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Profitability Analysis

Appendix B

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B-2

Absolute Profitability
Absolute profitability measures the impact on
the organizations overall profits of adding or
dropping a particular segment such as a
product or customer without making any
other changes.

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B-3

Computing Absolute Profitability


For
For an
an Existing
Existing Segment
Segment
Compare
Compare the
the revenues
revenues that
that would
would be
be lost
lost from
from
dropping
dropping that
that segment
segment to
to the
the costs
costs that
that
would
would be
be avoided.
avoided.
For
For aa New
New Segment
Segment
Compare
Compare the
the additional
additional revenues
revenues from
from adding
adding
that
that segment
segment to
to the
the costs
costs that
that would
would be
be incurred.
incurred.

McGrawHill/Irwin

Copyright2008,TheMcGrawHillCompanies,Inc.

B-4

Learning Objective 1

Compute the profitability


index and use it to select
from among possible
actions.

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B-5

Relative Profitability
Relative profitability is concerned with ranking
products, customers, and other business segments
to determine which should be emphasized in an
environment of scarce resources.

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B-6

Relative Profitability
Managers are interested in ranking segments if a
constraint forces them to make trade-offs among
segments.
In the absence of a constraint, all segments that are
absolutely profitable should be pursued.

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B-7

Relative Profitability

Incremental
Incremental profit
profit from
from the
the segment
segment is
is
the
the absolute
absolute profitability
profitability of
of the
the segment.
segment.

Incremental profit from the segment


Profitability
=
Index
Amount of the constrained
resources required by the segment

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B-8

Profitability Index
Management
Management of
of Matrix,
Matrix, Inc.
Inc. developed
developed the
the following
following
information
information concerning
concerning its
its two
two segments:
segments:

Incremental profit

Segment A

Segment B

Amount of constrained resource required


Profitability index

McGrawHill/Irwin

100,000
100 hours

1,000

200,000
400 hours

500

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B-9

Project Profitability Index


From Chapter 14
Project
Profitability
Index

Net present value of the project


Amount of investment
required by the project

The
The project
project profitability
profitability index
index is
is used
used
when
when aa company
company has
has more
more long-term
long-term projects
projects
with
with positive
positive net
net present
present values
values than
than itit can
can fund.
fund.
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B-10

Project Profitability Index


From Chapter 14
Project
Profitability
Index

Net present value of the project


Amount of investment
required by the project

The
The net
net present
present value
value of
of the
the project
project
goes
goes in
in the
the numerator
numerator since
since itit represents
represents
the
the incremental
incremental profit
profit from
from the
the segment.
segment.
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Copyright2008,TheMcGrawHillCompanies,Inc.

B-11

Project Profitability Index


From Chapter 14
Project
Profitability
Index

Net present value of the project


Amount of investment
required by the project

The
The investment
investment funds
funds are
are the
the
constraint,
constraint, so
so the
the amount
amount of
of investment
investment
required
required by
by aa project
project goes
goes in
in the
the denominator.
denominator.
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B-12

Quality Kitchen Design: An Example

Project A

Incremental
Profit

Constrained
Resource
Required

(a)

(b)

(a) (b)

9,180

17 hours

Project B

7,200

9 hours

800 per hour

Project C

7,040

16 hours

440 per hour

Project D

5,680

8 hours

710 per hour

Project E

5,330

13 hours

410 per hour

Project F

4,280

4 hours

1,070 per hour

Project G

4,160

13 hours

320 per hour

Project H

3,720

12 hours

310 per hour

Project I

3,650

5 hours

730 per hour

Project J

2,940

3 hours
100 hours

980 per hour

McGrawHill/Irwin

Profitability Index
$

540 per hour

Copyright2008,TheMcGrawHillCompanies,Inc.

B-13

Quality Kitchen Design: An Example

Project A

Incremental
Profit

Constrained
Resource
Required

(a)

(b)

(a) (b)

9,180

17 hours

Project B

7,200

9 hours

800 per hour

Project C

7,040

16 hours

440 per hour

Project D
Project E
Project F
Project G
Project H

Profitability Index
$

540 per hour

If management
8 hours
710
only has
available,410
5,330 46 hours
13 hours
4,280 projects
4 hours
which
should 1,070
4,160
13 hours
320
be
accepted?
3,720
12 hours
310
5,680

per hour
per hour
per hour
per hour
per hour

Project I

3,650

5 hours

730 per hour

Project J

2,940

3 hours
100 hours

980 per hour

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B-14

Ranking Based on Profitability Index

Project F

Incremental
Profit

Constrained
Resource
Required

Profitability
Index

(a)

(b)

(a) (b)

4,280

4 hours

Project J

2,940

Project B

Incremental
Profit

1,070

4 hours

3 hours

980

7 hours

2,940

7,200

9 hours

800

16 hours

7,200

Project I

3,650

5 hours

730

21 hours

3,650

Project D

5,680

8 hours

710

29 hours

5,680

Project A

9,180

17 hours

540

46 hours

9,180

Project C

7,040

16 hours

440

62 hours

Project E

5,330

13 hours

410

75 hours

Project G

4,160

13 hours

320

88 hours

Project H

3,720

12 hours
100 hours

310

100 hours

McGrawHill/Irwin

Cumulative
Hours

4,280

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B-15

Ranking Based on Profitability Index

The optimal profit


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B-16

Learning Objective 2

Compute and use the


profitability index in
volume trade-off decisions.

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B-17

Volume Trade-Off Decisions


Volume
Volume trade-off
trade-off decisions
decisions need
need to
to be
be made
made
when
when aa company
company must
must produce
produce less
less than
than the
the
market
market demands
demands for
for some
some products
products due
due to
to the
the
existence
existence of
of aa constraint.
constraint.

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Copyright2008,TheMcGrawHillCompanies,Inc.

B-18

Volume Trade-Off Decisions


Volume
Volume trade-off
trade-off decisions
decisions need
need to
to be
be made
made
when
when aa company
company must
must produce
produce less
less than
than the
the
market
market demands
demands for
for some
some products
products due
due to
to the
the
existence
existence of
of aa constraint.
constraint.

Profitability index
for a volume =
trade-off decision

McGrawHill/Irwin

Unit contribution margin


Amount of the constrained resource
required by one unit

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B-19

Volume Trade-Off Decisions Example


Matrix, Inc. produces the following three products:

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B-20

Volume Trade-Off Decisions Example


Matrix, Inc. produces the following three products:

A total of 2,700 minutes


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B-21

Volume Trade-Off Decisions Example


Matrix, Inc. produces the following three products:
If only 2,200 minutes of machine constraint
time are available, which products should
be produced in what quantities?

A total of 2,700 minutes


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B-22

Volume Trade-Off Decisions Example


First
First we
we calculate
calculate the
the profitability
profitability index
index for
for each
each product.
product.

Most profitable

McGrawHill/Irwin

Next most
profitable

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B-23

Volume Trade-Off Decisions Example


Next
Next we
we prepare
prepare the
the optimal
optimal production
production plan.
plan.
Total
Total minutes
minutesof
of constrained
constrained resource
resource
Less:
Less: Minutes
Minutesneeded
needed to
to produce
produce 400
400 VB30
VB30
Available
Available minutes
minutes
Less:
Less: Minutes
Minutesneeded
needed to
to produce
produce 100
100 SQ500
SQ500
Available
Available minutes
minutes
Less:
Less: Minutes
Minutesneeded
needed to
to produce
produce 200
200 RX200
RX200
Full
Full utilization
utilization of
of machine
machine time
time

McGrawHill/Irwin

2,200
2,200
800
800
1,400
1,400
400
400
1,000
1,000
1,000
1,000
--

Copyright2008,TheMcGrawHillCompanies,Inc.

B-24

Volume Trade-Off Decisions Example


Last,
Last, we
we compute
compute the
the total
total contribution
contribution margin
margin
earned
earned under
under the
the optimal
optimal production
production plan.
plan.

Unit contribution margin


Production per week in units
Total contribution

RX200
$
15
200
$ 3,000

Products
VB30
$
10
400
$ 4,000

SQ500
$
16
100
$ 1,600

Maximum
Maximum contribution
contribution is
is $8,600
$8,600 per
per week.
week.
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B-25

Learning Objective 3

Compute and use the


profitability index in other
business decisions.

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B-26

Sales Commissions

RX200
Unit selling price
$
40
Unit variable cost
25
Unit contribution margin (a)
$
15
Contrained resource required per unit (b) 5 minutes
Profitability index per minute (a) (b)
$
3.00

Products
VB30
$
30
20
$
10
2 minutes
$
5.00

SQ500
$
35
19
$
16
4 minutes
$
4.00

Sales commissions are based on gross selling


price. If you were a salesperson at Matrix,
which product would you prefer to sell?
RX200
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B-27

Sales Commissions

RX200
Unit selling price
$
40
Unit variable cost
25
Unit contribution margin (a)
$
15
Contrained resource required per unit (b) 5 minutes
Profitability index per minute (a) (b)
$
3.00

Products
VB30
$
30
20
$
10
2 minutes
$
5.00

SQ500
$
35
19
$
16
4 minutes
$
4.00

However,
However, RX200
RX200 is
is the
the least
least profitable
profitable product,
product,
given
given the
the current
current machine
machine constraint.
constraint. ItIt might
might be
be
aa better
better idea
idea to
to base
base sales
sales commissions
commissions on
on the
the
profitability
profitability index
index for
for each
each product.
product.
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B-28

Pricing New Products


The price of a new product should cover at least
the variable cost of producing it plus the
opportunity cost of displacing the production of
existing products to make it.

Selling price
of new
product

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Variable cost
of the new +
product

Amount of the
Opportunity cost
constrained
per unit of the
resource required
constrained
by a unit of the
resource
new product

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B-29

Pricing New Products

Matrix, Inc. is planning to introduce a new product


WR6000. The variable cost of production is $30 per
unit and requires six minutes of constrained machine
time per unit.
What is the minimum selling price Matrix should
charge for product WR6000?

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B-30

Pricing New Products


The
The first
first step
step is
is to
to recognize
recognize that
that the
the price
price of
of
WR6000
WR6000 must
must cover
cover its
its $30
$30 variable
variable cost
cost per
per unit.
unit.

Selling price
of new
product

McGrawHill/Irwin

$30

Amount of the
Opportunity cost
constrained
per unit of the
resource required
constrained
by a unit of the
resource
new product

Copyright2008,TheMcGrawHillCompanies,Inc.

B-31

Pricing New Products


The
The second
second step
step is
is to
to recognize
recognize that
that producing
producing
WR6000
WR6000 will
will require
require displacing
displacing production
production of
of
RX200,
RX200, VB30,
VB30, or
or SQ500.
SQ500.
Since
Since RX200
RX200 has
has the
the lowest
lowest profitability
profitability index
index
of
of $3
$3 per
per minute
minute itit should
should be
be displaced
displaced first.
first.

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B-32

Pricing New Products

The
The third
third step
step is
is to
to compute
compute the
the opportunity
opportunity cost
cost per
per unit
unit
associated
associated with
with displacing
displacing production
production of
of RX200
RX200 ($18
($18 per
per unit).
unit).

Selling price
of new
product

McGrawHill/Irwin

$30

$3
per
minute

6
minutes
per unit

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B-33

Pricing New Products

The
The fourth
fourth step
step is
is to
to add
add the
the variable
variable cost
cost per
per unit
unit ($30)
($30) to
to the
the
opportunity
opportunity cost
cost per
per unit
unit ($18)
($18) to
to arrive
arrive at
at the
the minimum
minimum selling
selling
price
price ($48).
($48).

$48

McGrawHill/Irwin

$30

$3
per
minute

6
minutes
per unit

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B-34

McGrawHill/Irwin

End of Appendix B

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