© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen

Profitability Analysis

Appendix B

© 2015 McGraw-Hill Education

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

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 3

 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.

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 4

 Learning Objective 1

Compute the profitability

index and use it to select
from among possible actions.

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 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.

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 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.

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 7

 Relative Profitability

Incremental profit from the segment is

the absolute profitability of the segment.

Profitability Incremental profit from the segment

=
index Amount of the constrained
resources required by the segment

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 8

 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

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 9

 Project Profitability Index
From Chapter 14

Project Net present value of the project

profitability =
index 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.
© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 10
 Project Profitability Index
From Chapter 14

Project Net present value of the project

profitability =
index Amount of investment
required by the project

The net present value of the project

goes in the numerator since it represents
the incremental profit from the segment.
© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 11
 Project Profitability Index
From Chapter 14

Project Net present value of the project

profitability =
index Amount of investment
required by the project

The investment funds are the

constraint, so the amount of investment
required by a project goes in the denominator.
© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 12
 Quality Kitchen Design – An Example
Constrained
Incremental Resource
Profit Required Profitability Index
(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

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 13

 Quality Kitchen Design – An Example
Constrained
Incremental Resource
Profit Required Profitability Index
(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 If management
5,680 8 hours 710 per hour
Project E only has
5,330 46 hours available,410
13 hours per hour
Project F which
4,280 projects should 1,070
4 hours per hour
Project G 4,160 13 hours 320 per hour
Project H 3,720
be accepted?
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

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 14

 Ranking Based on Profitability Index
Constrained
Incremental Resource Profitability Cumulative Incremental
Profit Required Index Hours 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
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

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 15

 Ranking Based on Profitability Index
Constrained
Incremental Resource Profitability Cumulative Incremental
Profit Required Index Hours 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
© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 16
 Learning Objective 2

Compute and use the

profitability index in volume
trade-off decisions.

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 17

 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.

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 18

 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.

Profitability index Unit contribution margin

for a volume = Amount of the constrained resource
trade-off decision required by one unit

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 19

 Volume Trade-Off Decisions – An Example
Matrix, Inc. produces the following three products:
Products
RX200 VB30 SQ500
Unit contribution margin $ 15 $ 10 $ 16
Demand per week in units 300 400 100
Contrained resource required per unit 5 minutes 2 minutes 4 minutes

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 20

 Volume Trade-Off Decisions – An Example
Matrix, Inc. produces the following three products:
Products
RX200 VB30 SQ500
Unit contribution margin $ 15 $ 10 $ 16
Demand per week in units 300 400 100
Contrained resource required per unit 5 minutes 2 minutes 4 minutes

Products
RX200 VB30 SQ500
Demand per week in units (a) 300 400 100
Contrained resource required per unit (b) 5 minutes 2 minutes 4 minutes
Total time required to meet demand (a) × (b) 1,500 minutes 800 minutes 400 minutes

A total of 2,700 minutes

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 21
 Volume Trade-Off Decisions – An Example

Matrix, Inc. produces the following three products:

If only 2,200 minutes of machineProducts
constraint
time are available, which products
RX200 VB30should
SQ500
Unit contribution margin $ 15 $ 10 $ 16
Demand per weekbe inproduced
units in what 300
quantities?
400 100
Contrained resource required per unit 5 minutes 2 minutes 4 minutes

Products
RX200 VB30 SQ500
Demand per week in units (a) 300 400 100
Contrained resource required per unit (b) 5 minutes 2 minutes 4 minutes
Total time required to meet demand (a) × (b) 1,500 minutes 800 minutes 400 minutes

A total of 2,700 minutes

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 22
 Volume Trade-Off Decisions – An Example

First we calculate the profitability index for each product.

Products
RX200 VB30 SQ500
Contribution margin per unit (a) $ 15 $ 10 $ 16
Contrained resource required per unit (b) 5 minutes 2 minutes 4 minutes
Profitabiltiy index (a) ÷ (b) $3 per minute $5 per minute $4 per minute

Next most
Most profitable
profitable

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 23

 Volume Trade-Off Decisions – An Example

Next we prepare the optimal production plan.

Total minutes of constrained resource 2,200

Less: Minutes needed to produce 400 VB30 800
Available minutes 1,400
Less: Minutes needed to produce 100 SQ500 400
Available minutes 1,000
Less: Minutes needed to produce 200 RX200 1,000
Full utilization of machine time -

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 24

 Volume Trade-Off Decisions – An Example
Last, we compute the total contribution margin
earned under the optimal production plan.

Products
RX200 VB30 SQ500
Unit contribution margin $ 15 $ 10 $ 16
Production per week in units 200 400 100
Total contribution $ 3,000 $ 4,000 $ 1,600

Maximum contribution is $8,600 per week.

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 25

 Learning Objective 3

Compute and use the

profitability index in other
business decisions.

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 26

 Sales Commissions

Products
RX200 VB30 SQ500
Unit selling price $ 40 $ 30 $ 35
Unit variable cost 25 20 19
Unit contribution margin (a) $ 15 $ 10 $ 16
Contrained resource required per unit (b) 5 minutes 2 minutes 4 minutes
Profitability index per minute (a) ÷ (b) $ 3.00 $ 5.00 $ 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
© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 27
 Sales Commissions

Products
RX200 VB30 SQ500
Unit selling price $ 40 $ 30 $ 35
Unit variable cost 25 20 19
Unit contribution margin (a) $ 15 $ 10 $ 16
Contrained resource required per unit (b) 5 minutes 2 minutes 4 minutes
Profitability index per minute (a) ÷ (b) $ 3.00 $ 5.00 $ 4.00

However, RX200 is the least profitable product,

given the current machine constraint. It might be
a better idea to base sales commissions on the
profitability index for each product.

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 28

 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.

Amount of the
Opportunity cost
Selling price Variable cost constrained
per unit of the
of new ≥ of the new + constrained
× resource required
product product by a unit of the
resource
new product

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 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?

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 30

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

Amount of the
Opportunity cost
Selling price constrained
per unit of the
of new ≥ $30 + constrained
× resource required
product by a unit of the
resource
new product

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 31

 Pricing New Products

The second step is to recognize that producing

WR6000 will require displacing production of
RX200, VB30, or SQ500.

Since RX200 has the lowest profitability index

of $3 per minute it should be displaced first.

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 32

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

Selling price
$3 6
of new ≥ $30 + per × minutes
product
minute per unit

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 33

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

$3 6
$48 ≥ $30 + per × minutes
minute per unit

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 34

 End of Appendix B

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 35