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 organization’s 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 For an an Existing Existing Segment Segment Compare Compare the the revenues revenues that would be that would 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 segment to to the the costs be incurred that segment costs that that would 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 Managers are are interested interested in in ranking ranking segments segments ifif aa constraint constraint forces forces them to make trade-offs trade-offs among among segments segments In the the absence absence of aa constraint, all all segments segments that that are are absolutely absolutely profitable profitable should should be be pursued pursued App B-5 Relative Profitability 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 App B-6 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 100,000 100 hours $ 1,000 200,000 400 hours $ 500 App B-7 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 App B-8 Project Profitability Index From Chapter 14 Project profitability index = Net present value of the project Amount of investment required by the project The The net net present value of present value of the the project project goes goes in in the since itit represents represents the numerator numerator since the the incremental incremental profit profit from from the the segment segment App 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 investment investment funds funds are are the the constraint, constraint, so amount of of investment investment so the the amount required required by project goes in the the denominator by aa project goes in denominator App B-10 Quality Kitchen Design – An Example Project A Incremental Profit Constrained Resource Required (a) (b) $ Profitability Index (a) ÷ (b) 9,180 17 hours $ 540 per hour Project B 7,200 hours 800 per hour Project C 7,040 16 hours 440 per hour Project D 5,680 hours 710 per hour Project E 5,330 13 hours 410 per hour Project F 4,280 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 hours 730 per hour Project J 2,940 hours 100 hours 980 per hour App B-11 Quality Kitchen Design – An Example Project A Incremental Profit Constrained Resource Required (a) (b) (a) ÷ (b) 9,180 17 hours Project B 7,200 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 hours 710 only has available,410 5,330 46 hours 13 hours 4,280 projects 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 hours 730 per hour Project J 2,940 hours 100 hours 980 per hour App B-12 Ranking Based on Profitability Index The optimal profit App B-13 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 some some products products due due to to the the existence existence of a constraint App B-14 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 some some products products due due to to the the existence existence of a constraint Profitability index for a volume = trade-off decision Unit contribution margin Amount of the constrained resource required by one unit 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 Amount of the Opportunity cost constrained per unit of the × resource required constrained by a unit of the resource new product App B-16 End of Appendix B App B-17 ... investment required by the project The The investment investment funds funds are are the the constraint, constraint, so amount of of investment investment so the the amount required required by project... 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... 14 Project profitability index = Net present value of the project Amount of investment required by the project The The net net present value of present value of the the project project goes goes