Profitability Analysis: Appendix B

Profitability Analysis
Appendix B
McGrawHill/Irwin
Copyright2008,TheMcGrawHillCompanies,Inc.
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.
McGrawHill/Irwin
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
B-4
Learning Objective 1
Compute the profitability

index and use it to select
from among possible
actions.
McGrawHill/Irwin
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.
McGrawHill/Irwin
B-6
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.
McGrawHill/Irwin
B-7
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
McGrawHill/Irwin
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
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.
McGrawHill/Irwin
B-10

From Chapter 14
Project
Profitability
Index

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.
McGrawHill/Irwin
B-11

From Chapter 14
Project
Profitability
Index

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.
McGrawHill/Irwin
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
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
McGrawHill/Irwin
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
B-15
Ranking Based on Profitability Index
The optimal profit

McGrawHill/Irwin
B-16
Compute and use the

profitability index in
volume trade-off decisions.
McGrawHill/Irwin
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.
McGrawHill/Irwin
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
B-19
Volume Trade-Off Decisions Example

Matrix, Inc. produces the following three products:
McGrawHill/Irwin
B-20

A total of 2,700 minutes

McGrawHill/Irwin
B-21

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

McGrawHill/Irwin
B-22

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
B-23

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
--
B-24

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.
McGrawHill/Irwin
B-25
Compute and use the

profitability index in other
business decisions.
McGrawHill/Irwin
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
McGrawHill/Irwin
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.
McGrawHill/Irwin
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
McGrawHill/Irwin
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
B-29
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?
McGrawHill/Irwin
B-30

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
B-31

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.
McGrawHill/Irwin
B-32
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
B-33
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
B-34
McGrawHill/Irwin
End of Appendix B

Profitability Analysis: Appendix B

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Profitability Analysis: Appendix B

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Profitability Analysis

Computing Absolute Profitability

Compute the profitability

Incremental profit from the segment

Amount of constrained resource required

Project Profitability Index

Net present value of the project

Project Profitability Index

Net present value of the project

Project Profitability Index

Net present value of the project

Quality Kitchen Design: An Example

800 per hour

440 per hour

710 per hour

410 per hour

1,070 per hour

320 per hour

310 per hour

730 per hour

980 per hour

540 per hour

Quality Kitchen Design: An Example

800 per hour

440 per hour

540 per hour

730 per hour

980 per hour

Ranking Based on Profitability Index

Ranking Based on Profitability Index

The optimal profit

Compute and use the

Volume Trade-Off Decisions

Volume Trade-Off Decisions

Unit contribution margin

Volume Trade-Off Decisions Example

Volume Trade-Off Decisions Example

A total of 2,700 minutes

Volume Trade-Off Decisions Example

A total of 2,700 minutes

Volume Trade-Off Decisions Example

Volume Trade-Off Decisions Example

Volume Trade-Off Decisions Example

Unit contribution margin

Compute and use the

Sales commissions are based on gross selling

Pricing New Products

Pricing New Products

Matrix, Inc. is planning to introduce a new product

Pricing New Products

Pricing New Products

Pricing New Products

Pricing New Products

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