Profitability Analysis

Appendix B
McGraw-Hill/Irwin
Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
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.
App B-2
Computing Absolute Profitability
For an Existing Segment
Compare the revenues that would be lost from
dropping that segment to the costs that
would be avoided.
For a New Segment
Compare the additional revenues from adding
that segment to the costs that would be incurred.
App B-3
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.
App B-4
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.
App B-5
Relative Profitability
Profitability
index
Incremental profit from the segment
Amount of the constrained
resources required by the segment
=
Incremental profit from the segment is
the absolute profitability of the segment.
App B-6
Profitability Index
Management of Matrix, Inc. developed the following
information concerning its two segments:
Segment A Segment B
Incremental profit $ 100,000 $ 200,000
Amount of constrained resource required 100 hours 400 hours
Segment A Segment B
Incremental profit $ 100,000 $ 200,000
Amount of constrained resource required 100 hours 400 hours
Profitability index 1,000 $ 500 $
App B-7
Project Profitability Index
Project
profitability
index
Net present value of the project
Amount of investment
required by the project
=
The project profitability index is used
when a company has more long-term projects
with positive net present values than it can fund.
From Chapter 14
App B-8
Project Profitability Index
The net present value of the project
goes in the numerator since it represents
the incremental profit from the segment.
Project
profitability
index
Net present value of the project
Amount of investment
required by the project
=
From Chapter 14
App B-9
Project Profitability Index
The investment funds are the
constraint, so the amount of investment
required by a project goes in the denominator.
Project
profitability
index
Net present value of the project
Amount of investment
required by the project
=
From Chapter 14
App B-10

Incremental
Profit
Constrained
Resource
Required
(a) (b) (a) (b)
Project A 9,180 $ 17 hours 540 $ per hour
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 980 per hour
100 hours
Profitability Index
Quality Kitchen Design An Example
App B-11

Incremental
Profit
Constrained
Resource
Required
(a) (b) (a) (b)
Project A 9,180 $ 17 hours 540 $ per hour
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 980 per hour
100 hours
Profitability Index
Quality Kitchen Design An Example
If management
only has 46 hours available,
which projects should
be accepted?
App B-12
Ranking Based on Profitability Index

Incremental
Profit
Constrained
Resource
Required
Profitability
Index
Cumulative
Hours
Incremental
Profit
(a) (b) (a) (b)
Project F 4,280 $ 4 hours 1,070 $ 4 hours 4,280 $
Project J 2,940 3 hours 980 7 hours 2,940
Project B 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 32,930 $
Project E 5,330 13 hours 410 75 hours
Project G 4,160 13 hours 320 88 hours
Project H 3,720 12 hours 310 100 hours
100 hours
The optimal profit
App B-13
Volume Trade-Off Decisions
Volume trade-off decisions need to be made
when a company must produce less than the
market demands for some products due to the
existence of a constraint.
App B-14
Volume Trade-Off Decisions
Profitability index
for a volume
trade-off decision
Unit contribution margin
Amount of the constrained resource
required by one unit
=
Volume trade-off decisions need to be made
when a company must produce less than the
market demands for some products due to the
existence of a constraint.
App B-15
Pricing New Products
The price of a new product should at least cover
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
Variable cost
of the new
product
Opportunity cost
per unit of the
constrained
resource
Amount of the
constrained
resource required
by a unit of the
new product
+
App B-16
End of Appendix B
App B-17