26 Organizational Goals-II: Managerial Theories of the firm (1)

Paramjeet Kaur

 

1. LEARNING OUTCOMES

 

After completing this module the students will be able to:

  • Know and understand variety of Organisational Goals
  • Know and understand Marris’s Managerial Theory of Organisational Goals

 

2. INTRODUCTION

 

Organisations survive for certain goals. These goals provide direction and show clear path to the organisations. As far as these goals are concerned, various managerial models which were applicable centuries back can’t be applied in the modern times. As the business definitions, conditions and environments are changing, new theories and models to manage organisational goals are also emerging. In the field of economics, price and output equilibrium can be easily reached under the assumption of profit maximization. But this assumption may not be true in all cases.

In the earlier times, managers used to concentrate only on maximizing their respective profits. This was the reason that most of economic theories proposed by renowned economists were based on the assumption of ‘Profit Maximization’. But slowly some economists realized that as organisations were growing, looking only at the profit side was too narrow and restrictive. A need was felt that the theorists must widen their horizons, as profit was not the only consideration for managers. In the modern times, the managers don’t only think about maximizing profits, but they carry many simultaneous goals as well in their minds. To handle these goals, new theories have been proposed by economists, which stress not only on profits but also on the how price and output are determined by the managers. These theories further define the role of managers and the effect of their behavioural patterns on the decision of output and price in specific market conditions. The theories are generally known as Managerial theories of the firm.

  1. GOALS AND DECISION MAKERS

The firms may have varied goals and the decision on the type of these goals to be followed depends upon the decision maker in the firm. Thus the goal to maximize the profit or to pursue any other goal, wholly solely depends upon who is controlling the firm, and who carries the power to take the decision of price, output and other major areas.

 

In case of sole proprietorship, a single brain controls the entire working. Every decision (major or minor) is taken are the manager/owner himself, he takes risks and perform all other functions. In case of partnership firms, the decision making power lies in the hands of partners. The decisions regarding price, output etc. are taken by the partners themselves. The situation of joint stock companies is entirely different, where the ownership is separated from management. The people who manage are not the people who own the corporations. Thus the firm is managed by someone else (managers), while the ownership and risk lies in someone else’s hands (shareholders). In these companies, the decisions of output and price are taken by the people who are appointed to manage the business.

 

In case of sole proprietorship, the individual will try to maximize the profits, as the profits belong to him entirely and same is the case with partnership firms, as the entire profits are shared among partners in the pre-determined ratio. But in case of corporations the profits go in the hands of shareholders and managers usually get fixed salaries (some extra benefit in certain cases when they are able to achieve targets or earn more profits for shareholders). These hired managers may not be interested in maximizing the profits, as they know that profits will not come to their hands. They are not going to claim this profit, so their concentration will certainly not be on maximizing the profits. Offering fixed incomes or certain percentage of profits will not attract them to put in their best efforts to have maximum profits. Thus managers in the organisations carry many other goals in their minds.

 

4.   MANAGERIAL THEORIES

 

Various theorists have come up with the different directions. These theorists tried to see the other side of picture and didn’t accept the hypothesis of profit maximization in the modern business arena. They suggested that the goal of profit maximization was too narrow for modern managers. As they are the people hired for managing the organisations, they look at many other considerations besides profits. Their managerial theories further lay stress on manager’s role and his self interest while making decisions regarding price, output and sales in the business organization.

Therefore, in the corporate sector, various other considerations (except profit maximization) motivate the managers. The decisions regarding price and output of such firms may be different from that of profit maximizing firms. These managerial theories can be applied accurately while fixing price and output under Oligopoly. Generally applied managerial theories of the firm are discussed here:

 

i) Marris’s Managerial Theory

ii) Williamson’s Managerial Theory

iii) Baumol’s Sales Maximization Theory

iv) Kafolgis’s Output Maximisation theory

  1. MARRIS’S MANAGERIAL THEORY

Robin Marris suggested a theory which laid stress on ‘Growth Maximization’ rather than profits. He supported that managers try to maximize balanced growth rate in the organisation instead of just profits. He discussed this dynamic balanced growth maximizing model in 1964 in his book ‘The Economic Theory of Managerial Capitalism’. Marris suggested that modern organisations were managed by hired managers but owned by the shareholders who take major decisions in the firms. These hired managers will not think of maximizing the profits, rather they would concentrate on maximizing the growth rate of their concerned organisations. He further added that it is the shareholders who aim at maximizing their dividends and share prices through profit maximization.

 

Marris proposed the concept of ‘Maximization of balanced growth rate of the firm’ (BG). According to him, maximization of balanced growth rate deals with maximizing the rate of growth of demand for the products of firm (GD) and rate of growth of capital supply (GCS). He connected growth rate with share prices of firm and developed a balanced growth model in which manager chooses a constant growth rate at which assets, profits, production, sales etc. of the firm grow. If the manager chooses a higher growth rate, he need to spend more on many other areas such as research and development, advertising etc to create more demand and new products. Such a manager will retain a higher percentage of profits for the growth and expansion of firm. Due to this the percentage of profits to be distributed to shareholders will reduce and share prices will come down.

 

Symbolically

 

BG= GD=GCS

 

Where,

 

BG = Balanced Growth

GD = Growth rate of demand for the products of firm

GCS = Growth rate of capital supply

 

5.1 Why Balanced Growth

 

 

The balanced growth viewpoint was a new step, as the goals/utility function of managers and goals of owners always have been different. Marris explained that in modern big organisations, ownership is divorced from management, but still both owners and managers may move with the common goal of balanced growth of the organisation. According to Marris, there are two different utility functions for the manager and the owner of the firm, which may converge at the same point. The utility function that the managers try to pursue consists of their emoluments, status, power, job security, salaries etc. On the other hand, the utility function which owners try to maximize include profits, capital supply, output size, market share, goodwill in the market etc. Marris explained that although utility functions of both managers and owners differ a lot, but most of the variables included in both constituents are positively correlated with a single variable i.e. size of the organisation. Size of the organisation further depends upon output level, capital supply, sales, market share etc.

 

The goal of balanced growth rate can help in maximizing the utility function of managers and the utility function of the shareholders (owners) too. Marris supported that a manager will favourthe maximization of balanced growth rate of firm, which is the joint product of maximizing the rate of growth of demand for firm’s products and growth rate of capital supply. The shareholders always concentrate on the balanced growth rate of the organisation, so that they are able to get a fair rate of return on their capital. On the other side, the managers are concerned more about their own job security and growth of the organisation. They will choose that growth rate which maximizes the market value of shares, give satisfactory dividends to shareholders, and avoid the risk of take-over of the firm. Thus the goals of the managers may coincide with that of owners of the firm and both can try to achieve balanced growth of the firm.

 

5.2 Assumptions of the model

 

The Marris’s Managerial model is based on the following assumptions:

 

a) The model assumes that there exists a certain price structure in the market.

b) Production costs are assumed to be given.

c) There is no oligopolistic interdependence.

d) Factor prices are assumed to be constant.

e) The growth in the organisations takes place through diversification.

f) All major variables such as profits, sales and costs are assumed to increase at the same rate.

 

 

Assuming the above conditions, the model favours that the objective of the firm is to maximise its balanced growth rate (BG). The balanced growth depends on two factors, which are the rate of growth of demand for the firm’s product (GD), and the rate of growth of capital supply (GCS).

 

5.3 Equilibrium of the Organisation

 

Marris suggested that the organisation can grow only when equilibrium is attained between utility function of manager and utility function of owners and both are maximized. He added that managers of the firm aim at maximizing their own utility, and their utility depends upon the rate of growth of the firm.

The firms grow through diversification i.e. grow in size through the creation of altogether new products which create new demands or by introducing new designs /models of existing products. Marris called it differentiated diversification. The rate at which firms grow depends upon various factors.

 

Symbolically

 

UFM = f (GD)

 

Where,

 

UFM = Utility function of managers

 

GD = Growth of demand for the products of the organisation

 

On the other side owners concentrate on maximizing their own utility which is not based on maximizing the profits, but on the rate of growth of capital supply.

 

Symbolically

 

UFO = f (GCS)

 

Where,

 

UFO = Utility function of owners

 

GCS = Rate of Growth of Capital Supply

 

The equilibrium situation will be attained by the organisation, when it achieves the maximum rate of balanced growth rate of demand for firm’s product and maximum growth rate of firm’s supply of capital. The equilibrium will be possible when

 

Equilibrium = Maximum GD = Maximum GCS

These two constituents of equilibrium have been discussed here:

a) Rate of Growth of demand for firm’s products (GD): Organisations can grow through various The most commonly used method is through diversification. As new products are introduced, the firm expands (grows) and profits increase. But as the growth rate increases further due to greater diversification into new products, the growth-profits relationship becomes negative. This is because there is the managerial constraint which sets a limit on the rate of managerial growth that restricts the growth of the firm.

 

 b) Rate of Growth of Capital Supply (GCS): The growth-profits relationship in organisation also depends upon the rate of growth of capital supply. The aim of the shareholders is to maximize the growth rate of capital stock. The main source of finance for its growth is profits. Thus profits determine growth on the supply side. Capital will be available from the market, when the organisation is able to generate sufficient profits. Thus financial constraints may obstruct the way of Growth of capital supply (GCS).A higher level of profits provides more funds directly for reinvestment. It also allows more funds to be raised on the capital markets. It, therefore, allows a higher rate of growth to be funded. This gives a direct and positive relationship between profits and growth.

 

The rate of growth of demand for the products of the firm and rate of growth of capital supply depend on two constraints:

 

i) Managerial Constraint

ii) Financial Constraint

 

i) Managerial Constraint: Growth rate largely depends upon the type of workforce available in the It deals with the quantity (strength) and quality (skills) of managerial team. The managerial ability to tackle a great number of changes at once is always limited. The organisation can’t develop the expert teams at once, which can produce and market the new products. When the organisation wants to follow the strategy of diversification, it has to made huge investments in research & development and advertisement. When the firm grows, beyond a certain growth rate, the further growth rate leads to a lower rate of profit. The diagrammatic presentation of the model discussed in the next pages depicts that the GD curve initially raises, reaches at its maximum point M and then stated falling.

 

ii) Financial Constraints: Finance may prove to be another constraint for the growth of an This constraint is related to job security. It deals with the following financial ratios:

 

a) Debt ratio: It is ratio of debt to total assets (D/A). Excessive dependence on debt may block the way of organisational growth.

b) Liquidity ratio: It is the ratio of liquid assets to total assets (L/A). An optimal amount must be available in form of liquid assets to facilitate growth.

c) Retention Ratio: It is the ratio of retained profits to total profits (R/T). Retained profits are required for promising investments.

 

Thus financial variables determine the job security of managers. If these financial ratios set by manager crosses the prudent limits, they expose the firm to the risk of being taken over by others or managers can be dismissed, which can endanger their job security. Thus managers keep in mind the aspect of job security while taking business decisions and plans.

 

5.4 Diagrammatic presentation of the model

 

For the equilibrium of the firm, the growth demand (GD) and growthsupply (GCS) relationship must be satisfied. The model has been depicted in the following diagram:

 

 

Marris explained that the equilibrium and optimal stage is reached where the two curves GD and GS cut each other. Here the combination of growth and profits is optimal. If the organisation grows and GS2 curve cuts the GD curve at point M, at this point the profits of the firm are maximized. But this point is not the optimal solution, as the managers will want more growth for the firm than is consistent with long-run profit maximization. How much they want to grow further from point M, the decision depends upon their desire for job security. Their job security is threatened if the shareholders feel that the share prices and dividends are falling and there is the threat of take-over by other firms. This will affect the growth rate of capital supply (GCS). Thus it is the financial constraint which sets a limit to the growth of the firm on the supply side.

 

Marris further explained that growth rate of capital supply of firm depends upon the retention ratio. The firm must keep an optimal amount out of profits as retained earnings. Keeping less retained earnings may slow down the growth of the firm, as limited funds will be available in hand. Distribution of more profits to shareholder lowers down the retention ratio. The retention ratio is the ratio of retained profits to total profits. When the retention ration is low, the growth-supply curve of a firm will be very steep e.g. GS1 curve. The equilibrium of the firm will shift to the left at point L, where the GS1 curve intersects the GD curve. This is again not the optimal equilibrium point of the firm because here the growth rate is low and profits are below the maximum level. On the other hand, when the firm keeps large amount of profits as retained earnings, the managers are left with more profits which can be invested in desirable avenues to facilitate more growth of firm. Higher retention ratio leads to more profits as well as more growth till point M of profits. But it is again not the optimum equilibrium. The managers may want to move further for higher growth rate and higher profits, as at this point there is no threat to their job security of managers. They will, therefore, be encouraged to raise the retention ratio further, invest more funds, expand and increase the growth rate of the firm. As a result, the growth-supply curve will become flatter and take the shape of GS3 curve as in the figure where it intersects the DS curve at point E. At this point, distributed profits to shareholders fall. But they are adequate to satisfy the shareholders so that there is no fear of fall in the prices of shares and of the threat of takeovers. There is also job security for managers.Thus point E is the optimal equilibrium point of the firm. If the managers adopt a higher retention ratio than this, the distributed profits will fall further and the shareholders will not be satisfied which will endanger the job security of managers. The existing shareholders may decide to replace the managers. If the distribution of low profits to shareholders brings a fall in the market prices of shares, it may lead to take-over of the firm.

 

5.5 Evaluation of the model

 

The Marris model has gave new directions by discussing the concept of financial constraint through its three financial ratios. The financial policies were considered as an important constituent of decision makings process by the managers of firms. But Marris’s growth maximisation model has been severely criticised for its over-simplified assumptions by Koutsoyiannis and Hawkins.

 

Evaluation of Marris Model

 

i) Marris discussed that the financial constraint depends upon three ratios which are fixed by the mangers of the firms within prudent limits, so that their job security is not endangered. The fixation of these ratios depends upon the discretion of managers, thus is a subjective issue. Some other factors may obstruct the way. Demands of the shareholders can affect the financial ratios and risk attitude of the manager may be another consideration, which depends upon his past experience and many other factors.

ii) To attain equilibrium situation between utility function of managers and utility function of owners is the ideal situation. But the matching of utility function of managers and owners can flourish in the case the organisation grows at a constant rate. Such equilibrium can’t be found in the conditions of uncertainty, recession and sluggish demand.

iii) Maximization of rate of firm’s growth and maximization of profits have been considered by the critics as conflicting goals. According to Koutsoyiannis “the model states that both managers and owners believe that the firm can’t simultaneously achieve maximum growth and maximum profits, while the owners prefer the maximized rate of growth at the cost of some profits. But Marris didn’t explain and justify the preference of owners for capital growth over the maximization of profits.

iv) Marris assumed a given cost and price structure for the firms. He, therefore, did not explain how prices of products would be determined in the market.

v) The model ignored the problem of oligopolistic interdependence of firms in non-collusive market. It did not analyze the interdependence created by non-price competition.

vi) The model assumed that firms can grow continuously by creating and developing new products i.e. diversification. This is unrealistic because no firm can sell anything to the consumers. After all, consumers have their preferences for certain brands which also change when new products enter the market. In the long run the products may be imitated by the competitors, which can obstruct the growth of firms.

vii) According to Koutsoyiannis, “Marris’s model is applicable basically to those firms which pro-duce consumers’ goods. The model is not appropriate for analysing the behaviour of manufacturing businesses or traders.”

Viii) Marris lumped together advertising and R&D expenses in his model. These two factors may behave differently in real life conditions.

ix) Marris assumed that firms have their own R&D division on which they spend much for creating new products. But, in reality, most firms did not have such departments. For product diversifi-cation, they imitate the inventions of other firms and in case of patented inventions they pay royalties for using them.

x) The assumption that all major variables such as profits, sales and costs increase at the same rate is highly unrealistic.

xi) It is difficult to arrive at the growth rate which maximises the market value of the firm’s shares and the rate at which the take-over is likely to take place.

Xii) Marris assumed that anything can be sold in the market through well organized market campaigns. H. Townsend suggested that firms didn’t enjoy unlimited influence over consumers demand. If some products of the firm fail in the market, consumers don’t rely on next products.

 

Thus publicity and marketing will not solve the purpose for such new products.

  1. SUMMARY

 

Marris put forth a significant thesis of firm as per which the managers don’t go after profits but look for to optimise balanced rate of growth of the firm. Marris’s theory is an important contribution to the theory of the firm in explaining how a firm maximises its growth rate. Though promoting the growth of the firm is the main aim of the manager, yet he is also motivated by his job security. The manager’s job security depends upon the satisfaction of shareholders who are concerned to keep the firm’s share prices and dividends as high as possible. Thus the manager aims at maximising the rate of growth of the firm and the shareholders (owners) aim at maximising their profits in the form of dividends and share prices. Marris analysed the means by which the firm tries to achieve its growth maximisation goal.

 

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