Definition of Profit Planning
Profit planning aims to set a profit objective for a budgeting period. Also, it seeks to establish the main policy decisions regarding how to achieve the objectives. The profit objective will normally be related to the return required on the investment in the business.
In profit planning, alternatives are evaluated to select the most likely option that will yield the required profit objective. Managers can plan their budgets on this basis.
Purpose of Profit Planning
There are several purposes of profit planning, namely:
- To set profit objectives for the budget period
- To specify the policy decisions and course of action to be followed during the budget period
- To give planning directives for the preparation of detailed operating plans
The profit objectives reflect the expected return on capital employed. This depends on:
- The commercial environment during the budget period
- Projected sales of the company
- Past profits
- Maintenance of liquidity
Profit Planning Guidelines
The main factors to specify in profit planning guidelines are:
- Changes needed in volume, price, and cost
- Availability of funds for investment
- Capital expenditure proposals
- Changes needed in the level of working capital
- Limits on discretionary expenditure (e.g., research and development)
Return Required on Capital Employed
After the capital employed has been determined, it is then necessary to specify the required rate of return. Criteria to consider include:
- What return can the company derive from other forms of investment?
- What degree of risk is involved in the company’s activities?
- Do considerations other than profit influence the owners, such as environmental or ethical concerns?
- How do competitors in the same industry sector perform?
- What is the company’s immediate past record?
- What are the expected trading conditions for the period of the profit plan?
The end result of this process is a statement of the profit objective and how it is to be achieved. This statement is the starting point for budgeting.
Profit Planning Techniques
The following chart clearly demonstrates the techniques of profit planning.