Causal link between business expansion and profit

Question

I'm working on a conceptual model regarding a restaurant business looking to expand (by adding more restaurants).

In that model, there are several variables which lead to lowering costs or increasing revenue when running a restaurant business. One way or the other, they contribute to increase profit, which is the ultimate goal.

In that model, I also have an "Expansion" box that I set as an independent module. I consider it as a side process that isn't a consequence of "Profit". Instead I see it as contributing to lowering costs and/or increasing revenues (and therefore is a potential cause of profit).

My teacher argues that there should be a link going from Profit (cause) to Expansion (consequence) and I argue there shouldn't be one.

According to you, who is right?

Here is my thinking:

I believe that this connection which considers that an Expansion can only happen if there is Profit first is a matter of opinion, not a fact. Because Profit is a sufficient condition to Expansion, true, but not a necessary one.

Indeed, there are many factors that are favorable to an expansion and profit is only one of them. It seems to me a company which has a negative profit, at a moment in time, that isn't structural but rather environmental could very well benefit from expanding in certain circumstances, depending on many factors. And therefore the causal link that goes from profit to expansion is arbitrary, not necessary. Which makes the decision making more of an art form rather than a mechanical response.

The more I think about it, the more it seems that it's the same political debate than the one regarding austerity policies Vs Stimulus policies. Some think that one should be profitable to invest while others think one should invest to become profitable. No one is right or wrong, unless they want to establish their opinion as a fact. It all depends on circumstances.

Am I totally off?

If profit = Revenue - costs, can't we consider that an expansion can correct a lack of profit by increasing revenue and/or lowering costs but doesn't require profitability to begin with?

I don't argue the fact that it makes more sense and that it is less risky to expand once a company makes profit. I argue that it is not a necessity we can establish as a fact on a theoretical model since expansion can, sometimes, be a tool to correct a lack of profitability. Therefore, profitability isn't necessarily a pre-requisite to expansion. So, to me that connection isn't strictly required.

Any thoughts so that I know if I'm completely off the rails? Of course, I don't want to challenge my teacher for the sake of it. He certainly knows better. I just want to understand because I need to elaborate further on this connexion on paper but I can't if I don't get it first.

Thanks.

Answer 1

No you are not off. Expanding first to eventually become profitable is what happens often with large projects, where there is the capital to cover the operational losses during the initial expansion.

Other vocabulary is "gaining market share first, then make a profit", "price dumping" (sell at a loss to attract customers, etc.

Answer 2

As pointed by other answer your thinking is not totally wrong. This being said, I think what your professor is trying to warn you about is potential for reverse causality. There is a rich literature showing that managers often exhibit empire building behavior. Managers often want to leave some legacy behind and as a result they might expand the firm size beyond what is optimal from the shareholder perspective.

In such case profit may actually also cause expansion, since managers in firms with higher levels of profit presumably can more afford to 'empire build'. Moreover, in such case profitability will be a pre-requisite for expansion.

Of course, if you are building theoretical model it is fine to abstract away from such issues as empire building and just assume no behavioral elements or principal agent problems. Nonetheless you should probably discuss this more with your supervisor. Maybe your supervisor expects you to build more nuanced model. It is very important to have clear and honest communication with your supervisor so you know what your supervisor expects from you.

Answer 3

I agree with you that in some cases firms expand first and then expect to gain profit. For example, Coursera expanded quite quickly during the pandemic (in terms of course offerings, number of employees, revenues etc.), though, they were not making positive profits during the time, as their costs were also high. They view this as an investment and a strategy to capture market share to gain better profits in the future, similar to the idea that Alecos Papadopoulos also mentioned. In other cases, large restaurant/supermarket chains can open up new locations just to deter the entry from competing restaurants/supermarkets, although this may reduce profits at the beginning (as new locations need to be invested), but later they will be able to benefit from this.

Though, I also would like to point out that profit can lead to expansion too. In some cases, small restaunrant owners may not have so much funds to open up new locations and expand when gaining negative profits. They may also be uncertain about their demand - if profits during their initial operating period is too low, they may be bankrupted or learned that the demand is low, and decide to drop out from the market. If profits during their initial operating period high, they may learn that their demand is high, and have more funds to expand.

Therefore, I am thinking that which direction of the causal link should go depends on the context. For example, it may be more applicable for small restaurant owners to open up new locations after they gain more profits from existing ones. But for restaurant chains, they may already have enough funds/external investors to bear the initial cost of expansion, which enables restaurant chanins expand to gain more profits in the future.