Profitability Analysis
Appendix B
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B-2
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.
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B-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.
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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 profit from the segment is
the absolute profitability of the 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 of Matrix, Inc. developed the following
information concerning its two segments:
Segment A
Incremental profit
$
Amount of constrained resource required
Incremental profit
McGraw-Hill/Irwin
100,000
$ 200,000
100 hours
400 hours
Segment A
Segment B
$
$
Amount of constrained resource required
Profitability index
Segment B
100,000
100 hours
$
1,000
200,000
400 hours
$
500
Copyright © 2008, The McGraw-Hill Companies, Inc.
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 project profitability index is used
when a company has more long-term projects
with positive net present values than it can 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 net present value of the project
goes in the numerator since it represents
the incremental profit from the segment.
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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 investment funds are the
constraint, so the amount of investment
required by a project goes in the 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
McGraw-Hill/Irwin
$
Profitability Index
$
540 per hour
Copyright © 2008, The McGraw-Hill Companies, 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?
5,680
per hour
per hour
per hour
per hour
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
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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
McGraw-Hill/Irwin
$
Cumulative
Hours
$
4,280
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B-15
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
$
Cumulative
Hours
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
Project C
9,180
7,040
17 hours
16 hours
540
440
46 hours
62 hours
9,180
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
100 hours
310
100 hours
$
4,280
The optimal profit
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Copyright © 2008, The McGraw-Hill Companies, Inc.
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 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.
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B-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
for a volume =
trade-off decision
McGraw-Hill/Irwin
Unit contribution margin
Amount of the constrained resource
required by one unit
Copyright © 2008, The McGraw-Hill Companies, Inc.
B-19
Volume Trade-Off Decisions – Example
Matrix, Inc. produces the following three products:
Unit contribution margin
Demand per week in units
Contrained resource required per unit
McGraw-Hill/Irwin
RX200
$
15
300
5 minutes
Products
VB30
$
10
400
2 minutes
SQ500
$
16
100
4 minutes
Copyright © 2008, The McGraw-Hill Companies, Inc.
B-20
Volume Trade-Off Decisions – Example
Matrix, Inc. produces the following three products:
Unit contribution margin
Demand per week in units
Contrained resource required per unit
RX200
$
15
300
5 minutes
RX200
Demand per week in units (a)
Contrained resource required per unit (b)
Total time required to meet demand (a) × (b)
300
5 minutes
1,500 minutes
Products
VB30
$
10
400
2 minutes
Products
VB30
400
2 minutes
800 minutes
SQ500
$
16
100
4 minutes
SQ500
100
4 minutes
400 minutes
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 machineProducts
constraint
RX200
VB30
time are available, which
products
shouldSQ500
Unit contribution margin
$
15
$
10
$
16
be
produced
in
what
quantities?
Demand per week in units
300
400
100
Contrained resource required per unit
5 minutes
RX200
Demand per week in units (a)
Contrained resource required per unit (b)
Total time required to meet demand (a) × (b)
300
5 minutes
1,500 minutes
2 minutes
Products
VB30
400
2 minutes
800 minutes
4 minutes
SQ500
100
4 minutes
400 minutes
A total of 2,700 minutes
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B-22
Volume Trade-Off Decisions – Example
First we calculate the profitability index for each product.
Products
VB30
RX200
Contribution margin per unit (a)
Contrained resource required per unit (b)
Profitabiltiy index (a) ÷ (b)
$
15
5 minutes
$3 per minute
$
10
2 minutes
$5 per minute
Most profitable
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SQ500
$
16
4 minutes
$4 per minute
Next most
profitable
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B-23
Volume Trade-Off Decisions – Example
Next we prepare the optimal production plan.
Total minutes of constrained resource
Less: Minutes needed to produce 400 VB30
Available minutes
Less: Minutes needed to produce 100 SQ500
Available minutes
Less: Minutes needed to produce 200 RX200
Full utilization of machine time
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2,200
800
1,400
400
1,000
1,000
-
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B-24
Volume Trade-Off Decisions – Example
Last, we compute the total contribution margin
earned under the optimal production 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 contribution is $8,600 per 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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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, 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.
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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
McGraw-Hill/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
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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 first step is to recognize that the price of
WR6000 must cover its $30 variable cost per unit.
Selling price
of new
product
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≥
$30
+
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-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.
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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
of new
product
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≥
$30
+
$3
per
minute
×
6
minutes
per unit
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B-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).
$48
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≥
$30
+
$3
per
minute
×
6
minutes
per unit
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B-34
End of Appendix B
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