011). To ensure appropriate decision-making, the measurement of the development of costs and yields lies in the focus of attention (Kaplan – Cooper, 2001). It is indispensable and necessary that corporate costs are monitored, measured, assessed and registered, based on multiple dimensions. Within the frameworks of cost monitoring, accurate measurement and assessment systems have to be developed in order to ensure the cost calculation of the value-added processes, products and services. The precise knowledge of corporate costs can have an influence on corporate finance decisions, as the incurred costs eventually generate cash flow changes in the form of expenditure, which is an issue of outmost importance due to the need for liquidity balance. The continuous recording and assessment of costs needs to be highlighted; it helps companies to substantiate control and certification of processes with numerical information generated by measurement. In financial planning, it is a major task to understand costs and assets used, as well as adjusting costs to the financing strategies applied (Sisa et al., 2017).

Before the financial management gets down to the details of acquiring the necessary resources, they must answer the following to questions:

• How much of the profit created by the company should be re-invested into the business and how much should be paid to the owners?
• How much of the necessary external resources should come from debt and capital?

Having answered the following questions, the next step is determining which or what combination of the continuously expanding financing opportunities would prove the most beneficial for the company.

Alongside the above, a sound decision takes the expiry of assets and liabilities, that is, the financing strategy chosen by the company, into consideration. Low-risk conservative financing strategies which ensure safe operations, according to which permanent resources are also used by companies for temporary assets financing, in other words, the net working capital is positive, due to the high capital costs of permanent resources (for example, equity), are not only the most expensive strategies, but they also fail to ensure corporate value maximisation. Aggressive financing strategies – namely, financing permanent assets from short-term resources –, although cheap, are very high risk financing solutions, which can only be applied under stable management and favourable market positions. This financing strategy is usually characterised by negative net working capital, however, the rate of permanent current assets commitment within temporary assets has to be accounted for, since, based on the matching principle, they also require permanent resources; thus, an aggressive financing strategy may occur with positive net working capital as well (Pataki, 2003).

In his book, Hidden Champions (2012), Hermann says that a solid financing strategy, that is, financing permanent assets from permanent resources and temporary assets from temporary resources, safeguards the long-term survival of companies. He also adds that internal financing is the most appropriate financing option; however, it requires profitable operations accordingly.

All the studies concerning optimal capital structure have concluded that the cost of capital plays an important – perhaps the most important – role in defining the optimal capital structure; therefore, it has a major role in increasing dividends payable and the company’s value, which is in the direct or indirect interest of not only the owners, but also the internal and external stakeholders, given that it is a kind of guarantee for the reimbursement of their payment claims (Sisa, 2009).

These financing sources, required for operations and growth, can be own and external resources, which – considering resource limitations – are expensive for enterprises, as, if they are not used internally, certain costs can be avoided and thus the freed up capital can be invested – profitably – elsewhere (Bélyácz, 2013). Alternatively, corporate capital cost is the expected return from the portfolio of the company’s securities (Brealey & Myers, 2011), in simpler terms, the cost of equity is the expected return by the owners, the cost of external sources is the interest paid for their use, thus, the expected return by the creditors and investors. In summary, within the capital structure, each and every capital element has its own cost, which is dependent on the risks involved (Pratt & Grabowski, 2010): the higher the risk in a sector, the higher the expected return is by the investors (Baranyi & Pataki, 2002).

Competitiveness perspective

These is a huge volume of domestic and international literature available on competitiveness. Although its literary definition is diverse, the need for differentiating between competitiveness realised on the domestic and international level is present in all the theories. This chapter does not seek to provide a broad overview of definitions; it only highlights the most dominant theories.

According to Findrik (2016), corporate competitiveness highly depends on the applied corporate strategy, the product portfolio, good marketing and up-to-date client management. He believes that all of these are factors that can have a major influence on corporate efficiency, effectiveness and performance. In Findrik and Szilárd’s definition (2000) “competitiveness is the sum of the activities and characteristics of a given producer unit, which helps them increase their market shares and/or profit in a given market in a given period of time.” Harsányi and his co-authors (2016) equate competitiveness with corporate performance, and they investigate the following within this framework: effectiveness, economy, quality, productivity, the quality of the workforce, innovation and profitability. They also emphasise that corporate competitiveness is vastly dependent on management. Porter also highlights the importance of management in numerous writings, however, in several of his books he says that companies must seek uniqueness, stressing that uniqueness helps the most successful companies to appear in international trade and be part of global value-chains, in other words, become active members of a county’s export. Porter also draws attention to the fact that competitive companies need active corporate and respective financial strategies.

However, Gill and Biger (2012) established in their research that one of the greatest obstacles for corporate competitiveness lies in the financing issues that provide adequate support for growth. Wiersch and Shane (2012), as well as Peek (2013) emphasise capital shortage, solvency issues and credit supply constraints. They found that all these have a significant influence on corporate competitiveness. In his research, Tóth (2016) mentions the following among the barriers to corporate competitiveness: liquidity constraints, indebtedness, inadequate management, inadequate financial and capital structure, human capital shortcomings and the lack of export orientation. Tóth (2016) argues that “tradable domestic companies are needed to increase export, as today about two thirds of domestic companies do not produce for export at all”. Based on international experience it can be stated that those businesses – and national economies – that are integrated into global value-chains and produce or provide for the export market as well, are more competitive, effective and financially more stable. The domestic market is rather restricted; consequently, Hungarian entrepreneurs should feel the necessity of active export activities. It has to be supported and encouraged though, as businesses present in the international market are likely to produce more added value, which entails employing better-qualified professionals, ergo knowledge, which itself can be considered as a competitiveness factor.

Summary

In conclusion, we believe that profit orientation is not outdated; on the contrary, it is a rather timely topic. The COVID-19 “world crisis” brought the question of profitability to centre stage again. Numerous companies have been operating under financial duress, with minimal or zero savings and a focus on maximal growth. The sudden termination of cash flow emphasises the need for change for companies. Business and financial awareness may enjoy new attention. It can be said that in any national economy stable, sustainable economic growth and improved competitiveness requires financially aware companies with diverse and up-to-date knowledge. To that effect, a financially aware entrepreneur society must be educated, to promote the prevalence of stable operations at the macroeconomic, the national economic level, as well.

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Petronella Gyurcsik
Economist, PhD candidate, Szent Istvan University, National Tax and Customs Administration – Head of Department,

Dr. Róbert Tóth Ph.D.
Chief Economist, PhD in Economics, Szent Istvan University, Hungarian Chamber of Commerce and Industry

Dr. Karabassov Rassul Ph.D.
Candidate of Sciences in Economics. Associate Professor

Dr. Imre Túróczi Ph.D.
college associate professor, University of Debrecen

Boglárka Szijártó
doctoral student, Szent István University, assistant lecturer, Budapest Business School