Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Appendix B Profitability Analysis

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Appendix B

Profitability Analysis


B-2

Absolute Profitability

Absolute profitability measures the impact on Absolute profitability measures the impact on the organization’s overall profits of the organization’s overall profits of adding or adding or

droppingdropping a particular segment such as a a particular segment such as a product or customer – without making any product or customer – without making any

other changes.other changes.


B-3

Computing Absolute Profitability

For an Existing SegmentFor an Existing SegmentCompare the revenues that would be lost fromCompare the revenues that would be lost from

dropping that segment to the costs that dropping that segment to the costs that would be avoided.would be avoided.

For an Existing SegmentFor an Existing SegmentCompare the revenues that would be lost fromCompare the revenues that would be lost from

dropping that segment to the costs that dropping that segment to the costs that would be avoided.would be avoided.

For a New SegmentFor a New SegmentCompare the additional revenues from addingCompare the additional revenues from adding

that segment to the costs that would be incurred.that segment to the costs that would be incurred.

For a New SegmentFor a New SegmentCompare the additional revenues from addingCompare the additional revenues from adding

that segment to the costs that would be incurred.that segment to the costs that would be incurred.


B-4

Learning Objective 1

Compute the profitability Compute the profitability index and use it to select index and use it to select

from among possible from among possible actions.actions.


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.


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.


B-7


ProfitabilityIndex

Incremental profit from the segment

Amount of the constrained resources required by the segment

=

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

the absolute profitability of the segment.the absolute profitability of the segment.


B-8

Profitability Index

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

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$


B-9

Project Profitability Index

ProjectProfitability

Index

Net present value of the project

Amount of investmentrequired by the project

=

The project profitability index is usedThe project profitability index is used when a company has more long-term projects when a company has more long-term projects

with positive net present values than it can fund. with positive net present values than it can fund.

The project profitability index is usedThe project profitability index is used when a company has more long-term projects when a company has more long-term projects

with positive net present values than it can fund. with positive net present values than it can fund.

From Chapter 14


B-10



Index



=

The net present value of the projectThe net present value of the project goes in the numerator since it represents goes in the numerator since it represents the incremental profit from the segment. the incremental profit from the segment.

The net present value of the projectThe net present value of the project goes in the numerator since it represents goes in the numerator since it represents the incremental profit from the segment. the incremental profit from the segment.

From Chapter 14


B-11



Index



=

The investment funds are theThe investment funds are theconstraint, so the amount of investmentconstraint, so the amount of investment

required by a project goes in the denominator.required by a project goes in the denominator.

The investment funds are theThe investment funds are theconstraint, so the amount of investmentconstraint, so the amount of investment

required by a project goes in the denominator.required by a project goes in the denominator.

From Chapter 14


B-12

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


B-13

Incremental

Profit


(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 managementIf managementonly has 46 hours available,only has 46 hours available,

which projects shouldwhich projects should be accepted? be accepted?


B-14

Ranking Based on Profitability Index

Incremental

Profit


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

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


B-15

Ranking Based on Profitability Index

Incremental

Profit


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 profitThe optimal profitThe optimal profitThe optimal profit


B-16


Compute and use the Compute and use the profitability index in profitability index in

volume trade-off volume trade-off decisions.decisions.


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.




B-18

Volume Trade-Off Decisions

Profitability indexProfitability indexfor a volumefor a volume

trade-off decisiontrade-off decision

Unit contribution marginUnit contribution marginAmount of the constrained resourceAmount of the constrained resource

required by one unitrequired by one unit=






B-19

Volume Trade-Off Decisions – Example

Matrix, Inc. produces the following three products:

RX200 VB30 SQ500Unit 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


B-20




Products

RX200 VB30 SQ500Demand per week in units (a) 300 400 100 Contrained resource required per unit (b) 5 minutes 2 minutes 4 minutesTotal time required to meet demand (a) × (b) 1,500 minutes 800 minutes 400 minutes

Products

A total of 2,700 minutes


B-21




Products

RX200 VB30 SQ500Demand per week in units (a) 300 400 100 Contrained resource required per unit (b) 5 minutes 2 minutes 4 minutesTotal time required to meet demand (a) × (b) 1,500 minutes 800 minutes 400 minutes

Products

A total of 2,700 minutes

If only 2,200 minutes of machine constraintIf only 2,200 minutes of machine constrainttime are available, which products shouldtime are available, which products should

be produced in what quantities?be produced in what quantities?


B-22

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

RX200 VB30 SQ500Contribution margin per unit (a) 15$ 10$ 16$ Contrained resource required per unit (b) 5 minutes 2 minutes 4 minutesProfitabiltiy index (a) ÷ (b) $3 per minute $5 per minute $4 per minute

Products

Most profitableMost profitableMost profitableMost profitableNext mostNext mostprofitableprofitableNext mostNext mostprofitableprofitable



B-23

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 -

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 -


Next we prepare the optimal production plan. Next we prepare the optimal production plan.


B-24

RX200 VB30 SQ500Unit contribution margin 15$ 10$ 16$ Production per week in units 200 400 100 Total contribution 3,000$ 4,000$ 1,600$

Products

Maximum contribution is $8,600 per week.Maximum contribution is $8,600 per week.Maximum contribution is $8,600 per week.Maximum contribution is $8,600 per week.


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

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


B-25


Compute and use the Compute and use the profitability index in other profitability index in other

business decisions.business decisions.


B-26

Sales Commissions

RX200 VB30 SQ500Unit 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 minutesProfitability index per minute (a) ÷ (b) 3.00$ 5.00$ 4.00$

Products

Sales commissions are based on gross selling price. If you were a salesperson at Matrix,

which product would you prefer to sell?

RX200RX200


B-27

Sales Commissions

RX200 VB30 SQ500Unit 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 minutesProfitability index per minute (a) ÷ (b) 3.00$ 5.00$ 4.00$

Products

However, RX200 is the least profitable product,given the current machine constraint. It might bea better idea to base sales commissions on the

profitability index for each product.

However, RX200 is the least profitable product,given the current machine constraint. It might bea better idea to base sales commissions on the

profitability index for each product.


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 priceof newproduct


Variable costof the new

product

Variable costof the new

product

Opportunity costper unit of theconstrained

resource


resource

Amount of theconstrained

resource requiredby a unit of the

new product



new product

≥≥≥≥ ++++ ××××


B-29


Matrix, Inc. is planning to introduce a new product – Matrix, Inc. is planning to introduce a new product – WR6000. The variable cost of production is $30 per WR6000. The variable cost of production is $30 per

unit and requires six minutes of constrained machine unit and requires six minutes of constrained machine time per unit.time per unit.

What is the minimum selling price Matrix should What is the minimum selling price Matrix should charge for product WR6000?charge for product WR6000?

Matrix, Inc. is planning to introduce a new product – Matrix, Inc. is planning to introduce a new product – WR6000. The variable cost of production is $30 per WR6000. The variable cost of production is $30 per

unit and requires six minutes of constrained machine unit and requires six minutes of constrained machine time per unit.time per unit.

What is the minimum selling price Matrix should What is the minimum selling price Matrix should charge for product WR6000?charge for product WR6000?


B-30




$30$30Opportunity cost

per unit of theconstrained

resource


resource



new product



new product

≥≥≥≥ ++++ ××××

The first step is to recognize that the price ofWR6000 must cover its $30 variable cost per unit.

The first step is to recognize that the price ofWR6000 must cover its $30 variable cost per unit.


B-31


The second step is to recognize that producing WR6000 will require displacing production of

RX200, VB30, or SQ500.

The second step is to recognize that producing WR6000 will require displacing production of

RX200, VB30, or SQ500.

Since RX200 has the lowest profitability indexof $3 per minute it should be displaced first.

Since RX200 has the lowest profitability indexof $3 per minute it should be displaced first.


B-32




$30$30≥≥≥≥ ++++ ××××

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

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

$3per

minute

$3per

minute

6minutesper unit

6minutesper unit


B-33


$30$30≥≥≥≥ ++++ ××××

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).

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).

$3per

minute

$3per

minute

6minutesper unit

6minutesper unit

$48$48


B-34

End of Appendix B

Documents

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Appendix B Profitability Analysis