Profit maximization occurs when the marginal costs, or the additional expense of producing one more item, equal marginal revenue, or the income generated by selling that good. This straightforward definition fails to provide insight as to how difficult it is to accurately calculate when this occurs. Difficulties in the production of goods and the necessity of making complicated assumptions make it incredibly difficult to find the profit maximization point.
Marginal cost is the expense generated by producing one more product. Marginal costs include variable expenses and a proportionate share of fixed costs. Variable costs are expenses that are incurred due to manufacture, such as the raw materials and labor that went into producing the good. Fixed costs are expenses that are incurred regardless of production, such as administrative costs and advertising. If you produce large batches of goods consistently, with a constant source of labor and material, marginal cost is generally consistent regardless of how many additional goods you produce. If production is less assured, with inconsistent sources of material and labor, marginal costs can vary from item to item.
Every time a product is sold, it generates income for the business. The amount of money you receive for selling an additional product is the marginal revenue. It is important to note the distinction between selling an additional unit versus producing it. Producing something is what generates the cost and generally occurs before the income is received. This distinction between increasing production and increasing sales is important when making any investment or business decision.
Profit is the take-home value that the owner of a business actually gets to keep, or what remains when you subtract expenses from the business’s revenue. Normally defined as the amount of cash the owners get to keep, profit can also be a decrease in the business’s liabilities or an increase in its assets. To maximize profit, a business must sell its products until selling one more would generate less revenue than the corresponding expense. Therefore, profit maximization occurs when the marginal cost of the product equals the marginal revenue from its sale.
Executing a profit maximization strategy in the real world is complicated because theory does not necessarily match up with execution. Just because you produce a product and put it on the market does not mean it will sell. Any profit maximization scheme is premised on assumptions that might not be correct. So while you may produce the “correct” number of products according to your calculations, conditions you were not aware of at the time you made your estimate may prevent those goods from being sold. However, you still incurred expenses making the products that ultimately did not sell. Therefore, striving for profit maximization could lead you to actually decreasing your profits.