The primary goal of most companies is to maximize profit. While non-profit organizations may instead be striving to maximize the services they provide, their existence is nonetheless conditional on revenues being able to cover their costs. In either case, the organization’s objective is dependent on the relationship between revenues and costs and increasing that difference makes for a more successful organization. In the following examples, we will focus on Profits as an organization’s objective for simplicity and consistency. However, the ideas naturally extend to other objectives such as maximizing service provision.

In order to develop successful strategies for maximizing profit, it is useful to break profit down into its most basic elements.

For any business, profits follow this straightforward relationship:


Revenues are the amount that a company earns for selling its products or services and costs are defined as the amount of money required to create those products and services.

The profit equation can also be written as:


We call this basic relationship the profit function. As the foundation of our strategic analysis, it comes up over and over again so we often abbreviate it as follows:


You can think of the (P – C) as the profit margin – it describes how much money the company makes on each product that it sells.

To illustrate how the profit function applies to a real business, let’s look at the example of Key Fire Hose, a company that produces high quality fire hoses for customers around the world.

The German-based company energy & meteo systems is one of the technological leaders in the areas of energy meteorology and wind power prediction. The company has a variety of costs, including: rent, advertising, cloud computing services with a “pay-as-you-go” pricing model, employee compensation, the cost of programming the core algorithm for their prediction technology, advertising (fixed fees for campaigns or payment based on click rate), and the cost of customizing solutions for individual customers. They also need to pay for data from different locations around the globe, which may have different types of payment models.

As you have discovered, cost is typically the most complicated element of the profit function because you need to deal with both fixed and variable costs. Based on what you have learned, sort the list of expenses below for energy & meteo systems into items that are fixed costs, items that are variable costs, and items that could be fixed or variable.

In the long term everything is variable. When thinking about “fixed costs,” consider items that are fixed on a short term basis. The activity below lists some of energy and meteo’s expenses. Drag and drop all of the expenses into the appropriate categories and then click “Submit” to check your answer.

Drag and drop the costs below into the three categories listed: Submit

In the first section, you learned about how the profit function can be used to think about the organization’s objective.

To use economics as a foundation for strategic thinking, we have to think of customers and their objectives as well. To do so, we bring in one more concept – willingness-to-pay. In this course, we’ll use WTP to represent the maximum amount that a customer is willing to pay for each product or service that a company sells. If you continue to learn about these topics outside of this course, you may also see willingness to pay represented by the letter B, which stands for benefit (as in, the value of the benefit that customers believe they will get by owning the product, which is their willingness to pay).

Now that you have learned the basics of value creation and capture, use the interaction below to see what happens to the consumer surplus, value captured (also known as producer surplus), value created, and quantity when you adjust the price of the product or service by clicking on the slider or the graph below.

Now that you have learned the foundational concepts related to profit, you can start to think about how you can use those concepts to maximize profit.

The basic intuition of the profit function and the Value Creation/Capture Framework suggest two generic strategies that companies can follow to be successful. Cost leadership is a common strategic approach in situations where the competitors in an industry offer products that are very similar in WTP to consumers. Companies that use a cost leadership approach can also be said to have a “low cost competitive advantage.” If a company consistently has lower costs than its competitors, then it can afford to cut prices in an effort to increase (WTP – P), and therefore, quantity sold. If the company’s prices are lower than those of its competitors, it can maintain a price lower than the competitors’ C, but higher than its own C. If a company can’t beat the competition on costs, it still has the opportunity to make profits if its product is more attractive (at least to a subset of consumers) than the alternatives. This is also known as having a perceived quality advantage.

In order to be successful, a company needs to determine which type of strategy they plan to follow. It is necessary to make a choice. Trying to focus equally on lowering cost and increasing willingness to pay through product differentiation may split the company’s strategic focus and impede decision-making.

In this exercise, we consider two industries. For each industry, we will describe two firms and then ask you to describe the firms' strategies using the terms developed above.

The US Food Retailing business consists of a variety of competing formats. "Traditional" supermarkets (such as Kroger and Safeway) hold a 39.2% market share in food retail, but two other supermarket segments, "Fresh format" and "limited assortment," accounted for much larger growth in 2014 than did the "traditional segment".

The retailer Whole Foods is an example of a "fresh format" supermarket.

The consultant Willard Bishop defines the fresh format segment as follows: "Different from supermarkets and natural food stores, fresh stores emphasize perishables and offer center-store assortments that differ from those of traditional retailers—especially in the areas of ethnic, natural, and organic."

Aldi, a German chain that making significant investments in the US market, is an example of a "limited assortment" supermarket. According to Forbes, Aldi is "a control label retail operator, selling primarily, if not entirely, its own privately branded knockoffs of established American foods." Aldi combines this choice with "an equally impressive deletion of conventional supermarket services: